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:
- Substantial basis in IRA
- 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:
- Low tax bracket
- Not dependent on IRA
- 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.
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.