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Plan Well, Retire Well

Saving and investing your money

More Roth Conversion Questions


There are more great questions from readers. Let's see what we can learn.

Question #3 – "The Cream in the Coffee" Rule

I have several vexing questions, but most of all about your statement regarding "having to add together the balances in all of your tax-deferred IRA accounts, and calculate the proportion of that total that is from nondeductible contributions."

-- R.H., Edwardsville

Dear R.H.,

Here's an example to clarify about the adding together of all traditional IRA balances to calculate the proportion of any conversion that will be tax-free.

John has two traditional IRA accounts. All the contributions to IRA #1 were deductible, and therefore all the money in that account is tax-deferred. Its balance was $10,000 at the end of 2009. All the contributions to IRA #2 were non-deductible, so John has already paid tax on those amounts. The balance in IRA #2 is $7000, and $5000 of that is from non-deductible contributions. The remaining $2000 is from earnings, which are tax-deferred.

He wants to convert to a Roth IRA this year. He cannot "cherry pick" which account to convert. Or, to use another analogy, you can't separate the cream from the coffee. Whatever amount he converts and from whichever account, the proportion of that converted amount that comes from non-deductible contribution and is therefore tax-free is $5000/$17,000 (the nondeductible contributions divided by the total value of all traditional IRAs at the end of 2009) which is about 29%.

Hope this helps.

-------

R.H. wrote back, restating this information to verify that he understood the points. So here's the same concept in his terms:

If I could paraphrase what your wrote above, John has calculated the percentage of ALL of his IRA holdings, that represents the non-deductible Basis that is exempt from being taxed as ordinary income in a rollover to a Roth IRA. Do I have it right?

And yes, R.H., you do have it right.

More questions:

Q Who would issue the 1099-R? I am presuming that the Custodian from which the rollover originates would issue it?

A Yes, the custodian (the bank, mutual fund, brokerage, etc.) issues the 1099-R, which states the amount of the distribution.

Q The Gross Distribution would be reported from his 1099-R on Line 1, and the Taxable Amount on Line 2a of a Federal Tax Return 1099-R entry? How would the issuer know about the calculation results so that they could break those amounts out on a 1099-R, box 1 and 2a, if there were multiple holdings at different Institutions?

A You're right – they often won't know the taxable amount. According to the instructions for the 1099-R that financial custodians follow, in many cases they may enter the entire amount of the distribution in box 2-a and check "Taxable amount is not determined" in box 2-b.

Q Would you include the value of a 401-K in that calculation? Your response only addressed IRA's.

A For conversions of traditional IRAs, you only use the value of your traditional IRA accounts to calculate the basis and taxable amount of the conversions. 401(k) accounts are treated separately. And if you have more than one 401(k), you do not add them together to calculate any basis – you treat each 401(k) account separately. (See IRS Pub. 590, pp.39-42, and 62-63. It refers to "IRA (or IRAs)" when calculating any basis, but does not say that about employer plans.)

Q If I my taxable income this year is very low (interest income dropped, still have high itemized deductions), it looks like I could have an additional $8000 of ordinary income and pay no taxes. income this year...Hence (if I am correct), I could do a partial rollover from one of my IRA's, and draw from the converted amount after I turn 59 1/2 in May, without EVER having to pay any Federal Tax on the rollover. That is, as the Tax Laws presently stand.

A That appears to be correct, you could totally avoid tax on that conversion. Low-income years are the ideal time to do a conversion. But be sure you understand the rules regarding the order of distributions from Roths – (see IRS Pub 590, p. 66)

Q Is the Taxable Amount in a Rollover counted as Ordinary Income, or is it taxed as a separate entity?

A Conversions are treated as ordinary income, meaning that you will pay income tax at your marginal tax rate. They do not qualify for long term capital gains rates. The one option you have if the conversion is done in 2010 is spreading the income across the 2011 and 2012 tax years. (IRS Pub. 590, p. 28 or 39)

Q I understand that you have until April 15, 2010 to make a Contribution to a Roth IRA for the 2009 Tax Year, but what about a Conversion? It has been unbelievably difficult to find that information.

A Conversions are taxed in the tax year in which they were converted. So if your tax year is Jan. 1 to Dec. 31, as it is for most taxpayers, a conversion made on Feb. 15, 2011 will be taxable income for 2011, not 2010. (IRS Pub. 590, p.28)



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