ESOP to Traditional to Roth
A client asked what state tax (MA) withholding percentage should she make when converting from a Traditional IRA to a Roth. Usually, since there was no deduction at the state level for the contributions to the IRA, there should be no state tax. However, she stated that the money in the current Traditional IRA came from an ESOP. Question: Are contributions to an ESOP on behalf of an employee made on a before-tax (Federal and state) basis? If so, wouldn’t the transfer to a Traditional IRA involve transfer of those deducted contributions and thus make them taxable (at the state as well as Federal level) upon conversion to a Roth?
Permalink Submitted by Alan Spross on Thu, 2007-09-20 19:45
You are on the right track. For the rollover of ESOP shares into a TIRA, there is no reported basis for either federal or MA, therefore those values constitute pre tax amounts in the TIRA.
I am not specifically familiar with how the basis tracking of a TIRA is done in MA, however I recall that there is no state form equivalent to the 8606 used on the federal returns and also that the after tax amounts are recovered first on the MA return in the event of an IRA distribution or Roth conversion.
Once you determine how much of the conversion is state taxable, you can arrange to adjust the client’s salary withholding or estimates to cover it. I do not recommend tax withholding from the conversion distribution itself, since the amount going to taxes and not to the Roth is subject to both tax and the early withdrawal penalty. The taxes should be paid from separate funds, not withheld from the conversion transfer.