Conversion of after tax IRA landmine?
I had a custodian tell a client that the conversion of an after-tax IRA would cause catastrophic tax consequences? I want to make sure I am not missing anything.
Client (Income if around $400k agi) has a couple separate accounts: 1. rollover IRA ($300k), 2. regular IRA ($50k) and 3. another IRA (non deductible IRA with $5k with a basis of $5k).
In 2010, client converted $50 k IRA (acct. #2) to a Roth. She also wanted to convert the the non-deductible $5k (acct #3). Custodian warned her that it would trigger massive taxation of the rollover IRA ($300k, acct. #1). I do not believe this is the case. I’m a missing something?
Even if the $5k was co-mingled into the rollover IRA (making account $305k), and she wanted to convert just the $5k ($5k basis) I assume the tax consequences would be that 1.64% would not be taxable ($5k divided by $305k).
In 2011, if she wants to do a partial conversion of any shape are there any pitfalls?
Thank you! 🙂
Permalink Submitted by mk foss on Mon, 2011-03-28 17:38
Most custodians try to steer clear of tax advice – it would have been better if this one had.
All the IRAs are treated as one for determining whether distributions or Roth conversions are taxable. So the $5K basis will be taken into account for determining the taxable portion of the Roth conversion in 2010. In 2011 the $5k will have been reduced slightly because of the nontaxable portion of the 2010 conversion and a little more of it will be used to offset the tax on the 2011 conversion. She will have basis remaiining that will be available when she begins distributions of the rollover account or decides to convert protions of the rollover.
Permalink Submitted by William Harris on Mon, 2011-03-28 20:19
How would you determine basis each year?
Permalink Submitted by Alan Spross on Mon, 2011-03-28 20:49
Form 8606 must be filed each year a taxpayer makes a non deductible contribution to a traditional IRA. Each successive 8606 adds the new non deductible contribution to the prior balance and updates the total basis.
Then when you take a distribution OR convert to a Roth IRA, you recover a pro rated amount of that basis tax free. Form 8606 is also used to calculate how much of a distribution or conversion is tax free by using some of the basis. The form then subtracts the basis you used and show a figure for the remaining basis you have to carry into the following year. Once you have a basis you will have a complete an 8606 every year you take a distribution or convert. The only way to eliminate it is to convert your entire IRA or totally distribute it. Even your beneficiaries inherit unrecovered basis and then they have to use an 8606 every year as well.
While this sounds onerous, tax software handles it easily as long as the initial input is correct. And fewer people complete returns on paper every year. e file is now up to 70%.
Permalink Submitted by Bruce Steiner on Mon, 2011-03-28 22:28
Do many people actually make nondeductible contributions to traditional IRAs (other than people with little or no other IRA assets and income too high to contribute to a Roth who do so with the intention of quickly converting to a Roth)?
Permalink Submitted by Alan Spross on Mon, 2011-03-28 23:01
They shouldn’t be under those other circumstances, since a Roth IRA contribution is always preferable to a non deductible TIRA contribution.
From 1987 through 1997 (before Roth IRAs), TIRA contributions dropped off substantially due to the deduction elimination, but perhaps 1/3 still made non deductible contributions because it was the only IRA contribution option available. In many ways this was similar to making a NQ annuity purchase without all the fees. Earnings would be generated on a tax deferred basis.
No doubt others expected their contributions to be deducted when they made them, but opted to complete the 8606 rather than asking for a return of contributions. With tax software, the 8606 was automatically generated and the lazy way out was to do nothing.
I think the parallel situation with employer plans was that HCE limits resulted in employees choosing to have the excess contributions recharacterized as after tax contributions rather than distributing the excess with taxable earnings. I have been surprised at the after tax balances existing in many 401k accounts, those for higher earners subject to plan discrimination testing.
Permalink Submitted by mk foss on Tue, 2011-03-29 01:34
I have many clients that make nondeductible IRA contributions each year. Their income is too high for a deductible contribution and their rollover IRAs are too high for a Roth conversion of the annual contribution. It’s just a forced way of saving that they started years ago.