Case of the Week: Taxability of IRA Conversions

The ERISA consultants at the Retirement Learning Center Resource regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and executive compensation arrangements.

A recent call with an advisor in Illinois is representative of a common inquiry involving a traditional IRA-to-Roth IRA conversion. The advisor asked:

I believe the IRS requires a person to treat a Roth IRA conversion as consisting of a pro rata share of the individual’s pre- and after-tax retirement assets. When determining the taxable amount of a traditional-to-Roth IRA conversion, does my client include his 401(k) plan balance in the calculation?

Highlights of Discussion

Your client would not include his 401(k) balance when determining the taxable amount of a traditional IRA-to-Roth IRA conversion. Please see IRS Publication 590-A for further guidance.

When calculating the taxability of a conversion in this case, your client would include all of his non-Roth IRAs for which he is the direct owner, including traditional IRAs, simplified employee pension (SEP) IRAs, and savings incentive match plan for employees (SIMPLE) IRAs.

Retirement accounts that are not considered include:

  • inherited traditional, SEP or SIMPLE IRAs (unless a spouse beneficiary has elected to treat the inherited IRA as his or her own);
  • defined contribution plans (e.g., 401(k) plans);
  • defined benefit pension plans;
  • 403(b) plans;
  • 457 plans;
  • nonqualified accounts and plans; and
  • annuities (unless they are individual retirement annuities under Section 408(b) of the Internal Revenue Code).

The steps for calculating the taxable amount of a traditional IRA-to-Roth IRA conversion are part of the IRS Form 8606, which your client must complete and file to report the conversion.

Encourage your client to discuss the conversion with his tax advisor.

Conclusion

Since a traditional IRA-to-Roth IRA conversion is (generally) a taxable and (always) a reportable transaction, investors should consult their tax attorneys or professional tax advisors concerning their particular situations.

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“Case of the Week” is the winner of an APEX Award for Publication Excellence for 2017.

Any information provided is for informational purposes only. It cannot be used for the purposes of avoiding penalties and taxes. Consumers should consult with their tax advisor or attorney regarding their specific situation.

©2017, Retirement Learning Center, LLC. Used with permission.

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