Advanced Underwriting Consultants

Question of the Day – January 11

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax questions posed by producers.  Here’s the question of the day.

Question: My client had a $5,000 IRA balance, all of which were after-tax contributions in February of this year.  That was the client’s only IRA at the time.  The client converted the IRA to a Roth.  Later in the year, the client rolled over a $95,000 401K account balance to a new traditional IRA.  Now the client’s tax preparer insists that the conversion of the original IRA is mostly an income taxable event.  Is the tax preparer right?

Answer: Surprisingly, the tax preparer is right.

When a taxpayer takes a distribution from a traditional IRA, or converts a traditional IRA to a Roth, the distribution or conversion is treated as coming pro-rata from the pre-tax and after-tax parts of the IRA.  Furthermore, the IRS says that all IRAs must be aggregated for the purpose of figuring out how much of the distribution is taxable.

In the example given, one would expect that if the only IRA existing at the time of conversion consisted 100% of after-tax contributions, the conversion would be completely tax free.  Unfortunately, that’s not how it works.

Here’s what Revenue Code Section 408(d) says:

(d) Tax treatment of distributions

(1) In general

Except as otherwise provided in this subsection, any amount paid or distributed out of an individual retirement plan shall be included in gross income by the payee or distributee, as the case may be, in the manner provided under section 72.

(2) Special rules for applying section 72

For purposes of applying section 72 to any amount described in paragraph (1) –

(A) all individual retirement plans shall be treated as 1 contract,

(B) all distributions during any taxable year shall be treated as 1 distribution, and

(C) the value of the contract, income on the contract, and investment in the contract shall be computed as of the close of the calendar year in which the taxable year begins. (Emphasis added.)

For purposes of subparagraph (C), the value of the contract shall

be increased by the amount of any distributions during the

calendar year.

The Code Section says that not only do you need to do a pro-rata calculation based on all IRAs in existence at the time of conversion (or distribution), you must also factor in all IRA balances that exist at the end of the year of conversion.

For the client in this example, that means that the IRA money created by the late-year rollover is part of the pro-rata calculation.  Taking that account into consideration, it means that only 5% of the conversion amount would be tax-free—the other 95% would be taxable.

A taxpayer in similar circumstances to that in the example would be best advised to wait to do the IRA rollover in the calendar year following the conversion.

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