A previous column discussed which federal employees should not consider converting their traditional IRAs to Roth IRAs. These employees include those whose marginal income tax bracket are expected to decrease by the time they withdraw their IRA assets. Also, those employees whose converted Roth IRAs are expected to decrease in value, those employees who own insufficient liquid assets outside of the IRA to pay the income tax due on conversions, and those employees or annuitants who expect to have large out-of-pocket medical expenses in the future are advised to not convert their traditional IRAs to Roth IRAs.
But for those employees who could benefit by converting their traditional IRAs to Roth IRAs, the following are four rules that they should be aware of with respect to Roth IRA conversions, one of which is the “pro-rata” rule.
For Roth IRA conversions, all of an individual’s traditional IRAs are treated as one BIG traditional IRA account. These traditional IRAs includes any contributory (deductible and nondeductible) IRAs, rollover IRAs, Simplified Employee Pension (SEP) and Savings Investment Match Plan for Employees (SIMPLE) IRAs. The following example illustrates:
Jordan, a federal employee, has three traditional IRAs. One is a contributory deductible (before-taxed) IRA consisting of $20,000 in before-taxed contributions and earnings. A second IRA is a SEP-IRA that Jordan had contributed to when he previously worked for another employer and is worth $50,000. A third IRA is a contributory nondeductible IRA consisting of after-taxed contributions and no accrued earnings and is worth $10,000. Jordan decides to convert the nondeductible IRA worth $10,000 to a Roth IRA. For income tax purposes Jordan has one BIG traditional IRA account worth $20,000 plus $50,000 plus $10,000, or $80,000. The $10,000 has already been taxed and is considered to come out of the $80,000 BIG IRA account.
Since all of one’s traditional IRAs are treated as one account, the traditional IRA owner cannot segregate the after-taxed contributions made to a nondeductible traditional IRA. Any conversion performed from any traditional IRA account will be deemed to consist of both before-taxed funds and after-taxed funds. This is known as the “pro-rata” rule. Returning to the example with Jordan’s IRA accounts:
Under the pro-rata rule, Jordan’s traditional IRA account has a balance of $80,000 ($20,000 plus $50,000 plus $10,000). $10,000 or 12.5 percent ($10,000/$80,000) consists of after-taxed dollars. That means that any distribution or conversions of Jordan’s IRAs will be 12.5 percent tax-free and 87.5 percent taxable. If Jordan were to convert his nondeductible traditional IRA, currently worth $10,000 and consisting entirely of Jordan’s contributions that have already been taxed and no earnings to a Roth IRA, then Jordan would pay income tax on 87.5 percent, or $8,750, of the $10,000 converted. The other $1,250 would be considered nontaxable income. This is the case even though all of the $10,000 was previously taxed.
The conversion to a Roth IRA and the pro-rata calculation are both reported on IRS Form 8606 which must be completed and submitted as part of the IRA owner’s federal income tax return for the year of conversion.
The pro-rata calculation is not determined based on the balances of an individual’s traditional IRAs on the date of conversion. Rather, it is performed based on the account balance as of year-end of the year of the transaction. This means that a federal employee or retiree is advised to not rollover traditional Thrift Savings Plan (TSP) balances to a traditional IRA in the same year that a Roth IRA conversion is performed. In so doing, the TSP funds rolled over to a traditional IRA will skew the results making more of the converted traditional IRA funds taxable.
Returning to the example above with Jordan: Suppose Jordan converted his nondeductible traditional IRA to a Roth IRA on September 24, 2018. Then Jordan retired from federal service on September 29, 2018 and in November 2018 directly transfers $120,000 of his traditional TSP to a traditional IRA. Assuming no gains or losses in the interim, when Jordan completes the Form 8606 as part of his 2018 federal income tax return, his Dec. 31, 2018 year-end traditional IRA balance will be $200,000 ($120,000 from the traditional TSP plus $70,000 still in traditional IRAs plus the $10,000 conversion amount – the conversion amount is added back in accordance with the pro-rata formula). With that information in mind and using Form 8606, the tax-free portion of the $10,000 converted IRA will be computed as:
$10,000 times [$10,000/$200,000] (5 percent), or $500 will be tax-free
Five percent rather than 12.5 percent is tax-free had the TSP funds not been transferred to a traditional IRA during calendar year 2018.
But the reverse strategy will work in favor of a Roth IRA conversion. That is, if a traditional IRA owner were to directly transfer or rollover all his or her before-taxed traditional IRA funds to a qualified retirement plan (such as the TSP) before converting to a Roth IRA, then the result could be a completely tax-free conversion.
Suppose Jordan transferred all of his traditional IRAS with the exception of the $10,000 nondeductible IRA to his TSP account before converting the nondeductible IRA to a Roth IRA. Traditional IRAs, including SEP IRAs and SIMPLE IRAs, can be transferred to an existing traditional TSP account at any time using Form TSP-60. If Jordan transferred the $70,000 of his traditional IRAs (the before-taxed traditional IRAs) to his traditional TSP account before converting to a Roth IRA, then the tax-free portion of the $10,000 converted IRA will be computed as follows:
$10,000 times [$10,000/$10,000] (100 percent) or $10,000, will be tax-free.
In performing the transfer of his pre-taxed traditional IRAs to his traditional TSP account before converting the $10,000 nondeductible traditional IRA, Jordan will not be liable for any federal and state income taxes due on the conversion. It should also be noted that Jordan is eligible to rollover the $70,000 of his IRA funds that were rolled over to his traditional TSP account back to a traditional IRA after he retires from federal service.