The “new normal” in 2020 has given many taxpayers plenty of reasons to worry about their futures, not only regarding health and work, but also retirement savings and future tax rates. But times of uncertainty like these should not prevent them from looking for planning opportunities such as the potential benefits of a Sec. 408A(d)(3) qualified rollover contribution to a Roth individual retirement arrangement (IRA) or a Sec. 402A(c)(4) in-plan rollover to a designated Roth account in the same qualified retirement plan. Although the statute refers to only a contribution from a traditional IRA as a “conversion,” this article uses the term “Roth conversion” to also include those from other qualified retirement plans and in-plan rollovers to designated Roth accounts.
For most taxpayers, the appeal of a Roth conversion directly correlates with the excess of the estimated net present value of cash flows, assuming a Roth conversion, over the value from assuming the account remains a traditional account. A series of lifetime Roth conversions can be especially attractive for married taxpayers where one spouse has a potentially fatal illness or condition and the other anticipates about the same pretax income after death but a higher tax liability from the effects of a higher single tax bracket and lower standard deduction or other factors. Wealthier taxpayers may find the potential to accumulate additional wealth that can be passed income-tax-free to beneficiaries most attractive, especially when the heirs are likely to be in tax brackets at least as high as that of the account holder. The income tax paid on the conversion would be excluded from the calculation of the account holder’s estate tax, if any.
An added benefit for some is that required minimum distributions (RMDs) do not have to be made from a Roth IRA account during an account holder’s life. Note, however, that designated Roth accounts are subject to RMDs during an account holder’s life, and beneficiaries inheriting Roth IRAs or designated Roth accounts are subject to RMDs (beneficiaries inheriting such accounts after Dec. 31, 2019, generally are required to complete withdrawals within 10 years; there are exceptions to this 10-year rule for surviving spouses, minor children, beneficiaries who are disabled or chronically ill, and those up to 10 years younger than the account holder). A Roth conversion can be indicated when, as in 2020, asset values may be depressed, reducing the taxable conversion amount, but future appreciation seems likely.
To make an informed Roth IRA conversion decision, account holders should carefully consider additional factors, including the ability to use nonretirement funds to pay tax on the conversion; the alternative option of making qualified charitable distributions (from a traditional IRA); the potential multiyear effects of conversion income on adjusted gross income, such as the calculation of taxable Social Security benefits and Medicare premiums; and the phaseout of many deductions, credits, and allowances. Because of the taxable income limitation under Sec. 199A, the effects of the conversion income on the qualified business income deduction, if applicable, should also be carefully considered on a multiyear basis. Beyond federal taxes, taxpayers should consider state tax ramifications, which assets to convert, and administrative fees.
Basic conversion rules and considerations have been the subject of prior articles (see “IRS Releases Rules for In-Plan Rollovers of Roth Accounts,” JofA, Dec. 12, 2013, and “When Clients Should Open or Convert to a Roth IRA,” JofA, July 2016). This article highlights strategies that may allow some taxpayers to minimize or altogether avoid income taxes on conversions and penalty taxes on subsequent distributions.
STRATEGY FOR ROLLING FROM AN INDIVIDUAL RETIREMENT PLAN
Sec. 408(d)(1) ordinarily requires a pro rata allocation between taxable and nontaxable amounts (using the Sec. 72 annuity rules) when reporting a distribution from an individual retirement plan (such as an IRA, simplified employee pension (SEP) IRA, or SIMPLE IRA). The practical effect is that an account holder must recover any after-tax amount (basis) in all such accounts ratably as distributions are received, by tracking basis on Form 8606, Nondeductible IRAs. Sec. 408(d)(3)(H) provides an important exception to the pro rata rule by which taxpayers can make a tax-free rollover from their individual retirement plan to a non-IRA eligible retirement plan (a qualified trust under Sec. 401(a) if it is a defined contribution plan, the terms of which permit the acceptance of rollover distributions; a qualified annuity plan under Sec. 403(a); a governmental plan under Sec. 457; or an annuity contract under Sec. 403(b)) equal to only the sum of deductible contributions and earnings on all contributions (whether earned on deductible or nondeductible portions).
Example 1: A has a $180,000 balance in a traditional IRA, consisting of $120,000 in pretax amounts (which includes pretax contributions of $70,000 and earnings on both pretax and after-tax contributions of $50,000) and $60,000 in after-tax amounts (nondeductible contributions). A also has a $20,000 balance in a SIMPLE IRA, none of which represents after-tax amounts (assume she has been a participant for more than two years), and a $300,000 balance in a Sec. 401(k) plan at her current employer, of which $2,000 represents after-tax amounts. The Sec. 401(k) plan accepts rollovers from IRAs. If she rolls $60,000 from her individual retirement plans (say, $40,000 from her traditional IRA and $20,000 from her SIMPLE IRA) to her Roth IRA, gross income attributable to the conversion will be $42,000 (the ratio of the $140,000 pretax amounts to the $200,000 balance in the individual retirement accounts before the distribution, multiplied by the distribution amount). The remaining $18,000 of the distribution, (the ratio of the $60,000 basis to the $200,000 balance in the individual retirement accounts before the distribution, multiplied by the distribution amount) represents a distribution of after-tax amounts. Note that the $298,000 future taxable amount in the Sec. 401(k) plan immediately before the conversion would not factor into the pro rata calculation because the Sec. 401(k) plan is not an individual retirement plan.
Example 2: Using the same pre-distribution assumptions as in Example 1, A first rolls over $140,000 from her individual retirement plans to her Sec. 401(k) plan (an eligible retirement plan). Under the rules of Sec. 408(d)(3)(H), the rollover to the Sec. 401(k) plan could consist of any combination that totals $140,000 (e.g., $120,000 from her traditional IRA and $20,000 from her SIMPLE IRA), leaving a $60,000 after-tax amount in her individual retirement plans. Second, she rolls over the $60,000 after-tax amount remaining in her individual retirement plans to her Roth IRA. Gross income attributable to these distributions will be zero.
Taxpayers who are ineligible to contribute to a Roth IRA because their income is too high could use this strategy to set themselves up for future “backdoor” Roth IRA contributions (see “Tax Practice Corner: Making a ‘Backdoor’ Roth IRA Contribution,” JofA, April 2013).
STRATEGY FOR ROLLING FROM A QUALIFIED DEFINED CONTRIBUTION PLAN
As demonstrated in the preceding examples, a conversion is excludable from income to the extent it represents a return of after-tax contributions (Joint Committee on Taxation, Technical Explanation of the Pension Protection Act of 2006 (JCX-38-06) (Aug. 3, 2006), p. 174). Normally, Sec. 72 annuity rules also apply to distributions from qualified defined contribution retirement plans, meaning that such distributions have to be allocated between pretax and after-tax amounts. However, direct rollovers of eligible rollover distributions to multiple destinations at the same time are treated as a single distribution for purposes of allocating pretax and after-tax amounts. This means taxpayers can roll over the pretax portion of a distribution to their traditional IRA or another eligible retirement plan and the after-tax portion to a different destination, such as their Roth IRA or designated Roth account. Taxpayers cannot roll over only after-tax amounts to a Roth IRA or designated Roth account and leave pretax amounts in the qualified defined contribution retirement plan (see Secs. 402(c)(2) and 402A(c)(4)(E), and Notices 2014-54 and 2013-74).
Example 3: Employee J participates in a Sec. 401(k) plan that does not contain a designated Roth account program. His $250,000 account balance consists of $200,000 in pretax amounts (which includes pretax contributions of $160,000 and earnings on both pretax and after-tax contributions of $40,000) and $50,000 in after-tax amounts (nondeductible contributions). He separates from service and is entitled to, and requests, a $100,000 direct rollover to one destination, his Roth IRA. His gross income will be $80,000, equal to the pretax amount of the distribution (the ratio of $200,000 pretax amounts to the $250,000 balance in the qualified retirement plan before the distribution, multiplied by the distribution amount). The remaining distribution amount of $20,000 (the ratio of the $50,000 after-tax amounts to the $250,000 balance before the distribution, multiplied by the distribution amount) represents a distribution of after-tax amounts.
Example 4: Using the same pre-distribution assumptions as in Example 3, J requests a $100,000 distribution, including an $80,000 direct rollover of pretax amounts to his traditional IRA and a $20,000 direct rollover of after-tax amounts to his Roth IRA. Because direct rollovers of eligible rollover distributions to multiple destinations at the same time are treated as a single distribution for purposes of allocating pretax and after-tax amounts, his gross income attributable to the distribution will be zero.
Several considerations are unique to conversions from qualified retirement plans. While employees separating from service are eligible for total distributions from their eligible retirement accounts that can be rolled over, active employees may face restrictions on their ability to take in-service distributions. And for some employees, converting means they give up access to the exception to the 10% additional tax on early withdrawals for being age 55 and separated from service and to preferential tax rates on net unrealized appreciation on employer securities held in their eligible retirement plan (Secs. 72(t)(3) and 402(e)(4)).
Qualified retirement plans with designated Roth programs may (but are not required to) allow in-plan rollovers of any vested balance of other accounts in the plan. The amount rolled over, less the after-tax amounts transferred, is included in gross income. Although no income tax withholding is required on a direct in-plan rollover, a cash distribution from qualified retirement plans is subject to 20% federal income tax withholding on the pretax amounts, even if the taxpayer subsequently rolls over the distribution to a designated Roth account within 60 days.
BEWARE THE 10% ADDITIONAL TAX ON EARLY WITHDRAWALS
The 10% additional tax under Sec. 72(t) on the taxable portion of an early distribution does not apply to the distribution in a Roth IRA conversion (Sec. 408A(d)(3)(A)(ii)). However, an account holder who does not have the cash to pay income tax on the conversion using nonretirement funds and does not otherwise meet an exception will be subject to the 10% additional tax on the taxable portion of any distribution not rolled over.
Following a conversion, the 10% additional tax will apply (unless excepted under Sec. 72(t)) to any distributions includible in gross income and to nonqualified distributions, even if not then includible in gross income, to the extent allocable to a conversion contribution, if the distributions are made within the five-tax-year period beginning with the first day of the individual’s tax year of conversion and ending on the last day of the individual’s fifth consecutive tax year thereafter (Sec. 408A(d)(3)(F)). This means that once the five-year holding period expires, taxpayers can withdraw conversion amounts (but not earnings) without incurring the 10% additional tax, regardless of their age. Distributions of earnings (but not conversion amounts) withdrawn after the five-year period has expired (unless the taxpayer is at least age 59½) are subject to the 10% additional tax. If a taxpayer has multiple conversions, each has its own five-year holding period requirement (Regs. Sec. 1.408A-6, Q&A 5).
Example 5: R, age 45 (born July 1, 1975), converts the entire $100,000 balance in his traditional IRAs to a Roth IRA on Dec. 1, 2020. The $100,000 includes $20,000 attributable to nondeductible contributions. In 2020, R will be subject to income tax, but not the 10% additional tax, on the $80,000 taxable portion of the distribution. In 2022, at a time when R does not meet an exception under Sec. 72(t), the entire $110,000 balance in the account is distributed to him. The $110,000 consists of $100,000 of conversion contributions ($20,000 attributable to nondeductible contributions and $80,000 attributable to income recognized on the 2020 conversion) and $10,000 of earnings subsequent to conversion. The $10,000 of earnings subsequent to conversion will be subject to both income tax and the 10% additional tax in 2022. The $80,000, because it was recognized as taxable within the previous five tax years, will not be subject to income tax but will be subject to the 10% additional tax in 2022.
Roth IRA distributions are made in a specific order following a Roth IRA conversion: (1) first from regular Roth IRA contributions; (2) next from conversion and rollover contributions (on a first-in, first-out basis), with amounts taxed at conversion distributed first; and (3) last from earnings (Sec. 408A(d)(4)(B)).
Example 6: Use the same conversion assumptions as in Example 5. Assume further that between the Dec. 1, 2020, conversion and Jan. 1, 2025, the Roth IRA earns an additional $50,000. On Jan. 1, 2025, at which time the Roth IRA has a balance of $150,000 (consisting of $20,000 attributable to nondeductible contributions prior to the 2020 conversion, $80,000 attributable to income recognized on the 2020 conversion, and $50,000 of earnings after the conversion), $100,000 is distributed to R. Based on the ordering rules, gross income in 2025 would be zero (i.e., distributions are deemed to come from $100,000 of conversion amounts before any earnings amount) and, because five tax years have elapsed since the conversion, R would not be subject to the 10% additional tax in 2025 on the $80,000 of conversion income, even though he is only age 50.
ROLLOVER RELIEF FOR 2020 RMDs WAIVED UNDER THE CARES ACT
Section 114 of the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, P.L. 116-94, amended Sec. 401(a)(9)(C) to change the required beginning date for RMDs for Sec. 401(a) plans and other eligible retirement plans, including IRAs. For distributions required to be made after Dec. 31, 2019, for individuals who attain age 70½ after that date, the new required beginning date is generally April 1 of the calendar year following the calendar year in which the individual attains age 72.
Usually, RMDs from eligible retirement plans and individual retirement plans cannot be rolled over (Sec. 408(d)(3)(E)). And during the year of a Roth IRA conversion, if the account holder fails to receive an RMD, the first dollars distributed during the year are considered an RMD until the amount of the RMD has been distributed (Regs. Sec. 1.408A-4, Q&A 6(a)). However, since RMDs from defined contribution plans and IRAs were waived for tax year 2020 under Section 2203(a) of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, any distribution received in 2020 from a defined contribution plan or IRA technically is not an RMD; accordingly, taxpayers may have the opportunity to roll over such distributions.
In Notice 2020-51, the IRS announced taxpayers that had already taken 2020 distributions from defined contribution plans or IRAs that would have been RMDs except for the 2020 RMD waiver or the increase in the age at which RMDs must begin could roll these funds back into a retirement account. The notice further provided that such rollovers completed by Aug. 31, 2020, would not be subject to the rules requiring the rollover to be completed within a 60-day window. In addition, while the repayment will be treated as a rollover, the Sec. 408(d)(3)(B) one-rollover-per-year limitation and the Sec. 408(d)(3)(C) restrictions on rollovers for nonspousal beneficiaries will not apply to the distribution.
MAKE SURE YOU HAVE ALL YOUR BASES COVERED
A key to any conversion strategy is understanding before implementation what is permitted and when it is permitted. Make sure you communicate with all parties involved to avoid unintended results. Remember, Roth IRA conversions cannot be recharacterized (Sec. 408A(d)(6)(B)(iii), as amended by the law known as the Tax Cuts and Jobs Act, P.L. 115-97, §13611(a)); nor can in-plan Roth rollovers (Sec. 402A(c)(4), as amended by the Small Business Jobs Act of 2010, P.L. 111-240, §2112(a)). These provisions suggest that account holders should make conversion decisions closer to year end, when they are better able to project their taxable income; but more importantly, they might suggest that taxpayers should fully understand the tax and nontax consequences before making a conversion.