If you haven’t yet read last week’s post, I recommend that you do so before reading this one. Last week’s post listed three types of partial Roth IRA conversion scenarios and stated that the calculation of taxable gain in scenarios #2 and 3 can be problematic when basis exists if you’re not careful. This week’s posts illustrates each of the three scenarios.
Scenario #1 – Conversion of a Portion of a Single Traditional IRA Account
Suppose you own one traditional IRA account with a value of $120,000 and basis of $100,000. If you convert 50% of the account value, or $60,000 to a Roth IRA, you would use 50% of your basis, or $50,000 to calculate your taxable gain as follows: $60,000 – $50,000 = $10,000. Your remaining unused basis would be $50,000 (total basis of $100,000 less basis used of $50,000).
Scenario #2 – Conversion of a Portion of a Traditional IRA Account Where There are Multiple Traditional IRA Accounts
For this scenario, let’s assume that you own two traditional IRA accounts, consisting of a contributory and a SEP-IRA account with the following value and basis:
Let’s assume that you convert 50%, or $100,000, of your SEP-IRA account to a Roth IRA. What is the amount of basis that you should use to calculate your taxable gain? Is it (a) $0 (50% of your SEP-IRA basis), or (b) $26,667 (1/3 of the total basis of both of your traditional IRA accounts)?
For those of you who guessed “b,” you are correct. Per last week’s post, whenever you calculate the taxable gain in connection with a partial Roth IRA conversion, you always need to include the basis from all of your traditional IRA accounts in your calculation. Since you are converting $100,000, or 1/3 of the total value of your traditional IRA accounts of $300,000, you need to use 1/3 of the total basis of your two accounts, or $26,667 ($80,000 divided by 3), resulting in a taxable gain of $73,333 ($100,000 – $26,667).
Scenario #3 – Conversion of 100% of One of Two or More Traditional IRA Accounts
Suppose in Scenario #2, instead of converting 50% of your SEP-IRA, you decide instead to convert 100% of your contributory IRA to a Roth IRA. Your contributory IRA account has a high basis since all of the contributions to it have been nondeductible vs. 100% deductibility for all of the contributions to your SEP-IRA, resulting in $0 basis. If you convert 100% of your contributory IRA to a Roth IRA, is the amount of basis used to calculate your taxable gain (a) $80,000 (100% of your contributory IRA basis), or (b) $26,667 (1/3 of the total basis of both of your traditional IRA accounts)?
Once again, “b” is correct. As with Scenario #2, you cannot simply use the basis from the traditional IRA account that you are converting to calculate your taxable gain. When there are two or more traditional IRA accounts, you must use a pro rata portion of your basis based on the relative values of the accounts that you are converting. Since you are converting $100,000, or 1/3 of the total value of your traditional IRA accounts of $300,000 you need to use 1/3 of the total basis of your two accounts, or $26,667 ($80,000 divided by 3), resulting in a taxable gain of $73,333 ($100,000 – $26,667).
In both Scenarios #2 and #3, after doing your Roth IRA conversion, you will have remaining basis of $53,333 (total basis before conversion of $80,000 less basis used for the conversion of $26,667).
Whenever you’re considering a Roth IRA conversion, you should always follow these four steps:
- Take an inventory of your various traditional IRA accounts to make sure that you’re including all of them in your calculations, even those you aren’t converting. Include all of your regular, or contributory IRA accounts, rollover IRA’s, SEP-IRA’s, and 72(t) IRA’s in your inventory.
- Make sure that you include the basis of all of your traditional IRA accounts in your calculations. Assuming that you have basis in at least one account, you should be able to locate this on Form 8606 – Nondeductible IRAs that is part of the tax filing for the most recent year that you made a nondeductible contribution to a traditional IRA, received a distribution from a traditional IRA or Roth IRA, or did a Roth IRA conversion.
- For partial conversions of a single traditional IRA, include a pro rata portion of the basis of the account based on the value of the account being converted relative to the total value of the account.
- Where there are multiple accounts and you are either converting a portion of one account or 100% of one of two or more accounts, include a pro rata portion of the basis of all accounts based on the value being converted relative to the total value of all accounts.
Above all, always remember that if you’re not converting 100% of your traditional IRA’s to a Roth IRA, don’t use all of your basis!
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.