Categories
Roth IRA

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

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

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
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.