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Maximization of Tax Return When Converting Traditional IRA to Roth IRA

Folks, this is an old concept with a new twist.  I would like to discuss how to convert a traditional IRA to a Roth IRA and present an idea on how to reduce the resulting tax burden.  There are old and new rules that apply to the conversion.  The main difference between a traditional IRA and a Roth IRA is how they are taxed.  In a traditional IRA, the contributions are tax deductible when you make them and you pay income tax on the withdrawals in retirement.  With Roth contributions, there is no tax deduction when the contribution is made, but the withdraws are tax free.  Also, there no required minimum distributions (RMD) under the Roth IRA regime.

So why wouldn’t everyone make the conversion?  Well folks, you have to pay taxes on the amount converted from the traditional IRA.  That is, you must pay taxes on the previously deducted amounts and taxes on earnings resulting from nondeductible contributions.  No, you cannot get the nondeductible portion out of the traditional IRA without paying tax on the earnings.  So, you better have a real good reason to convert.  Oh, did I tell you that you should not pay the taxes due from the traditional IRA? 

So, what are the reasons to compel you to write a check to the Department of the Treasury?  The first reason might be that you are in a higher tax bracket in retirement.  In this case, long term benefits can outweigh any tax you may pay on the conversion.  Damn, wouldn’t it be nice to have more income in retirement?  But don’t count on it.

The second reason, and I feel the best reason for a conversion, is that the value of the assets within the traditional IRA are temporarily low or the growth potential of these assets are high.  The assets might be impacted due to temporary economic conditions.  The value of the assets might increase dramatically.  In both of these cases, a conversion will help the tax payer avoid paying taxes on any growth after the conversion.  One such example might be certain assets classified as alternatives such as timber holdings or certain real estate holdings.

If there is a compelling reason to convert, I will show you how to do it, what the resulting tax would be, and how to reduce this tax. 

The conversion starts by transferring the funds from a traditional IRA to a Roth IRA.  The transfer can be done by three methods:

  1. Indirect Rollover—You get the contribution from your traditional IRA and deposit it in your Roth IRA within sixty days.  You must do this within sixty days or you lose.
  2. Transfer to transfer rollover—This happens when you get different providers.  You ask the traditional IRA provider to transfer the funds directly to your Roth IRA provider.
  3. Same trustee transfer—If the same provider maintains both IRA’s, ask them to make the transfer.

There are a number of things to consider in addition to the conversion mechanics.  First, if an RMD is required at the time of transfer, then it has to be paid from the traditional IRA before the transfer is completed.  Second, if you have a nondeductible contribution to your traditional IRA and it has earnings, you cannot transfer the nondeductible portion without the applicable earnings.  Third, if you convert to a Roth IRA, there is no going back.  Effective January 1, 2018, pursuant to the Tax Cuts and Jobs Act, a conversion from a traditional IRA to a Roth IRA cannot be recharacterized to a traditional IRA.  This is permanent, so be careful.  Fourth, there is a five-year holding period after a conversion.  Be sure you do not need the funds for at least five years.  Fifth, be sure you have the funds to pay all taxes outside of your traditional IRA.  Sixth, if you do this early in the year, you may owe additional estimated taxes resulting from the conversion. 

When you convert from a traditional IRA to a Roth IRA, the amount you convert (including earnings on any nondeductible contributions), is added to your gross income for that tax year.  It increases your income and you pay ordinary tax rates.  You will complete IRS form 8606 when you file your income tax return.  This amount is then reported on line 15 of form 1040 entering the total amount on line 15A and the taxable portion on line 15B. 

Now let’s take a look at an example.

Assume the taxpayer, before the conversion, has $500,000 in taxable income.  For simplicity purposes, assume taxable income equals adjusted gross income.  The taxpayer plans to convert a traditional IRA, which results in an addition to taxable income of $1 million. 

Taxable income before conversion     $500,000

Conversion income                               1,000,000

Taxable income                                    $1,500,000

Income tax on $1,500,000

North Carolina MFJ                             $567,022

Now you invest a real estate partnership with a conservation option.  This is limited to 50% of adjusted gross income which in the example equals taxable income.  Accordingly, the taxpayer will receive a $750,000 noncash charitable contribution for an investment of $150,000.

Taxable income before conversion     $500,000

Conversion income                              1,000,000

Taxable income before real

       estate partnership                         1,500,000

Less real estate partnership                    750,000

Taxable income                                    $750,000

Income tax on $750,000 NC MFJ       $248,279

Tax savings as a result of using a real estate partnership

Income tax on $1,500,000                   $567,022

Income tax on $750,000                      248,279

Tax Savings                                         $318,743

The tax savings of $318,743 were generated by an investment of $150,000.  Accordingly, the cash on cash return is 213%.  You all keep thinking about ways to reduce your taxes and maximize your returns!  Remember, all this has to happen before December 31!  

Don Deans CPA / PFS