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Case of the Week: What Accounts ‘Count’ When Determining the Taxability of a Roth Conversion?

The ERISA consultants at the Columbia Management Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. A recent call with an advisor in Illinois is representative of a common inquiry involving a traditional-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-to-Roth IRA conversion.
• 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); see IRS Pub. 590, p. 18.
— Defined contribution plans (e.g., 401(k) plans)
— Defined benefit pension plans
— 403(b) plans
— 457 plans
— Nonqualified accounts and plans
— 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-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

Because a traditional-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. Financial advisors who can demonstrate their familiarity with conversion rules set themselves apart from the average advisor and are better positioned to support their clients.

The Columbia Management Retirement Learning Center Resource Desk is staffed by the Retirement Learning Center, LLC, a third-party industry consultant that is not affiliated with Columbia Management. For informational purposes only. Please consult a tax advisor or attorney for specific tax or legal needs. © 2013 Columbia Management Investment Advisers, LLC. Used with permission.

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