Roth IRA

Roth IRA Conversion Insights – Part 2 of 2

Last week’s post discussed the first three insights to be gained from analyzing two scenarios – one with no Roth IRA conversion and a second with a Roth IRA conversion – that were presented in the April 25, 2011 post, Roth IRA Conversions – Don’t Let the Tax Tail Wag the Dog – Part 6 of 6. This week’s post addresses three additional insights that can be used when confronted with a Roth IRA conversion decision.

Availability of Nonretirement Investment Assets is Essential

As we saw in the two scenarios in Part 6, the availability of nonretirement investment assets is essential (1) in meeting financial needs prior to distributions from a traditional IRA account where there will be no Roth IRA conversion and (2) in fulfilling income tax obligations related to (a) Roth IRA conversions or (b) distributions from traditional IRA accounts in the case of non-conversion.

In the case of nonconversion, insufficient retirement assets to (a) pay the income tax liability attributable to required minimum distributions (“RMD’s”) from traditional IRA accounts and/or (b) meet ongoing financial needs will result in larger distributions from traditional IRA accounts that will in turn result in a larger income tax liability. Per Exhibit 1 of Part 6 of Roth IRA Conversions – Don’t Let the Tax Tail Wag the Dog, the traditional IRA account distribution increased by 30% in the year that this occurred vs. the approximate 5% annual increases attributable to increasing RMD’s up until that point.

Whenever you do a sizeable Roth IRA conversion or series of conversions and the Roth IRA conversion income isn’t sheltered by offsetting losses and/or deductions, a sizeable income tax liability will arise. Per Exhibit 2 of Part 6, there was total Roth IRA conversion income of approximately $236,000 resulting in associated income tax liability totaling approximately $71,000, or 30% of the amount of the conversions over five years. As a result of this immediate and substantial drain of cash, when it came time for taking distributions to meet retirement needs beginning at age 65, the remaining assets in the nonretirement account could only sustain six years of withdrawals before the account was depleted.

Calculation of Projected Capital Gains and Losses is Important

While it was assumed in both scenarios that there would be no capital gains or losses in connection with withdrawals from the nonretirement investment account, the calculation of projected capital gains and losses is important to simulate real life. Unless cash is readily available, there will be a taxable transaction any time that a withdrawal is taken from a nonretirement investment account. As we saw in Exhibits 1 and 2, this will occur in the following three situations:

  1. Income tax liability attributable to a Roth IRA conversion or series of conversions
  2. Ongoing distributions to meet retirement needs
  3. Income tax liability attributable to distributions from traditional IRA accounts

Depending upon the value vs. cost basis of the assets that are liquidated to generate the cash for the withdrawal, there will either be a capital gain or a capital loss. Furthermore, capital gains will either be short- or long-term depending upon how long the assets were held before they were sold, with the latter resulting in favorable tax treatment. To the extent that net capital gains are generated, additional withdrawals from nonretirement accounts will be required to pay the income tax liability attributable to the gains. On the other hand, annual net capital losses in excess of $3,000 can be carried forward to offset future years’ capital gains.

Worst Case Assumptions Should Always be Used

Given the fact that, per insight #1 of Part 1 that actual results are likely to be different than projected results, worst case assumptions should always be used in the preparation of any Roth vs. non-Roth IRA conversion analysis. While there’s a natural tendency to use current interest, inflation, and income tax rates in all projection years since we’re familiar with these rates and it’s easy to do, there’s a strong likelihood that the projected results will be flawed, especially given today’s historic low rates for all three of these items. While many of my readers may not be old enough, I remember 15% interest and 13% inflation rates when I reentered the working world after receiving my MBA in 1980.

In addition to using worst case assumptions, multiple Roth vs. non Roth IRA projections should be prepared to simulate a wide range of possibilities. Having said this, you don’t want to prepare so many projections that you suffer from analysis paralysis.

I hope that the six-part Roth IRA Conversions – Don’t Let the Tax Tail Wag the Dog plus this two-part Roth IRA Conversion Insights series enables you to look at Roth IRA conversions from a new perspective.

Financial Planning Roth IRA

Remember Your IRA Basis Scorecard When Planning Roth IRA Conversions

Most people who sell assets are familiar with the income tax concept of “basis.” Basis, in its simplest form, is essentially what you pay for something. When you sell an asset, you’re not taxed on the sales proceeds. Instead, you pay tax on the difference between your net sales proceeds and your cost basis. Net sales proceeds is equal to gross sales proceeds reduced by any selling expenses. Cost basis is equal to purchase price plus increases to the purchase price less accumulated depreciation or amortization. Basis, therefore, reduces the amount of otherwise taxable gain.

The concept of “basis” also applies to traditional IRA’s. When you make a contribution to a traditional IRA, your contribution is either deductible, partially deductible, or nondeductible depending upon (1) whether you’re an active participant in a qualified retirement plan, (2) the amount of your modified adjusted gross income, and (3) your tax filing status. To the extent that any portion of your IRA contributions are deductible, they aren’t credited with any basis. Nondeductible IRA contributions, on the other hand, are counted as, and increase, traditional IRA basis.

So what’s so important about basis when it comes to traditional IRA’s? As stated above, basis reduces the amount of otherwise taxable gain. When might you have taxable gain with IRA’s? Unlike assets which can result in a taxable gain when you sell them, traditional IRA’s can result in taxable gains when you take distributions from them. As we’ve learned from previous blog posts, a Roth IRA conversion is, in essence, an IRA distribution.

Similar to assets whereby you’re taxed on the difference between your net sales proceeds and your cost basis, with traditional IRA’s, you’re taxed on the difference between the value of your distribution and your basis in the distribution. How do you know what your basis is in your IRA? Keeping in mind that IRA basis originates from nondeductible IRA contributions, you need a way to keep track of your nondeductible IRA contributions. IRS has provided us with this ability with Form 8606 – Nondeductible IRAs. Form 8606 is your scorecard for keeping track of your traditional IRA basis.

Form 8606 is required to be filed with your tax return in any year that you make nondeductible contributions to a traditional IRA. In addition to reporting the amount of your current year’s nondeductible traditional IRA contributions on line 1, you are required to report your total basis in traditional IRAs on line 2. Total basis in traditional IRA’s represents your cumulative nondeductible IRA contributions reduced by any previously used basis.

Since Form 8606 isn’t required to be filed every year, it’s easy to forget about basis when calculating the amount of taxable IRA distributions, especially if it’s been a while since you’ve made nondeductible contributions to your traditional IRA and you haven’t retained copies of all of your tax returns. This can be especially problematic if you haven’t used a professional income tax preparer to prepare your income tax returns in all of the years that you’ve made nondeductible traditional IRA contributions or if you’ve changed tax preparers over the years. Tracking IRA basis can be further complicated to the extent that the basis in your traditional IRA is different for federal vs. state income tax purposes as a result of state vs. federal deductible IRA calculation differences such as has been the case in California.

If you’re considering doing a Roth IRA conversion, don’t forget about Form 8606 – your traditional IRA basis scorecard. It will reduce the amount of your taxable Roth IRA conversions and, in turn, will reduce the amount of income tax you will otherwise pay.