Roth Conversion of After-Tax Money

Natalie Choate answers reader questions about Roth conversion rules as they relate to inherited IRAs and profit-sharing plans.

Question: "Rose" has $20,000 in her traditional IRA, of which $16,000 is aftertax money (representing her nondeductible annual contributions over the

years). She also owns, as beneficiary, an inherited IRA (left to her by her grandmother), from which she is taking annual minimum required distributions

over her life expectancy. There is no aftertax money in the inherited IRA, which is now worth $100,000. Rose would like to convert her $20,000 traditional

IRA to a Roth, if only the $4,000 pretax portion of that account would be taxable. But someone told her "all IRAs are aggregated." If she has to consider her own IRA and the inherited IRA as if they were one aggregated single account, then only a small portion of any Roth conversion would be considered a taxfree conversion of aftertax money. Must the inherited IRA be aggregated with her own for this purpose?

Answer: No. "Your own" IRA(s) must all be aggregated (treated as one) for purposes of determining how much of any distribution (or Roth conversion)

from any one of them is taxable. In other words, the aftertax portion of your own IRAs is deemed to be spread ratably over all of your IRAs--it is not

"attached" to the particular IRA account that you actually made the nondeductible contributions to. However, inherited IRAs are NOT aggregated with your own IRA(s) for this purpose.

This rule applies for minimum distribution purposes as well as for purposes of determining what portion of any distribution is taxable. Rose must take

minimum required distributions attributable to the inherited IRA from the inherited IRA. Distributions from her own IRA would not count toward the

distribution requirement applicable to the inherited IRA. And IRAs inherited from one decedent are not aggregated with IRAs inherited from any other

decedent!

Question: "Wally" is retiring soon. His company's profit-sharing plan maintains two accounts for him, the "pre-1987 money" account and the "post-1986

money" account. The pre-1987 account contains aftertax money as well as pretax money. The post-1986 account is all pre-tax money. Can he convert the

pre-tax money, by itself, to a Roth IRA?

Answer: Generally, a retirement plan cannot distribute the aftertax money in an employee's account separately from the pretax money. That's because

retirement plan distributions are generally governed by § 72 of the Code. Since 1986, § 72 has applied a general rule that all plan distributions are deemed

to contain proportionate amounts of the pre- and aftertax money in the account being distributed. Sometimes called the "cream in the coffee rule," this

means that, if the total account contains 25% aftertax money, only 25% of each distribution will be deemed to be a tax-free distribution of aftertax money.

Distributions will generally be 75% taxable and 25% tax-free.

However, § 72 does have some exceptions to this "cream" rule. One exception is in the nature of a grandfather rule: "In the case of a plan which on May 5,

1986, permitted withdrawal of any employee contributions before separation from service, subparagraph (A) shall apply only to the extent that amounts

received before the annuity starting date (when increased by amounts previously received under the contract after December 31, 1986) exceed the

investment in the contract as of December 31, 1986." Translated into English, this exception allows a "grandfathered" employee to withdraw his pre-1987

aftertax contributions tax-free, separately from all post-1986 balances and separately from the earnings on the pre-1987 contributions. If Wally's plan has

properly kept track of these balances and is willing to distribute the pre-1987 aftertax contributions to him ahead of time, he should indeed be able to

convert this aftertax money separately, tax-free, to a Roth IRA.

Needless to say there are not many people who can take advantage of this, because few of today's retirees have aftertax contribution accounts from 25

years ago still in their plans. Also, there is little or no IRS guidance on this "grandfather rule," so plans may or may not be willing to implement it.

The views expressed are the author's.

Estate Planning with Roth IRAs

As Roth usage increases, so do questions about best estate-planning practices for these accounts.

Natalie Choate, 11/11/2011

Since the "income cap" was lifted on Roth conversions in 2010, more and more clients have Roth IRAs. It's time to consider where those assets should be placed in the estate plan.

Question: I read in a financial publication that giving away a Roth IRA is "a good planning idea." Several other articles are out there about this strategy. Does it really work?
Answer: No. You cannot give away a Roth IRA. Or rather, you can do so, but giving it away would cause it to cease to be an IRA. The gift-transfer would be treated as a complete distribution of the account to the donor, followed by a gift of the proceeds to the transferee. The deemed distribution might be tax-free (if the donor meets the requirements for a "qualified distribution"), but there will be no further tax-free accumulation because the Roth ceases to exist.

A "Roth gift" strategy that does work is for a donor (typically the parent of a teenager) to open a Roth IRA for the donee (the teenager). Example: Teenager earns $5,000 in a summer job. Teenager therefore has compensation income, and if his income is low enough, he is entitled to contribute to a Roth IRA. The parent and teen can open the account together in the teen's name and the parent contributes $5,000 to it.
Both of these strategies are discussed in ¶ 5.8.06(C), "Gifts with Roth IRAs," of my book Life and Death Planning for Retirement Benefits (7th ed. 2011).

Question: "Duncan" wants to leave some of his assets to charity, some to his wife, and some to his children. He has some assets in a traditional retirement plan, some in a Roth plan, and some in outside (nonretirement) investments. Which asset should he leave to which beneficiary?

Answer: With a traditional IRA, all three of Duncan's proposed beneficiaries are considered "tax-favored" choices for income tax purposes: Children (or other young people) because of their long life expectancies (facilitating a long tax-deferred "stretch" payout), the spouse (because she can roll over to her own IRA), and charity because it is income tax-exempt. In Duncan's case, leaving the traditional plan to charity is very appealing, since the charity (unlike the wife and children) can receive these retirement plan benefits income tax-free.

With the Roth plan, the picture changes slightly. Charity is not an income tax-favored choice of beneficiary for a Roth plan. Because distributions from a Roth plan are generally income tax-free anyway, there is no advantage to leaving this asset to an income tax-exempt entity. Thus, Duncan should leave the Roth plan either to his spouse or to the children.

If federal estate taxes are a concern, there is a strong argument against making the traditional IRA payable to the children. By inheriting the traditional IRA, they would be inheriting an asset that has a built-in income tax "debt." Duncan does not get a marital or charitable deduction for leaving assets to his children; the only estate tax "shelter" there is for bequests to his children is the federal estate tax exemption. Part of that exemption is "wasted" if the children inherit an asset that they then have to pay income tax on--part of the "exempt" amount goes to the IRS. So the children should inherit either the Roth plan or the nonretirement assets; either way, they will owe no income tax on their inheritance.

We have figured out that the charity should inherit the traditional retirement, and the children should not inherit it; that leaves the Roth plan and the nonretirement assets to be divided somehow between the spouse and the children. The question is, what is the best income tax scenario for the Roth plan?
If a Roth IRA is left to the children, they can stretch it out via annual tax-free distributions over their life expectancies. That's a pretty darn good scenario.

But if the Roth plan is left to the surviving spouse, she can get an even better scenario: She can roll the inherited Roth plan over to her own Roth IRA (only the surviving spouse has this right). Then she will be able to stretch out the tax-free distributions much longer than the children possibly could: She does not have to take any minimum required distributions at all from the rollover Roth IRA during her lifetime. After her death it can be left to the children for gradual tax-free distributions over their life expectancy.

Duncan's choice is made: Leave the traditional retirement plan to the income tax-exempt charity, the Roth plan to the wife for her to roll over and keep accumulating tax-free, and the nonretirement assets to the children.

Resources: For all details regarding Roth retirement plans, including who is eligible to contribute (and how much), income tax treatment of Roth distributions, and minimum distribution requirements for Roths, see Chapter 5 of Natalie Choate's book Life and Death Planning for Retirement Benefits (7th ed. 2011).

The views expressed are the author’s.