Basis on IRA to Roth IRA Conversion | Ed Slott and Company, LLC

Basis on IRA to Roth IRA Conversion

Need some guidance and refresher on how basis works. Have a client that has a $1 million dollar IRA. This is the only IRA he has. He is never going to need the money, other than for his annual RMD, and his accountant recommended doing IRA to Roth conversions. Although I see how this benefits the clients family, but causes a tax liability him, can someone refresh me on what happens and what the numbers look like if he converts $100,000 per year over the next 10 years? Also, his accountant is telling him he can convert his annual RMD without basis. Have not heard of this rule ever. Any review and information you can give me is greatly appreciated. Thank you in advance.

He cannot convert his RMD, he must completely satisfy his RMD before doing any conversions of additional amounts. He will be taxed on both the RMD and the conversion amounts. If he has any basis in his IRA from non deductible contributions as reported on Form 8606, there will be a small portion of both his RMD and any conversions that will be non taxable. For his interests, he should not convert if his tax rate will be higher on the conversion than he thinks it would be in the future if he does not convert. But if his beneficiaries are expected to be in a higher bracket while taking RMDs than he would pay when he converts, conversions would benefit them. If not, then conversions would not be helpful as the beneficiaries would be better off inheriting a larger TIRA and paying taxes than a smaller Roth IRA on which client paid a higher tax rate to convert. Maybe he should convert a more modest amount than 100k, some amount that does not spike his tax bracket or cause him to pay IRMAA surcharges on his Medicare premiums. 

Thank you as always Alan.  Makes sense.  Can you help me with the math please?  Assuming the $1 million was all pre-tax contributions, and he wants to convert $100,000 of his $1 million IRA, is the full $100,000 taxable as ordinary income?   Or since the $100,000 represents 10% of his IRA is only $10,000 of the $100,000 conversion taxable and the client now has a 10% basis in their IRA?  Just want to make certain I understand how all the basis numbers work.  Thank you in advance,

In your example, there is no basis. Therefore, the entire 100,000 conversion will be taxable. Conversions and other distributions do not create basis, but if there was basis in the account beforehand, some of it will be applied to the distribution thereby  reducing the tax due AND  the remaining amount of basis. This math is all completed on Form 8606.

Stepping into this post to make sure I understand Roth conversions from a traditional IRA (with no basis) for those of us over age 70.5.  You have to complete the RMD first, then do the conversion.  The conversion will be supported on my federal tax return with Form 8606 indicating no basis in the Roth.  Therefore the RMD and conversion will be taxable income for that tax year.  How often thereafter and under what circumstances does Form 8606 have to be included with the annual federal tax return?    Tom D.  

  • Tom, since there is no basis in the TIRA, an 8606 is not needed to report TIRA distributions unless there is a conversion, then Part II of Form 8606 only. A year with only the RMD distributed would not need an 8606.
  • As for Roth IRA distributions after age 70.5, almost all Roth accounts for people of that age are qualified. Form 8606 is not needed to report qualified Roth distributions, they go directly on line 4a of Form 1040 only.

Thank you very much for the detailed explanation Alan.  Your input on the various forums in which you participate are appreciated by many people and I am sure I speak for many of them.    Tom D.

For some reason, and probably because I am getting my rules mixed up, I was under the impression that an IRA to Roth conversion with no basis, may not be a good idea based upon a $1 million IRA, unless the full conversion would be done within 3 years.  If the only income tax that needs to be paid is ONLY on the amount of conversion, in my example $100,000 and the remaining $900,000 would continue to have no basis, is there any reasonable reason why we should not continue to do annual IRA conversions of about $100,000 per year, after the RMD has been satisfied, for a 10 year period?  The client has enough income from other sources and never anticipates taking more than the RMD.  Just want to make sure I am not missing anything.

  • The prime factor in doing conversions is that the tax rate paid on the amount converted should be less than or in some cases no more than what would be paid on later RMDs and distributions if there had been no conversions. Determining the tax rate for the conversion is fairly simple, but determining the tax rate years down the road can only be made by making good guesses regarding a number of occurrences that could affect your later tax rates. Converting a huge amount at one time will obviously spike the current tax rate making it much less likely the total tax due is less than or equal to future rates. Therefore, converting in smaller incremental amounts is preferable in most cases, but there are always exceptions. One of many factors is the death of a spouse when the surviving spouse will receive the IRA, but will be taxed at a higher rate due to filing single. 
  • Having basis in a TIRA just means that the amount you are able to convert can be grossed up to reflect the portion of basis that will not be taxed upon conversion. If you had 100% basis, then a total conversion would be a no brainer because there would be no current tax due and all future gains would eventually be non taxable as well. I don't think you are missing anything, but converting 100k should also be quantified since detailed calculations must be made to determine the optimal amount to convert in a given year. 
 

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