Advanced Underwriting Consultants

Question of the Day – March 13

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 intends to make an after-tax $5,000 IRA contribution in April of this year.  The client intends to convert the after-tax IRA to a Roth.  Later in the year, the client will roll over an existing $95,000 pre-tax IRA account balance to the client’s 403(b) plan.  Will the Roth conversion be a non-taxable event?

Answer:  Surprisingly, the answer is yes.

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 the conversion of the after-tax traditional IRA occurs while another pre-tax IRA exists, the conversion will be mostly taxable.  Fortunately, 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 you need to do the pro-rata calculation based on all IRAs in existence at the end of the year of conversion.  If there’s no pre-tax IRA balance, at the end of the calendar year of conversion, the conversion is completely tax-free.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.