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