Tax on IRA and 401K to Roth conversion

Question

I have a 403b account with my employer, a simple IRA account, a SEP IRA account, and a Roth IRA account. My wife has a simple IRA account, a Roth IRA account and a rollover IRA account from a previous employer. We are planning to work another 6 years and then retire. I am 67 and my wife is 61.

Since in 3 years I will get to the RMD age, I would like to convert the IRA account and possibly the 401K account to Roth. Some of my contributions to IRA have been after tax and some before tax, same with my wife's contributions. Some questions:

1. What are the tax implications of our conversion? Which parts are subject to tax and which are not subject to tax (given that those contributions have been after tax).

2. What is the tax rate on the part that is subject to tax, our current tax rate or the tax rate at the time of contribution?

3. Is tax only applied to the contribution or it is applied also to the dividend and increase in the value of investment?

4. Overall, with this scenario, does conversion make sense?

Answer 1

The first rule of taxation is you don't have to pay tax twice on the same money.

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Unfortunately the first rule of Roth conversions is that you don't get to select which part of your IRA converts.

For instance if your IRA is worth $45,000 but $15,000 of that was NDIRA contribs ... and you convert $15,000... you don't get to say "we're converting the NDIRA $15,000". You must convert in proportion. Since only 1/3 of your IRA is NDIRA, 1/3 of your conversion is NDIRA, so only $5000 exempts from having to pay income tax on the conversion.

You must then remember that $10,000 of NDIRA is not yet converted. If your now-$30,000 IRA further appreciates to $40,000, and you convert $16,000, you must again say "the NDIRA portion is 25% of the IRA, so 25% of $16,000 ($4000) is exempt from income tax". That leaves $6000 of NDIRA. It's all on you to keep this paperwork straight, and have it available to present to IRS at audit.

Most people suck at keeping paperwork, so this is where it'll go off the rails for them. I keep my tax paperwork concise - forms, worksheets and W-2/1099 only, so I would write myself an explanatory letter saying what I did.

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When you do a Roth conversion, that amount (minus the NDIRA exempted part) is declared as plain income on the Income section of your 1040 of the year you do the conversion. I haven't used Trump's postcard, so I'm sure it's broken into one of the numbered Schedules now. That means if you contributed to the deductible IRA while you were in a 28% bracket, and you convert while in a 0% bracket, you pay 0%. Great thing to do in a gap year! I did mine in a gap year.

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What's taxable is the amount of money converted (minus the NDIRA exempted part). It doesn't really matter whether it came from initial contribution ("corpus" as we say in endowments) or appreciated value. The only part of the corpus that matters is the NDIRA part. For instance if you contribute $10,000 to a deductible IRA, and get snackered in the market and it's now worth $4000, when you convert, you pay tax on $4000.

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Usually people trot out the math argument that IRAs and Roths are the same mathematically. As a math expert, I say the math doesn't address any of the "soft" issues that make Roth much more beneficial, and the last time I counted them, there were at least six. Right off the bat, no mandatory distributions. The "same mathematically" presumes uniform withdrawals from retirement to death - which is hard to do when you don't know when you're going to die, and worse, *don't know when your medical needs will flare up". I've seen people yank out $200,000 in a single year and get murdered on taxes. Not a problem on Roth.

So for all those soft reasons, I recommend Roth over IRA, and I'm happy to see you converting. However you need to plan it very carefully, so you don't accidentally create some very high tax years for yourself.

Lastly, it's always a good idea to know how to do your taxes yourself, not let TurboTax make you forget how to stick-fly an airplane. In your case, the reason is so you can grab a 1040 and a pencil and just do a "dry run" for what your taxes would look like in a variety of scenarios. Play with the numbers, see what they look like.

Answer 2

To answer your questions in the order it was asked.

1. What are the tax implications of our conversion? Which parts are subject to tax and which are not subject to tax (given that those contributions have been after tax).

   You have tax deferred (403(b), Simple IRA and SEP IRA )and Tax Exempt (Roth IRA) assets here on the deferred you are going to be forced to take contributions from it (which you mentioned already, In the form of RMD'S) where you will be taxed at ordinary income on the cost basis and the growth. You don't have to pay any taxes on the after tax contribution cost basis in the IRA (I would hope you have documentation on this). On the exempt account you don't have to worry about taxes in any way shape or form with your Roth, assuming your wife is also older than 59 yrs.

   On the conversion part of your question, You cannot convert tax deferred or Qualified money into a Non Qualified or tax exempt account. You will still pay taxes or in your case the RMDs you are trying to reduce.

2. What is the tax rate on the part that is subject to tax, our current tax rate or the tax rate at the time of contribution?

   You pay taxes at the effective tax rate when distribution begins and its on both the cost basis and growth. At time of contribution is irrelevant you deferred taxes for the benefit of paying less in retirement.

3. Is tax only applied to the contribution or it is applied also to the dividend and increase in the value of investment?

   I may have indirectly answered this question by answering the first two :)

4. Overall, with this scenario, does conversion make sense?

   It makes total sense but you have to work with a Financial Advisor to make sure to mediate your RMD issue in 3 yrs and not to transfer/convert tax deferred money into tax exempt account you will be defeating the purpose of what you are trying to accomplish.

If you need me to recommend an Advisor to you. Let me know.