Conversion clarification
A client over ager 59.5 has a Roth which was establihed over 5 years ago. In February 2010 we converted $160,000 into the account with the intent of claiming it in 2011 and 2012. At the time the Roth already had about $60,000 it (it seems moot, but in case it matters the “basis” was approximately $50,000). The client took a distribution of $80,000 from the Roth in Novemeber 2010. Theoretically part of the distribution probably came from the $160,000 that he converted. How does this impact his ability, if at all, to claim the income in 2011 and 2012.
Permalink Submitted by Alan Spross on Mon, 2011-01-17 17:47
You are correct, the “income acceleration” provisions apply here. The accelerated income will be reported on the 2010 return on line 15b, as generated from Form 8606, lines 26-36.
Using your example, I come up with 30,000 of accelerated income (basically 80k less 50k), from the 2010 conversion. This income would come from the 2012 taxable income leaving the conversion of 160k taxable as follows: 30k in 2010, 80k in 2011, and 50k in 2012. The income acceleration provision purpose is to prevent conversions for cash flow reasons, ie when the taxpayer actually needs funds from his IRA, the taxes are due on that amount in the year of distribution, rather than allowing the two year deferral. But the formula reintroduces ordering rules for Roths that are already qualified like this one, and gives credit for basis in regular contributions only before assuming that any remaining part of the distribution emanates from the 2010 conversion.
If the taxpayer can wait until Jan, 2012 to take distributions, the income acceleration provision expires without effect.
Permalink Submitted by Peter Lingane on Mon, 2011-01-17 18:13
It’s hard to discuss the tax treatment in detail without full access to the facts and circumstances. Fundamentally,
The November distribution is not taxed since the customer has had a Roth IRA for more than five years and is more than age 59.5.
Part of the November distribution is allocated to the conversion under the ordering rules described at 408A(d)(4) or Natalie Choate, 7th Edition, 5.2.07. To make the allocation, you may need to know the history of contributions to the Roth IRA and of prior conversions and distributions.
There is no early distribution penalty on that portion of the November distribution which is allocated to the February conversion since the customer is more than age 59.5.
The tax on that part of the distribution which is allocated to the conversion is accelerated to 2010. See 408A(d)(3)(E)(i). Refer to a tax service for the details. The IRS will probably provide an example when Pub. 590 is updated for 2010.
Alan-Oniras assumes that the $50,000 basis is associated with the conversion rather than with the pre-existing Roth IRA.
I doubt that there were any tax attributes favoring conversion since the customer intended to report the conversion income in 2011/12. My hunch is that your customer should probably not have made a conversion, especially if the need to withdraw funds should have been anticipated.
Recharacterization allows your customer to rethink his or her strategy. If your customer decides, in retrospect, that the February conversion was unwise, he/she could recharacterize most of the conversion and elect to report the reduced conversion income in 2010. For example, your customer could recharacterize $135,000 leaving, after the November distribution, a $135,000 traditional IRA, a $5,000 Roth IRA, $25,000 in taxable 2010 income and no extra taxable income in 2011/12. All numbers are approximate since basis and the earnings on the February conversion have not been considered.
Permalink Submitted by Alan Spross on Mon, 2011-01-17 23:03
[quote]Alan-Oniras assumes that the $50,000 basis is associated with the conversion rather than with the pre-existing Roth IRA.
[/quote]
No, the poster stated that the Roth had basis of 50k just prior to the 2010 conversion. The new 8606 for 2010 is designed such that for income acceleration purposes it does not matter whether that basis was due to regular contributions or conversions done prior to 2010. That basis is applied against the distribution of 80k reducing the accelerated amount to 30k, which is now taxable in 2010 instead of 2012.
It took the IRS several months to publish the final version of the 8606, and prior to that there was no way to be sure how the IRS would interpret the amount “attributed to the conversion” in the tax code describing the accelerated amount. The first draft edition of the 8606 that was pulled in August resulted in the current distribution being applied to conversions done prior to the 2010 conversion as well as the 2010 conversion, thus triggering acceleration. This latest version does not do that, it allows prior regular contributions and pre 2010 conversions to be deemed distributed before any distributions are assigned to the 2010 conversion.
Permalink Submitted by Peter Lingane on Tue, 2011-01-18 17:19
I misspoke. Alan-Oniras did not assume that the $50,000 basis was associated with the conversion. Alan-Oniras interpreted “basis was approximately $50,000” to mean that the basis in the pre-existing Roth IRA was $50,000.
I had mentioned basis in my earlier post because the basis in the pre-existing IRA and the basis in the 2010 conversion (more precisely, the taxable income associated with the conversion) affect the amount of accelerated income.
I’ll use Form 8606, Part IV to illustrate. The IRS adapted this form to the determination of accelerated income so read the instructions carefully. I’m assuming no prior distributions from the pre-existing Roth IRA, no 2010 contributions to the pre-existing Roth IRA and none of the other possible complications.
Line 26 is $80,000; see the paragraph beginning “Certain qualified distributions…” on p. 8 of the instructions. If contributions (line 29) and prior conversions (line 31) total $50,000, then the accelerated income is the smaller of $30,000 (line 32) or the 2010 taxable conversion income (line 33). Unless the basis in the 2010 conversion is huge, the accelerated income is $30,000.
The phrase “basis was approximately $50,000” could be interpreted to mean that there was $50,000 basis in the conversion.
If $50,000 is the basis in the 2010 conversion, we need the contributions and prior conversions to the pre-existing Roth IRA. If contributions and prior conversions total $30,000, the accelerated income is $50,000. If contributions and prior conversions total $70,000, more than the current value of the Roth IRA, it would appear that the accelerated income is $10,000.
Form 8606 distinguishes between contributions and prior conversions because there could be an early withdrawal penalty on some or all of the accelerated income in some circumstances.
The logic underlying Form 8606 is that distributions are taken, in order, from contributions to the pre-existing Roth IRA, from prior conversions to the pre-existing Roth IRA, from the taxable portion of the 2010 conversion, from the nontaxable portion of the 2010 conversion and finally from earnings. (Pub 590, p. 68 or Choate, 5.2.07.) Income is accelerated to 2010 to the extent that the 2010 distribution is allocated to the taxable portion of the 2010 conversion.