Proposal to Limit the Conversion of a Non-Deductible IRA to a Roth IRA
Each year the Department of the Treasury issues General Explanations of the Administration’s Fiscal Year Revenue Proposal. The Fiscal Revenue Proposal for 2017 was released in February of 2016.
The proposal would permit only those pre-tax dollars in a non-deductible IRA account to be converted to a Roth IRA. Thus, after-tax amounts held in a traditional IRA could not be converted to a Roth IRA. The Proposal would apply to conversions occurring after December 31, 2016.
The reasoning behind the proposed limitation is to no longer allow individuals to make non-deductible contributions to a traditional IRA and then converting the traditional IRA to a Roth IRA (often referred to as the back-door Roth strategy). Currently you would pay tax on the accumulated earnings in a non-deductible when it is converted to a Roth.
Thus, if you have been funding a non-deductible IRA, strong consideration should be given to converting that into a Roth IRA account prior to a change in the tax law. The conversion from a non-deductible IRA account to a Roth IRA account may have significant advantages, especially if you are about to retire and move money from a 401K into an IRA account. For example, assume that you have a non-deductible IRA account with a balance of $50,000; of which $10,000 is tax deferred growth and $40,000 were non-deductible IRA contributions (referred to as basis in the IRA). Further assume the tax deferred 401K account is $1,950,000.
If the 401K account is transferred into an IRA account prior to conversion into a Roth IRA, the basis of future distributions is allocated to the entire value of all IRA accounts. Consequently, a distribution of $50,000 would generate taxable income by taking the tax basis and dividing by the total value of all IRA accounts; $40,000/$2,000,000=2% of the distribution would be a return on basis. For a distribution of $50,000, $49,000 would be taxable and $1,000 return of basis.
Assuming the same set of facts above, in the year prior to the 401K rollover, the non-deductible IRA was rolled into a Roth, the taxpayer would incur taxes on $10,000 on the conversion to the Roth. Once in the Roth, any future distributions would be tax free. In this manner, converting the non-deductible IRA to a Roth IRA prior to the 401K rollover (instead of doing the Roth conversion after the 401K rollover) will lower the taxable income in that year.
If you have an IRA account from a previous 401K plan in addition to the non-deductible IRA and your current 401K plan allows for rollovers, the tax deferred IRA account would be rolled into the current 401K plan prior to the non-deductible IRA being converted into a Roth. The allocation of basis in a non-deductible IRA account does not take into account the value of a 401K. By moving the IRA account into the 401K, you are then able to limit the taxability on the growth of the non-deductible IRA account.
The positive thing about a Roth conversion – if you do not like the tax results or the investments decrease in value, the Roth conversion may be “recharacterized” and treated as if it never happened. Note that the recharacterization must be completed by October 15th of the year following the year of conversion.
Other Roth IRA advantages include, but are not limited to, a) no minimum required distributions for as long as you live, and b) you can pass your Roth IRA on to your beneficiaries and their withdrawals will be tax free (as long as you held the Roth account for at least 5 years).
These are just some of the factors to consider. Everyone’s individual situation is unique and we would welcome the opportunity to meet with you to discuss your specific goals and objectives. Please contact us at 952-844-2500 or 651-227-9431 to schedule a meeting with your BGM advisor.
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