Roth IRA Conversion Questions for Alan Oniras
November 17, 2009
Questions for Alan Oniras of Ed Slott’s IRA Discussion Forum
Regarding a Roth IRA Conversion next year, assume an individual owns the following investment accounts:
Simple IRA: $85,000
Roth IRA: $75,000
Non-Deductible IRA: $15,000
Total IRA’s $175,000
Also assume that the cost basis of the Non-deductible IRA is greater than its fair market value of $15,000.
Questions:
1. A. If this individual wishes to do a partial conversion, can he just convert the non-deductible IRA and not have to pick up any of the $15,000 in his income?
Or, is he forced to use the pro-rata rule regardless of whether he does a partial or full conversion (I believe it’s the latter but want to confirm).
B. If he is forced to use the pro-rata rule, would the Roth IRA not be taken into account and the ratio of the Non-Deductible IRA to Non-Deductible IRA and Simple IRA (15%) be what is not subject to income tax (in this case because the value of the Non-Deductible IRA is less than its cost basis)?
C. Accordingly, if the individual just converts the $15,000 Non-deductible IRA, would only 15% of it ($2,250) not be subject to income tax? When we refer to income tax, presumably we are including both federal and state (please correct me if mistaken)?
2. Assuming the above individual converts both the Simple IRA and Non-Deductible IRA, is the amount subject to income tax 85% of the $100,000 (the proportion of the Simple IRA relative to the Simple IRA & Non-Deductible IRA)? Once again, I am assuming the existing Roth IRA gets ignored for purposes of the conversion and resulting income/tax.
3. If this individual converts either or both of the Simple IRA or Non-Deductible IRA and assuming they want to create one or more separate Roth IRA’s for the conversion to hold different types of assets, how should the new Roth IRA(s) be titled? Does it need to be titled any differently than the already owned Roth IRA to acknowledge the fact that the new Roth IRA(s) is being funded by a conversion and not contributions?
4. Assuming the individual is
Permalink Submitted by Ronald Birnbaum on Tue, 2009-11-17 23:26
I’m not Alan, but I’d be real careful about recommending IRA/Roth conversions to clients. Only a small % of people should be considering it. My rule is this – if they’ll need the converted Roth funds for themselves – don’t do the conversion! IF they want to convert to avoid MRDs and leave all the funds to their heirs – a conversion can then be a wise choice.
Permalink Submitted by Alan Spross on Wed, 2009-11-18 00:31
1A) You are right – the pro rata rule applies.
B) The Roth value is not considered. The tax free portion is based on the ratio of basis ($15,000 + ? not specified) to total adjusted value of $100,000.
C) More than 15% of the conversion would be tax free because the basis is more than 15% of the total adjusted value. Yes, federal plus state taxes is assumed to apply.
2. Roth is ignored. Taxable amount somewhat less than 85% because the actual basis is somewhat more than 15%. You should have stated what the basis amount was.
3. No requirement as to the registration of the different Roth accounts, whether conversion produced or not.
4. The Roths can be combined from the beginning, but best not to combine them until the recharacterization date has passed. No need to wait 5 years.
5. 100,000 income limit disappears for ALL years after 2009. Same for the married separate limitation on conversions.
6. The employee cannot convert while still in service unless they meet some provision within the plan allowing in service distributions, eg reaching 59.5. After separation, the conversion must be allowed for both.
6b) Direct transfer must be offered directly to Roth IRA.
7) The pro rate rules apply only to the 401k plan balance for direct conversions. If the entire distribution is instead first transferred to a traditional IRA, then the pro rate rules apply to the total basis in the IRAs from both IRA contributions AND rollover of after tax 401k plan contributions.
8) For direct conversions without using a traditional IRA, a recharacterization must still go to a traditional IRA as it cannot go back to the 401k plan. It is more tax efficient to convert higher basis (after tax accounts) to a Roth before diluting the basis % with pre tax rollovers.
Permalink Submitted by David Hochstadt on Wed, 2009-11-18 01:49
Hi Alan,
Thanks for the reply. Based on your previous response, just to further clarify the tax liability in 3 different scenarios:
Assume an investor has a Simple IRA worth $80,000 and a Non-Deductible IRA worth $15,000, with a cost basis of $20,000.
1. If only the Non-Deductible IRA is converted, will the income subject to tax will be $12,000 ($15,000 converted – [$20,000 basis / $100,000 combined IRA value x $15,000 value])?
2. If both the Non-Deductible IRA and Simple IRA is converted, the income subject to tax will be $80,000 ($100,000 converted – [$20,000 basis / $100,000 combined IRA value x $100,000])?
3. If the entire Non-Deductible IRA and 1/2 the Simple IRA is converted, the income subject to tax will be $44,000 ($55,000 converted – [$20,000 basis / $100,000 combined IRA value x $55,000])?
Thank you in advance for your time.
Permalink Submitted by Alan Spross on Wed, 2009-11-18 04:27
1. No. Combined IRA value is not increased to reflect the basis. Total value = 95,000/20,000 basis = 21% non taxable. Taxable is 79% of 15,000 = 11,850. And it does not matter which IRA is the source of the conversion.
2. For converting all IRAs, the taxable amount is 75,000. 95,000 converted less basis of 20,000 or 79% of 95,000.
3. Cost basis is 21%. Taxable amount 79% of 55,000 or 43,450.
The taxable portion of each example is 79%. No matter which IRA funds the conversion, they are all figured as one combined IRA account. The basis for all examples is 20,000 and the total value of IRAs is 95,000. That factor is multiplied by the amount of each conversion.