Roth conversions gains, losses, and tuition
Hello,
I previously had two traditional IRAs that I converted to Roth IRAs in 2002 and 2009. These are my only Roth IRAs. In 2010 I distributed both of the Roth IRAs in 2010 to pay for my children’s college tuition. I had $25K of college tuition. I am under 59.5.
The first IRA-Roth’s conversion value in 2002 was $27K. The first Roth’s value decreased to $10K in 2010 when I distributed it, for a loss of $17K.
The second IRA-Roth’s conversion value in 2009 was $10K. The second Roth’s value increased to $19K in 2010 when I distributed it, for a gain of $9K.
1) Am I allowed to net the gain and loss from these two distributions and simply claim an $8K loss as a miscellaneous itemized deduction subject to 2% of AGI? I’m guessing the answer is no because the second distribution was profitable and because 5 years hadn’t passed on the second distribution it might be subject to a 10% penalty tax on the $9K gain. Therefore if I can’t net the two distributions together:
2a) If I have to account for these separately because one distribution met and one distribution didn’t meet the 5 year holding period, can I take a $17K misc itemized deduction for the first distribution, and for the second distribution would the $9K gain count as IRA income at regular tax + 10% penalty?
2b) Again if I have to account for these two distributions separately, remember I had $25K of college tuition in 2010 and the two Roth distributions totaled $29K. Can I shelter the entire $9K of gain on the second distribution because I had $25K of college tuition (my actual college expenses of $25K were greater than the potential 10% penalty income of $9K) …. or because I distributed more ($29K) than my total tuition ($25K) will $4K of gain still be subject to the 10% penalty tax?
Thanks!
Permalink Submitted by Peter Lingane on Sun, 2011-02-06 19:46
IRS worksheet 2-3 (p. 67, 2009 Pub 590) addresses nonqualified distributions from multiple Roth IRAs. All Roth IRAs are aggregated. You distributed $29K from Roth IRAs with a combined basis of $37K. No earnings were distributed, taxable income is zero and you have a $6K loss to claim as a miscellaneous itemized deduction subject to 2% of AGI.
There is no early distribution penalty on the earnings because no earnings were distributed.
There is no penalty on the amount converted in 2002 because the distribution is more than five years after conversion.
However, there may be a penalty on the distribution which is allocated to the 2009 conversion. The ordering rules suggest that $2K of the distribution is allocated to the 2009 conversion. But this is only an estimate since you did not mention the taxable portions of the conversions; taxable parts are distributed before nontaxable parts.
The penalty for premature distribution of a conversion would not apply to the extent that distributions were used for qualified education expenses. This exception is discussed in Chapter 1 of Pub. 590. Compare what you paid for against the list of qualified expenses. Your qualified expenses might be more than $25K. You would appear to need $29K in qualified expenses to avoid the penalty completely.
It would be prudent to complete the worksheet and the penalty calculations for yourself as I may have made an error.
Permalink Submitted by Alan Spross on Sun, 2011-02-06 20:11
I agree with peter’s post with following exceptions:
1) The potential misc itemzied deduction would be 8k (37k basis less 29k total distribution)
2) As long as the college expenses meet the definition of qualified, only 2k of such expenses would be needed to waive the early withdrawal penalty on 2k of taxable conversion contributions not held the required 5 years.
Therefore, your distribution should be tax and penalty free, but you need to report it correctly on Form 8606 and a 5329 will be needed to claim the penalty exception from the higher education expenses.
Even though you drained your Roth IRAs, there is nothing in the IRS Regs that indicate you must now start a new 5 year holding period for purposes of Roth qualification. Therefore, if you now want to make regular or more conversions to a Roth IRA, you can still consider your first Roth contribution to be in 2002 and your Roth would be qualified when you hit 59.5.
Permalink Submitted by Peter Lingane on Mon, 2011-02-07 16:35
The loss on full distribution of both Roth IRAs is $8K. Thank you Alan for correcting my sloppy math.
Alan and I appear to disagree on how the early distribution penalty is affected by qualified higher education expenses. I illustrate my approach below; perhaps Alan would share his reasoning or cite an example from the IRS or other creditable source.
Assume an early distribution from a traditional IRA or Roth IRA and some qualified higher education expenses. The early distribution penalty does not apply to that part of the distribution which does not exceed the higher education expenses . That is, the penalty applies to the amount by which the distribution exceeds the qualified expenses. The penalty is 10% of that portion of the excess which is includible in gross income.
***
§72(t). 10-percent additional tax on early distributions from qualified retirement plans.
(1) If any taxpayer receives any amount from a qualified retirement plan … , the taxpayer’s tax … shall be increased by an amount equal to 10 percent of the portion of such amount which is includible in gross income.
(2) … paragraph (1) shall not apply to any of the following distributions:
(E) Distributions … from an individual retirement plan to the extent such distributions do not exceed the qualified higher education expenses … .
***
There will be a penalty on a $29K early distribution from a traditional IRA unless qualified higher education expenses equal or exceed $29K so long as the FMV of the traditional IRA exceeds basis.
It is possible to have a penalty with a Roth IRA even if no part of the excess of the distribution over the qualified expenses is includible in gross income because a distribution from a qualified rollover contribution (which we know as a conversion) less than five years previously is treated, for penalty purposes, as if it were gross income.
***
§408A(d)((3)(F). Special rule for applying section 72.
(i) In general. If—
(I) any portion of a distribution from a Roth IRA is properly allocable to a qualified rollover contribution described in this paragraph; and
(II) such distribution is made within the 5-taxable year period beginning with the taxable year in which such contribution was made,
then section 72(t) shall be applied as if such portion were includible in gross income.
(ii) Limitation. Clause (i) shall apply only to the extent of the amount of the qualified rollover contribution includible in gross income under subparagraph (A)(i).
***
Assume a $29K distribution from a Roth IRA. The basis consists of a $27K conversion more than five years prior to the distribution plus a $10K conversion less than five years prior. Qualified higher education expenses are $25K. The excess of the distribution over qualified expenses is $4K. None of the excess is includible in gross income because basis is recovered first under the ordering rules and basis exceeds the amount distributed.
The penalty is 10% of that portion of the excess which is allocated to the second conversion, with the caveat that both conversions were fully includible in gross income. The ordering rules distribute the older conversion first so $2K is allocated to the second conversion. The penalty is 10% of $2K or $200.
If qualified higher education expenses were to exceed $27K, the penalty would be less. If qualified expenses equaled or exceed $29K, there would be no penalty.
Whether the early distribution is taken directly from the traditional IRA or indirectly following conversion to a Roth IRA, there is a penalty of some magnitude unless qualified expenses equal or exceed the amount of the distribution.
Permalink Submitted by Alan Spross on Mon, 2011-02-07 18:39
Here is the the key portion of 72t:
>>>>>>>>>>>>>>.
72(t)(2)(E) DISTRIBUTIONS FROM INDIVIDUAL RETIREMENT PLANS FOR HIGHER EDUCATION EXPENSES. –Distributions to an individual from an individual retirement plan to the extent such distributions do not exceed the qualified higher education expenses (as defined in paragraph (7)) of the taxpayer for the taxable year. Distributions shall not be taken into account under the preceding sentence if such distributions are described in subparagraph (A), (C), or (D) or to the extent paragraph (1) does not apply to such distributions by reason of subparagraph (B).
>>>>>>>>>>>>>
This paragraph addresses the higher education exception. To paraphrase it, it indicates that the penalty does not apply except to the extent the distribution exceeds the QHEEs (25k). If the taxable distribution is less than the QHEE the penalty is completely waived. I think the problem here is your interpretation of a double negative, since the paragraph deals first with the waiver and then states when the waiver will not apply. If the distribution is MORE than the QHEE, the penalty applies to the excess over the QHEE. In this case there is only 2k subject to the premature conversion distribution early withdrawal penalty, but there is several times that in QHEE.
Another way of putting this – “Distributions to an individual” in the first sentence refer to distributions with the penalty waived, not distributions to which the penalty applies.
Permalink Submitted by chris erickson on Tue, 2011-02-08 05:53
Peter and Alan,
Thanks much but I still am missing one point. You mentioned a $2K part or allocation of the distribution. Where does the $2K come from? Also to clarify, both original IRA-to-Roth conversions involved 100% pre-tax money in the traditional IRAs, in case that info affects your $2K number/estimate.
Permalink Submitted by Peter Lingane on Wed, 2011-02-09 04:21
Sorry to have confused you. Let’s see if I can summarize this thread.
Alan and I appear to differ in our interpretation of the word “distribution” in 72(t)(2(E). To me, distribution means the amount received from the IRA while Alan appears to interpret distribution to mean the taxable portion of the amount received from the IRA.
You ask, “Where does the $2K come from?” The ordering rules say that the basis associated with the conversion in 2002 is distributed before the basis associated with the conversion in 2009. You took a $29K distribution. The first $27K is attributed to the 2002 conversion and the remaining $2K is attributed to the 2009 conversion. There is, potentially, a penalty when a conversion is distributed before five years. There is potentially a penalty on $2,000.
If Alan is correct, the qualified higher education expenses offset the distribution attributed to the second conversion and the penalty is zero. If I am correct, the penalty is 10% of $2,000.
I doubt that your situation has been addressed by the IRS or other creditable commentator. Neither Alan nor I have offered citations and there has been a deafening silence from the others who have followed this thread. Thank you for an unique query.
Permalink Submitted by chris erickson on Tue, 2011-03-01 15:25
Gentlemen,
If I might follow up with one more question, I totally agree with you about how to complete form 8606. However you indicated I also should complete form 5329. Looking at the instructions for Lines 1/2/3 on 5329 I’m not sure if 5329 applies.
* Line 1 wants to know about early distributions “included in income”. I think this should be zero because nowhere on my 1040 (with my net loss on my Roth distributions on form 8606) is any “income” shown from Roth distributions.
* Line 2 is where I get to exempt some of that income from the penalty tax, but again, no Roth “income” elsewhere on the 1040 to report.
* Line 3 is line 1 – line 2.
So I’m thinking there’s nothing to enter on 5329? I’d appreciate your thoughts again if you don’t mind.
Permalink Submitted by Alan Spross on Tue, 2011-03-01 17:55
5329 is needed to claim the penalty exception on the portion of your distribution allocated to Roth conversions that did not meet the 5 year holding requirement.
There is a convoluted mess of instructions for line 1 of Form 5329 for dealing with taxable conversions on a FIFO basis. To summarize things, your distribution included 27,000 from the old conversion which is outside the penalty period, but 2,000 was allocated to the 2009 conversion. Assuming your conversion was fully taxable when made, then 2,000 goes on line 1 of the 5329, 2,000 on line 2 with exception code 08, 0 on line 3 and that’s it. If your conversion was not fully taxable, then the 2,000 amount would be less but your penalty is still waived.