Sometimes an investment held in a taxpayer's traditional individual retirement account (IRA) does not pan out. Instead of rising in value as the taxpayer had hoped, it tanks. But the taxpayer still hopes that it will rise again and does not plan to sell it. Here is a way to turn a lemon into lemonade (with a little help from the stock market). It might be a "push," but taking the suggested steps is a no-lose proposition.
The ingredients: The taxpayer has a traditional IRA; the traditional IRA purchased a stock or bond that has decreased significantly in value; the taxpayer expects it to increase in value over time, so the taxpayer will not be selling it; the taxpayer has or can start a Roth IRA; and the taxpayer does not mind a little paperwork.
Example 1: The taxpayer purchased R Corp. stock in the taxpayer's IRA for $25,000, but the stock now is worth $5,000. The taxpayer believes in R and does not want to sell the stock. The taxpayer is over age 59½. The taxpayer has the stock transferred to the taxpayer's Roth IRA on June 27, 2016.
The taxpayer will incur a 2016 income tax on $5,000. Years later, the R stock increases in value to $18,000, and the Roth IRA sells it. Under current law, the $13,000 never will be subject to federal income tax no matter when it is withdrawn from the Roth IRA. Had the taxpayer left the R stock in the traditional IRA and sold it in that IRA, ultimately, when distributions were made from that IRA, the taxpayer (or the beneficiaries) would pay ordinary income tax.
The IRA area is replete with traps and pitfalls. For example, to avoid unwanted income tax consequences and penalties, as a general rule, the Roth IRA owner must be over 59½ at the time of the distribution of income, and the Roth IRA must have existed for five years before earnings can be taken out tax-free.
Be aware that a second five-year period applies to a conversion, i.e., a new five-year period starts at the time of every Roth conversion. Note that the second five-year rule is deemed to begin to run on Jan. 1 preceding the conversion date. In the example above, the five-year holding period for the R stock would be met on Jan. 1, 2021. Ignore the preceding warning for the converted item if the Roth IRA owner turns 59½ during the five-year period.
A Roth IRA owner generally must pay the 10% additional tax on any amount attributable to the part of the amount converted that he or she had to include in income because of the conversion. However, an owner may not have to pay the additional tax on early distributions if he or she has reached age 59½ or is totally and permanently disabled, and in certain other situations.
Required Minimum Distribution: Over 70½
Taxpayers over age 70½ have additional considerations, since they are subject to the required minimum distribution (RMD) rules. Suffice it to say, a conversion to a Roth IRA after the taxpayer is 70½ will not qualify as (i.e., will not reduce) part or all of the RMD for that year. Another twist for this older taxpayer who wants to convert the R stock to a Roth IRA is that he or she first needs to withdraw the current year's RMD before being allowed to trigger the conversion.
Example 2:The brokerage house told the taxpayer the RMD for 2016 is $30,000. Usually, the taxpayer is informed of the current year's RMD along with the January statement. Before the taxpayer can transfer the $5,000 of R stock to the Roth IRA, the taxpayer needs to take the $30,000 out of the taxpayer's traditional IRA.
The result can be a piling on of income in the tax year; i.e., the RMD plus the value of the converted R stock all winds up on the 2016 tax return. The increased income can have additional tax ramifications, such as increasing the taxpayer's Medicare Part B (doctors) and Part D (drugs) premiums going forward and subjecting the taxpayer to the 3.8% tax on net investment income.
State Tax Benefits
Consider the effects of IRA distributions on the taxpayer's state income tax, if any. For example, New York excludes the first $20,000 each year of a "qualified" distribution. It may be beneficial to start taking distributions after reaching age 59½ by converting at least the qualified distribution amount each year into a Roth IRA. Essentially, the taxpayer will pay the federal tax immediately but permanently avoid the state tax on each year's $20,000. The taxpayer should also consider what his or her future federal tax rate will be if and when he or she expects to retire. The benefit can be doubled if the spouse also is over 59½ and maintains a traditional IRA. While the exclusion is beneficial, do not lose sight of the increased state tax expense on the income over the excluded amount in the year of the conversion.
The No-Lose Result of the Conversion
The taxpayer in the example above did a conversion in 2016. If the R stock does not subsequently do as well as the taxpayer had hoped, he or she might feel "conversion remorse." Fortunately, the conversion to a Roth IRA in 2016 can be undone (often called a "recharacterization") up until Oct. 16, 2017 (Oct. 15 is a Sunday), even if the 2016 tax return was filed earlier than its normal due date. By undoing the conversion, the taxpayer eliminates any 2016 income tax on the converted amount. From a practical standpoint, if the taxpayer thinks the Roth conversion might be undone in 2017, the taxpayer should delay having the 2016 tax return finalized and filed, to avoid the additional professional costs associated with the need to file an amended 2016 income tax return.
Other Factors Pointing Toward a Conversion
Practitioners may think this planning technique does not apply to their clients—but what about clients' parents? Did someone in the family recently pass away? How about some planning for that recently inherited IRA? Also, if the taxpayer had less income from other sources or a net operating loss carryforward in a given tax year, that might be the ideal time to convert some traditional IRA funds to a Roth IRA.
Mark Heroux is a principal with the Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.