Roth Conversation Case – Taxation Of Earnings When Conflicting Order Of Withdrawals Exist – Example
Thank you for reviewing / advising here: ***Joe is 73 yrs old and has no Roth IRA prior to this conversion proposal***
A) A strategy has been shared with me; I want to confirm all is legal (with the Roth distribution rules being more complex than you’d think).
Let’s say Joe would like to do a Roth conversion of IRA dollars (5 yrs, $100k / yr).
- Under this strategy, Joe needs to be able to pay for the conversion expense outright with separate dollars (he is in that position).
- The angle presented to me: For each conversion, Joe’s ballpark conversion expense is $24,000 (24% tax bracket). As each $100,000 is converted to the Roth IRA, it is placed in a variable annuity with an income rider.
- Under this Roth conversion strategy / annuity, as opposed to Joe paying the full conversion expense, utilizing the annuity now held in the Roth IRA with the income rider (say 5%), Joe will pay the $24,000 outright… then receive $5,000 tax-free income from the annuity over the following yr… where Joe is ultimately net out of pocket $19,000 for that conversion (year 1), as opposed to $24,000.
- Yr 2, another $100,000 conversion; if Joe did outright – his expense would be $24,000 (24% tax bracket).
- With the annuity and the income rider, Joe’s ultimate expense is $24,000 – $10,000 received (5%; $5,000 from the 1st $100,000 & $5,000 from the 2nd $100,000, etc.; etc. throughout the yrs).
- ***My question: Joe did not have a Roth IRA prior to this move & this annuity would be considered new anyways. While he is 73 (past the 59 1/2 – good); I am concerned of how earnings will be taxed over the initial 5 yrs of the acct? On one side, I believe the distribution order for Roth IRAs is (1) Contributions (2nd) Conversion dollars & (3rd) earnings – good. With an annuity, earnings are typically distributed earnings 1st / then contributions – bad. I do not want the client to pay ordinary income on the funds received from the Roth IRA (due to the annuity), as one would expect Roth IRA distributions to be tax-free income (how it is being presented).
- ************What will take presidence here? The Overall Roth IRA (conversion dollars distributed 2nd, then earnings 3rd).. or the annuity held within the Roth IRA with an income rider generating distributions? (where earnings are distributed 1st / then principal).
- **It is being presented to me that the Roth IRA annuity would distribute tax-free dollars. I want to verify that is the case here.
- TY For your help – Sincerely, Mark Langdon (317) 797-6538
Permalink Submitted by Alan - IRA critic on Wed, 2025-07-02 14:46
Roth IRA ordering rules govern all Roth distributions. The annuity rules do not apply. Therefore, all the Roth annuity payments will be tax free, but still must be reported on Form 8606. Line 24 will show the conversion basis starting with 100k in year 1. The 5000 distribution will leave 95k for year 2 plus 100k new conversion, less 10000 distribution. That leaves 185k of conversion basis left at the end of year two, etc. The Roth custodian will issue a 1099R each January to report the amount distributed in the prior year. It will be coded either J or T.
The 8606 must be filed for each year 2025-2029, but starting in 2030 the Roth will be fully qualified and Form 8606 will no longer be needed.
Accordingly, there will be no Roth earnings distributed in the first 5 years (not even close) and therefore no taxes due.
Note that because he is 73, his RMD must be completed before doing any conversions, so he will be taxed on both his RMD and the 100k converted. Probably would have been better to complete the conversions prior to age 73 and the start of RMDs.
Permalink Submitted by [email protected] on Wed, 2025-07-02 16:57
I am assuming that only the specific year’s RMD must be distributed before the Roth conversion takes place. Separately, as long as the full RMD is processed thoughout the year (the previous 12/31 value is recorded)… why does it matter whether the RMD or conversion take place first … when both these activities only represent a minor portion of the acct?
Could there ever be a reporting order / timing violation?
Permalink Submitted by Alan - IRA critic on Wed, 2025-07-02 19:10
The tax code states that in an RMD year, the first distribution is applied to the RMD for that year, and that an RMD is not eligible for rollover. For this reason, the RMD must be completed before a conversion because a conversion is a rollover to Roth.
No doubt there are thousands every year that are unaware of this, and the IRS does not know the dates of the distributions because they are not reported on a 1099R. However, should there be an audit for whatever reason, and these transactions are done out of order, the RMD is treated as completed, but the amount of the RMD that was converted becomes an excess Roth IRA contribution and must be removed to avoid the annual 6% excise tax. This is not particularly expensive if caught in time, but creates a tax reporting hassle because the 5498 that reports the conversion will be higher than the legally allowed amount of the conversion.
Moreover, the final Secure Act Regs clarify that for an owner of multiple IRA accounts, the RMD for all of them must be completed before a conversion can be done from any of them because of the IRA RMD aggregation rules.