Advanced Underwriting Consultants

Question of the Day – November 2

Ask the Experts!

Here’s the question of the day.

Question: My client has an IRA with both after-tax contributions, and pre-tax contributions.  The IRA also has untaxed earnings.  Is there any way the client can separate the after-tax contributions and convert that to a Roth IRA?

Answer: For most people, the answer is no.

The problem is that many of these clients already have other IRAs with significant pre-tax contributions in them.  When a conversion of an IRA is accomplished, the conversion amount is considered taxable and non-taxable in the same proportion as the total account balance in the IRA immediately before conversion.

Here’s an example.  Suppose the IRA has a total account balance of $100,000 of which $10,000 represents after-tax contributions and $90,000 is the amount of pre-tax contributions and earnings in the account.  If $10,000 is converted, the conversion will be considered to be $1,000 tax-free as conversion of after-tax contributions, and $9,000 will be the taxable amount representing pre-tax contributions and/or earnings.

Why not just segregate the IRA money into two or more IRAs with all the pre-tax money in one and all the after-tax money in another?  The answer is it can’t be done!  For purposes of determining the taxable portion of a Roth conversion, all IRAs owned by the taxpayer are aggregated together.

For clients with access to an employer plan such as a 403(b) or 401(k) that accepts IRA rollovers, there may be a solution to the dilemma.  The client may

  1. roll the pre-tax IRA contributions and earnings into the employer plan, leaving only after-tax money in the IRA, and then
  1. perform the Roth conversion.

When an IRA is rolled over to a pension plan, the rules provide that only the pre-tax money can be moved.  In fact, employer plans are not allowed to accept rollovers of after-tax contributions at all.  There are special rules that say rollovers of IRAs to pension plans drain the pre-tax part of the IRA first.  Rolling over that portion effectively strips out all the untaxed money and puts it in the pension plan, leaving only after-tax money in the traditional IRA.

On the subsequent Roth conversion, only after-tax money is converted from the traditional IRA.  While all the client’s IRAs must be aggregated for purposes of determining the taxable and non-taxable portion of the conversion, employer-sponsored retirement plans are not included in the aggregation.

For clients lucky enough to have employer plan accounts that accept rollovers, it’s possible to roll all the pre-tax contributions and earnings from an IRA into the employer plan, leaving only after-tax contributions in the IRA, and then accomplish a tax-free conversion to a Roth IRA.

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.