Life and Death Planning for Retirement Benefits

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Life and Death Planning for Retirement Benefits

C. Realizing a loss on a Roth conversion. Suppose the individual’s traditional IRA consists entirely of after-tax money, and the value of the IRA (at the time of conversion to a Roth) is less than his basis: Tucker Example: Tucker made nondeductible contributions totaling $20,000 to a traditional IRA in the years leading up to 2010. This was and is his only IRA, and he made no contributions to it in 2010. As of the date in 2010 when he does his conversion to a Roth the account is worth only $17,000. What becomes of his “missing” $3,000 of basis? A transfer from a traditional to a Roth IRA is to be taxed as if it were a distribution that was not rolled over. § 408A(d)(3)(A)(i) . If Tucker’s IRA had been totally distributed to him, rather than being rolled to an IRA, he would have been entitled to deduct the $3,000 loss as a miscellaneous itemized deduction. See ¶ 8.1.02 . Accordingly, it would appear that Tucker would report a miscellaneous itemized deduction of $3,000 on his Form 1040 for 2010 as a result of the Roth conversion. In adding plan-to-Roth-IRA rollovers, Congress applied the same rule it had used to make IRA conversions taxable (see ¶ 5.4.03 (A)), just throwing a few more Code sections into the “notwithstanding” clause: “Notwithstanding sections 402(c), 403(b)(8), 408(d)(3), and 457(e)(16), there shall be included in gross income any amount which would be includible were it not part of a qualified rollover contribution.” § 408A(d)(3)(A)(i) , (B) , and (C) , as in effect after 2007. Emphasis added. Notice 2008-30, 2008-1 CB 638, Section II, questions 1–7, and Notice 2009-75, 2009-39 IRB 436, provide guidance on plan-to-Roth-IRA conversions. For conversions in 2010, special “income spreading” treatment is allowed; see ¶ 5.4.05 . If the assets converted include an annuity contract, see ¶ 5.4.03 (A). A. The fictional two-step process. The income tax treatment of a Roth conversion directly from a nonIRA plan employs a fiction: “For this purpose, the amount included in gross income is equal to the amount rolled over, reduced by the amount of any after -tax contributions that are included in the amount rolled over, in the same manner as if the distribution had been rolled over to a non-Roth IRA that was the participant’s only non- Roth IRA and that non-Roth IRA had then been immediately converted to a Roth IRA.” Notice 2009-75, A-1(a). Emphasis added. Thus, the one-step process of transferring funds directly from the nonIRA plan to a Roth IRA is treated as if it were a two-step process, with the distribution passing through a hypothetical traditional IRA on its way to the Roth IRA. The two-step fiction means that special tax treatments that might otherwise be available for ( e.g. ) a lump sum distribution (LSD; ¶ 2.4 ) from the nonIRA plan are NOT available for a Roth conversion, even if the amount converted otherwise qualifies as a “lump sum distribution.” For example, if an employee takes an LSD of appreciated employer stock from the employer’s QRP, the “net unrealized appreciation” (NUA) inherent in the stock receives special income tax treatment if it is not rolled over to an IRA; see ¶ 2.5. If the employee rolls (converts) the NUA stock directly to a Roth IRA, the conversion will be fully taxable as ordinary income Tax treatment of converting nonIRA plan to Roth IRA