On a recent occasion, I was discussing the Roth IRA conversion strategy with a long-time friend who told me that he converted his IRA to a Roth IRA years ago, and furthermore, he spread the income from the conversion over four years to reduce his tax bite. My friend was referring to the one-time opportunity to do a Roth IRA conversion in 1998 and spread the income from the conversion over four years starting with 1998 provided that your modified adjusted gross income was less than $100,000.
I knew that, in addition to his Roth IRA, my friend, who is an employee of his closely-held corporation, had another type of retirement plan. When I questioned him about this, he told me that he also has a SEP-IRA account into which he makes contributions every year. I asked him if he was aware that he could convert a portion, or all, of his SEP-IRA to a Roth IRA and he told me he didn’t know he could do this.
My friend is not alone. Some of you may have noticed in last week’s blog post, The 45 to 60 5-Year Roth IRA Conversion Strategy – Part 4 that a SEP-IRA was used in the hypothetical Roth IRA conversion strategy spreadsheet and may have wondered about the ability to use a SEP-IRA to do a Roth IRA conversion.
When you hear about doing a Roth IRA conversion, most people immediately think about using a traditional IRA account into which you made, or are still making, deductible and/or nondeductible contributions, the maximum contribution limits of which began at $1,500 in 1974, increased to $2,000 in 1981, $4,000 in 2005, and $5,000 in 2008, with an additional $1,000 for individuals 50 and over beginning in 2002. Traditional IRA’s can also include rollovers, or tax-free distributions, from another retirement plan, such as a 401(k) or 403(b) plan.
What isn’t so common, and is often lost in the Roth IRA conversion conversation, is the ability to use a SEP-IRA for the conversion. For those of you not familiar with SEP-IRA’s, this is a retirement plan used by self-employed individuals and small business owners. Sole proprietorships, Subchapter “S” and “C” corporations, partnerships, and LLC’s are all eligible to establish a SEP-IRA. Unlike traditional IRA’s which have relatively small contribution limits, currently $5,000 if under age 50 and $6,000 for individuals 50 and older, the maximum allowable contribution limit for SEP-IRA’s is much greater. Contributions of up to 25% of salary, or 20% of net adjusted self-employment income, up to $49,000, may be made to a SEP-IRA.
With this higher contribution limit, it isn’t unusual for SEP-IRA accounts to quickly grow to several hundred thousand dollars. Assuming similar starting dates, other than traditional IRA’s that contain sizeable rollovers from other retirement plans, the value of most SEP-IRA accounts typically dwarf those of traditional IRA’s. Given this situation, partial, rather than full, conversions of SEP-IRA’s generally will achieve the goal of minimizing income tax liability attributable to the conversion. Furthermore, assuming that ongoing contributions are still being made to the plan, a multi-year conversion strategy such as the hypothetical Roth IRA conversion strategy illustrated in last week’s blog post, The 45 to 60 5-Step Roth IRA Conversion Strategy – Part 4 can make a lot of sense.
If you have a SEP-IRA account, I would strongly urge you to explore the possibility of converting a portion, or all, of the current balance, as well as future contributions, to a Roth IRA, using a multi-year strategy such as the one illustrated in the four-part series, The 45 to 60 5-Setp Roth IRA Conversion Strategy.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.