Will I Pay Tax When I Convert to AND Distribute Funds from a Roth IRA?

By Sarah Brenner and Beverly DeVeny
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It’s time for another edition of The Slott Report Mailbag, where we answer consumer questions on situations involving Roth conversions and the pro-rata rule, whether you need earned income to contribute to a Roth IRA and certain Roth IRA tax scenarios (reminder: Tax Day is Monday!). As always, we stress the importance of working with a competent, educated financial advisor to keep your retirement nest egg safe and secure. Find one in your area at this link.

1.

I subscribed to your website through the PBS membership.

I have considerable money in my employer’s 401(k) and am nearing 65 years old. I now realize that it should be converted to a Roth (to avoid future increase in tax rates) with respect to ongoing contributions and the portfolio I currently have built up.  The fund manager (TRP) sent me forms to convert to a Roth. However, they indicated that:

“A qualified Roth distribution is tax-free only if taken at least five years after the year of your first Roth contribution and you have reached age 59 ½, become totally disabled, or died. If your distribution is not qualified, any withdrawal from your account will be partially taxable. These rules apply to Roth distributions from employer-sponsored retirement plans only.”

I have not heard about this 5-year requirement and it is of concern since I don’t want to pay taxes twice! Is what they said correct? Any alternatives to convert to tax free?

Thanks for your response.   

Joann Selleck

Answer:
No need to be concerned! The rules can be a little confusing, but there is no need worry that you will pay taxes twice. Here is how it works. You will pay taxes when you convert your pre-tax funds to the Roth 401(k), but not again when these funds are distributed from that account. No double taxation! However, any earnings in your Roth 401(k) will be taxable if distributed within five years from the year of your first contribution. The rules require that a pro-rata formula be used for such distributions, so a portion of each distribution will represent converted funds (nontaxable) and a portion will represent earnings (taxable).

The rules are slightly different if you convert to a Roth IRA. You still have the 5 years and age 59 ½, or, death, or disability rule. You will have NO required distributions from your Roth IRA. You can take as much or as little as you want during your lifetime. Distributions from your Roth IRA will come first from your converted amounts and last from earnings. As long as you do not withdraw all of your converted amounts in the first five years, you will pay no tax on any distributions from your Roth IRA.

2.

I am 61 years old and I have made after-tax contributions to my 401(k), which allows in-service withdrawals. If I want to transfer all of the after-tax dollars to a Roth IRA and its earnings to a Traditional IRA, does the pro-rata rule apply to this distribution? I will still have a significant amount of pre-tax contributions remaining in the 401(k).

Answer:
Generally, the rules do not allow you to only have the plan distribute your after-tax dollars and their earnings. Instead, your distribution will consist of a proportionate amount of all of your pre-tax and after-tax funds. However, many plans allow only after-tax funds to be available for an in-service withdrawal. In that case, the after-tax contributions, and usually the earnings on those contributions which are pre-tax, can be withdrawn and rolled over to a Roth IRA. You will have two options. One is to also roll the pre-tax earnings to the Roth IRA and pay income tax on that amount only. The other is to have the pre-tax earnings transferred directly to an IRA and to rollover the remaining after-tax funds to a Roth IRA, tax free.

3.

Must you have earned income (W-2) to start and maintain a Roth IRA? One other example and question: funds from a decedent’s IRA are used to pay funeral expenses by a non-spouse and the remaining money after expenses is paid to several non-spouse beneficiaries. Are the IRA funds taxable? If so, can the tax be paid from the IRA funds before distribution of the remainder, or must each beneficiary pay income tax on their portion of the distribution?

Answer:
In response to your first question, an IRA or Roth IRA contribution must be based on your compensation. Generally, compensation is what you earn from working. While for many taxpayers this will mean income reported on Form W-2, this is not always the case. Other examples of compensation include; self-employment income, alimony and nont-axable combat pay.

In response to your second question, an IRA distribution is generally taxable to the beneficiary. The IRA custodian will produce a Form 1099-R for each beneficiary to whom they send a check to the IRS reporting the taxable IRA distribution. Each beneficiary will then include IRA distributions they receive from the IRA custodian as taxable income for the year. When only one beneficiary receives funds from the IRA custodian and shares those funds with other beneficiaries who were not named as IRA beneficiaries, then all taxes are owed by the one beneficiary who originally receives the funds from the IRA custodian.

4.

Ed,

I am confused as to when (or if) I need to file Form 8606 with my income tax return. I have made Roth conversions (from my traditional IRA) over the last few years. Last year, I read Jeffrey Levine’s article in the April 3, 2015 Slott Report regarding Roth conversion tax scenarios. It appeared to me that I should be filing the form, so I forwarded the article to my accountant. This was his response:  

“Thanks for the info. Form 8606 would apply in your case if you also made a non-deductible contribution to a traditional IRA. Since you did not, the form does not have to be filed.” 

My accountant does not include the form with my return, although the conversion is included on line 15b of Form 1040.

I am semi-retired, and my wife and I are making Roth contributions with the income from my part-time job. We are not making non-deductible IRA contributions.

I continue to read that the form should be filed in certain scenarios. When I ran my information through Turbo Tax to determine the amount I could convert to stay within the 15% tax bracket, it did include Form 8606.  Should I include the form with my income tax return? Also, if the form is required, do I need to file amended returns and pay the $50 penalty for each year if was not filed?

Thank you,

Pete    

Answer:
Form 8606 is a multipurpose form, so it can be a little confusing. It is used to report non-deductible contributions to a traditional IRA, but it also must be filed for the year you convert a Traditional IRA to a Roth IRA. Roth IRA contributions are not reported on Form 8606.

If you are required to file Form 8606, but do not do so, you must pay a $50 penalty, unless you can show reasonable cause. You can file Form 8606 by itself. If your tax returns are not affected, you would not need to file amended returns. You cannot use the 2015 version of Form 8606 to report Roth conversions in years prior to 2015. You can find older versions of the form on the IRS website, www.irs.gov.