Tag: rollover IRA

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Roth IRA

Not Converting 100% of Your Traditional IRA’s? – Don’t Use All of Your Basis – Part 2

Retirement Income Center

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:

Account Type

Current Value

Basis

Contributory IRA

$100,000

$ 80,000

SEP-IRA

$200,000

  

$   0

 

TOTALS

$300,000

$ 80,000

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:

  1. 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.
  2. 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.
  3. 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.
  4. 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!

Categories
Roth IRA

Not Converting 100% of Your Traditional IRA’s? – Don’t Use All of Your Basis – Part 1

Retirement Income Center

In the August 2, 2010 post, Remember Your IRA Basis Scorecard When Planning Roth IRA Conversions, the concept of basis, including the importance of tracking it and using it to offset otherwise taxable gains in connection with Roth IRA conversions, was discussed. This post and next week’s post are follow-ups to that post since they expand upon the discussion of how taxable gains are calculated in connection with a partial Roth IRA conversion when basis is available.

We learned in Remember Your IRA Basis Scorecard When Planning Roth IRA Conversions that you’re taxed on the difference between the value of your distribution and your basis in the distribution. This is a relatively simple calculation when you convert 100% of all of your traditional IRA accounts, however, it’s a different story when you do a partial Roth IRA conversion.

A partial Roth IRA conversion occurs when you convert less than the total value of all of your traditional IRA accounts to a Roth IRA. Partial Roth IRA conversions come in three flavors. They include conversions of:

  1. A portion of a single traditional IRA account,
  2. A portion of a traditional IRA account where there are multiple traditional IRA accounts, or
  3. 100% of one of two or more traditional IRA accounts

Scenario #1 is pretty straightforward when calculating taxable gains, however, scenario’s #2 and #3 can be problematic when basis is present if you’re not careful. The best way to illustrate is by using examples. Before doing so, however, it’s important to point out an often-overlooked issue when dealing with scenarios #2 and #3 which can contribute directly to the taxable gain calculation problem.

When considering one’s traditional IRA’s, always keep in mind that there are several types of accounts that fall under the traditional IRA umbrella. Basically, any IRA account that isn’t a Roth IRA, beneficiary IRA, or SIMPLE IRA account is generally a traditional IRA account. This includes regular, or contributory IRA accounts which can include both deductible and nondeductible IRA contributions, rollover IRA’s, SEP-IRA’s (see the June 21st post, Don’t Forget About Your SEP-IRA for Roth IRA Conversions), and 72(t) IRA’s (see the July 26th post, Considering a Partial 72(t) Roth IRA Conversion? – Tread Lightly).

Whenever you calculate the taxable gain in connection with a partial Roth IRA conversion, the first thing you should always do is take an inventory of your various IRA accounts to make sure that you include all of your traditional IRA accounts as well as the basis from each of your accounts in your calculation.

Next week’s post will illustrate each of the three partial Roth IRA conversion scenarios, including the calculation of taxable gain. Stay tuned.

Categories
Roth IRA

Don’t Forget About Your SEP-IRA for Roth IRA Conversions

Retirement Income Center

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.