By now, most financial advisers know that when you have after-tax money in an individual retirement account, you can't just convert those funds and pay no tax on the conversion. Instead, when an IRA is partially converted to a Roth IRA, a prorated amount of after-tax money, or basis, is included with each dollar converted.
The formula for calculating this amount is (total basis in all IRAs/total value of all IRAs) multiplied by the amount converted.
So where is there a tax trap?
Well, unless you wait until the last second and do a conversion Dec. 31, you won't be able to do an exact calculation until the end of the year.
That is because the total value of all IRAs used for the denominator in the pro-rata calculation comes from the balances Dec. 31 of the year of conversion. That could leave some clients paying a little more (or less) in taxes than they originally planned on.
For example, Sally does a Roth conversion Jan. 4. On the date of conversion, the total value of all her IRAs is $50,000, of which $20,000 is after-tax contributions, and $30,000 is pretax contributions and/or earnings.
The tax-free percentage at this point is 40% ($20,000/$50,000 = 0.4), and the remaining 60% is taxable. Sally decides that she would like to convert half the value of her accounts to a Roth.
This might lead you to think that she will have only $15,000 in taxable income from the conversion ($25,000 x 0.6 = $15,000).
But remember, the total value of Sally's IRAs isn't determined until year-end. So let's say that Sally makes some great investments, and by the end of the year, the $25,000 that was left in the traditional IRA (which wasn't converted) has grown to $75,000.
Now the denominator, which includes the converted amount, is increased by the $50,000 increase in account value, so the new tax-free percentage is 20% ($20,000 basis/$100,000 total value of all IRAs at year-end). That means the taxable percentage is 80%.
Instead of $15,000 of taxable income generated from the $25,000 conversion, Sally now has $20,000 of taxable income.
Another big tax trap occurs when clients change the equation by rolling plan money into an IRA in the same year that they make a Roth conversion. When an IRA is converted, only IRA assets are taken into consideration for the pro-rata rule.
Plan assets have no effect.
For example, let's say that Allen has an $50,000 IRA, of which $25,000 is non-deductible contributions and $25,000 is earnings. He also has a 401(k) worth $450,000 (all pretax).
If he converts the entire IRA, he will owe tax only on $25,000, as the plan assets are excluded from the pro-rata formula.
But let's say that Allen changes jobs midyear.
Knowing that IRAs are generally better for clients than company plans, you advise him to roll his 401(k) into an IRA. Like a good client, he listens to your advice right away and rolls the money over.
You just cost Allen thousands in taxes. Why?
Remember, it is the end-of-year IRA balance that determines the denominator for the pro-rata calculation — not the balance on the date that the IRA is converted.
Now, since the 401(k) funds aren't excluded from the calculation, the pro-rata calculation changes dramatically. And instead of owing tax only on $25,000, Allen will now owe tax on $47,500.
The new balance in the IRA at year-end is $500,000 (the $50,000 of IRA funds + the $450,000 of 401(k) funds rolled into the IRA). The denominator for calculating the pro-rata rule now changes from $50,000 to $500,000, making the $25,000 of non-deductible IRA contributions a much lower percentage of the total IRA balance.
The tax-free percentage of the $50,000 conversion thereby goes from 50% to only 5% ($25,000/$500,000 = 0.05), which significantly increases the taxable amount of the conversion. Now the tax-free part of the conversion is only $2,500 (5% of the $50,000), as opposed to the $25,000 (50% of the $50,000) that would have been tax-free without the later 401(k) rollover.
How can Allen avoid this mistake? Simply wait until Jan. 1 of the following year to roll over the funds.
That way, he will have a $0 year-end IRA balance. Of course, if Allen wants to convert his 401(k) to a Roth IRA, this is a non-issue.
Ed Slott, a certified public accountant, created the IRA Leadership Program and Ed Slott's Elite IRA to help advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com. For archived columns, go to arjuna-design.com/iraalert.
For archived columns, go to arjuna-design.com/IRAalert.