Updated Thursday, April 24, 2014 as of 7:53 AM ET
Blogs - Ask Ed Slott
Strategizing Tax Payments on IRA Conversions
Thursday, July 19, 2012
Print
Email
Reprints

Ed Slott was named "The Best" source for IRA advice by The Wall Street Journal and called "America's IRA Expert" by Mutual Funds Magazine. He is a widely recognized professional speaker and educator specializing in retirement distribution planning, teaching both financial advisors and consumers how to best take advantage of our complicated tax code.

-- Have something you want to ask Ed? Send your questions to mailbag@irahelp.com

IRA expert Ed Slott answers readers’ questions about the best way to pay for taxes resulting from an IRA conversion.

Question 1: How long have they not charged a penalty when taking a distribution from an inherited IRA? My situation goes back to 1995-2000 with my mother's IRA. The five-year rule was the only option then. But on these tax returns I had to pay the 10% penalty on all distributions.

Thanks,

Anne

Answer:

There has never been an early distribution penalty on a distribution from an inherited IRA. It is one of the exceptions to the penalty. The 1099-R you received from the IRA custodian for the distributions in 1995 – 2000 should have shown a code 4 – Death in box 7.  If the distributions were subject to the 10% penalty, a code of 1 – Early distribution, no known exception would be used.  

Unfortunately, there does not appear to be any reference to death distributions being exempt from the penalty on the current Form 1040. You also cannot request repayment of the penalty since you can only amend tax returns for the last three years and you are well beyond that time period.  Hopefully your question will help others avoid a similar fate.

Question 2:

If I can't afford to pay the tax out of pocket on the funds I want to convert from an old 401(k) plan to a Roth IRA, is it still of benefit to use some of the transferred funds to pay the tax and absorb the penalty?

Answer:

Using money from the 401(k) plan (e.g., withholding) to pay the tax on the conversion means less money is reinvested, which means less tax-free compounding of interest.  Also, if you are under age 55 and not working for that firm, a distribution from the 401(k) to pay for the taxes (i.e., the money not converted to the Roth) is taxable and subject to the 10% early distribution penalty.

Paying the taxes from money outside the 401(k) is better.

Whether the conversion is a good move for you depends on many factors and assumptions that are unique to you. Speaking with a competent advisor would be helpful.

Question 3:

I have both pre-tax and after-tax contributions to my 401(k), and I am over age 59 ½ and currently working. Prudential, the plan administer, says that I can take just the after-tax money in the 401(k) and move it to a Roth IRA leaving the pre-taxed money in the 401(k), which according to them would not produce any tax since they would provide a 1099R indicating the moving of taxed money. 

They said I can do this moving of only taxed money as long as I continue to work since I would have to do a total distribution once I retire. I have read the Fairmark.com article by Kaye Thomas, “Isolating 401(k) Basis for a Conversion” and this seems to contradict the paper or I may be missing something. What tax issues should I be aware of if I do this transfer/conversion to a Roth IRA?  Thanks for your help.

Answer:

Separating before and after-tax funds (basis) in an employer plan is a controversial topic.  Further IRS clarification is needed but has not been issued. You should discuss IRS Notice 2009-68 and the Fairmark article with your tax advisor.  The custodian cannot give you tax advice.  Until the IRS issues guidance, your CPA will have to determine how much of the funds moved to the Roth IRA are taxable.

-- Have something you want to ask Ed? Send your questions to mailbag@irahelp.com

 

 

 

Comment
Be the first to comment on this post using the section below.
Post a Comment
You must be registered to post a comment.
Not Registered?
You must be registered to post a comment. Click here to register.
Already registered? Log in here
Please note you must now log in with your email address and password.
Lists
Advisors on the Move: Cambridge Snags $500 Million Team

Current Issue

The April Issue is now online!


TWITTER
FACEBOOK
LINKEDIN
Already a subscriber? Log in here