Roth IRA

Roth IRA Conversion – Analysis Paralysis? – Part 1 of 2

As is evident by the sheer number of blog posts to date about Roth IRA conversions – 33 – there’s a lot of things to consider when deciding whether a Roth IRA conversion makes sense for you. These include, but are not limited to, the following questions:

  • Should you do a Roth IRA conversion?
  • How much traditional IRA should be converted?
  • In which year(s) should a conversion be made?
  • Should you employ a multi-year conversion strategy, and, if so, what’s the best plan for you?
  • At which point during a particular year should a conversion be done?
  • Does it make sense to do multiple conversions in a single year?
  • Even though the income from a conversion in 2010 can be deferred to 2011 and 2012, should you do a conversion in 2010?
  • If you do a Roth IRA conversion in 2010, should you go with the default of reporting 50% of the conversion income on your 2011 tax returns and 50% on your 2012 returns or should you instead make an election to report 100% of your conversion income on your 2010 income tax returns?
  • Will your income tax rate be higher or lower than what it is now when you take distributions from your IRA accounts?
  • Which assets should be converted?
  • Should you set up multiple Roth IRA conversion investment accounts?
  • Is the current primary beneficiary of your traditional IRA a charity?
  • Are there retirement plans available for conversion other than active 401(k) plans?
  • What is the amount of projected income tax liability attributable to a potential conversion?
  • When will the tax liability attributable to the conversion need to be paid?
  • What sources of funds are available for payment of the tax liability?
  • Will withdrawals need to be made from the converted Roth IRA within five years of the conversion?
  • Do you have a life expectancy of five years or less with no living beneficiaries?
  • Do your itemized deductions and personal exemptions exceed your gross income such that you can convert a portion, or perhaps all, of your traditional IRA to a Roth IRA without incurring any income tax liability?
  • Do you own a rental property with a large passive activity loss carry forward that you can sell and do a Roth IRA conversion while incurring minimal or no income tax liability?
  • Is there a net operating loss that you can use to offset Roth IRA conversion income?
  • Is there a large charitable contribution available from the establishment of a charitable remainder trust that can be used to offset income from a Roth IRA conversion?
  • What is the basis of your traditional IRA, i.e., how much of your IRA has come from nondeductible IRA contributions or qualified retirement plan after-tax contributions?
  • Are you a surviving spouse in a low tax bracket who isn’t dependent on your IRA and one or more of your children are in a high income tax bracket?
  • What are the years and amounts of your projected required minimum distributions with and without a Roth IRA conversion?
  • What is the amount of projected taxable Social Security benefits that can be reduced by doing a Roth IRA conversion?
  • Do you have a SEP-IRA that can be converted to a Roth IRA?
  • Do you have a dormant 401(k) plan that can be converted?
  • How will a Roth IRA conversion affect financial aid qualification?
  • Will your Medicare Part B premium increase if you do a Roth IRA conversion?
  • If you do a Roth IRA conversion in 2010, will your Medicare Part B premium increase in more than one year?
  • What are the income tax consequences of a partial 72(t) Roth IRA conversion?
  • Should you not do a full Roth IRA conversion and instead leave funds in your traditional IRA for future nondeductible IRA contributions?

Feeling overwhelmed? Read Part 2 next week.

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.


Two Great Roth IRA Conversion Candidates

In the two previous blog posts, I examined four scenarios where it’s possible to convert a portion, and possibly all, of a traditional IRA to a Roth IRA while incurring minimal or no income tax liability attributable to the conversion, and, as such, qualify as ideal Roth IRA conversion candidates.

This week’s blog presents two additional Roth IRA conversion candidates that I would classify as “great,” but not “ideal,” candidates. Both scenarios have the potential for the IRA owner or beneficiaries to end up with more assets than they would if they don’t do a conversion, however, there could be a sizeable amount of income tax liability attributable to the conversion, depending upon the situation. The two scenarios are as follows:

  1. Substantial basis in IRA
  2. Surviving spouse in low tax bracket not dependent on IRA with children in high tax bracket

Substantial Basis in IRA

Whether or not you’re considering a Roth IRA conversion, if you’re an IRA owner, it’s important to know the amount of your basis in your IRA. What does this mean? If the origin of your IRA is entirely from deductible IRA contributions or other deductible retirement plan contributions assuming your IRA was rolled over from a qualified retirement plan, such as a 401(k) plan, then your basis is $0. When you either take distributions from your IRA or do a Roth IRA conversion, 100% of your distributions or conversion amount will be taxable.

On the other hand, suppose that part or all of your IRA came from either nondeductible IRA contributions or after-tax contributions from a qualified retirement plan that was rolled over to your IRA. In this case, distributions from your IRA or Roth IRA conversions that are attributable to your nondeductible IRA contributions or qualified retirement plan after-tax contributions will be nontaxable. All prior year, as well as current year, nondeductible and after-tax contributions are required to be reported to IRS on Form 8606 – Nondeductible IRAs.

As an example, I had a client recently approach me about converting his wife and his IRA accounts to Roth IRA accounts. The combined value of their IRA accounts is $98,000 with a basis arising from nondeductible IRA contributions totaling $67,000. Assuming they convert 100% of their respective IRA accounts to Roth IRA accounts, they would recognize ordinary income equal to the difference between the account values of $98,000 and their basis of $67,000, or $31,000. This is less than one-third of the total value of their IRA accounts.

Even though my clients are in a combined 45% federal and state marginal income tax bracket, resulting in income tax liability of approximately $14,000 attributable to a Roth IRA conversion, this is only 14% of the total combined value of their IRA accounts of $98,000. Taking into consideration the fact that my clients are in their early 40’s, they may never need to take distributions from their IRA accounts, they have nonretirement funds from which to pay the tax attributable to the conversion, and the stock market is currently priced well below its highs of a couple of years ago, I encouraged them to pursue a conversion of 100% of their respective traditional IRA accounts to Roth IRA accounts.

Surviving Spouse in Low Tax Bracket Not Dependent on IRA With Children in High Tax Bracket

The second great candidate for conversion of a portion, or all, of a traditional IRA to a Roth IRA is a surviving spouse who meets the following three criteria:

  1. Low tax bracket
  2. Not dependent on IRA
  3. Has one or more children who are in a high tax bracket

The goal here is to reduce, or potentially eliminate, income tax liability that the surviving spouse’s beneficiaries will incur upon inheriting a traditional IRA since they will be required to take minimum distributions each year from their inherited IRA’s. Anyone in this situation should have a multi-year income tax projection prepared to determine the amount of traditional IRA that should be converted to a Roth IRA in the current and future years while keeping the surviving spouse in a relatively low tax bracket.

While both of these scenarios are not ideal Roth IRA conversion candidates since they could result in a sizeable amount of income tax liability upon conversion, they nonetheless present great opportunities to end up with greater assets than without doing a Roth IRA conversion, especially when beneficiaries are considered.