Tax consequences of a traditional IRA to a Roth conversion and how soon money is available

Question of the Week 2/10/21: Can my client transfer funds from his traditional IRAs to a backdoor Roth and what are the tax consequences of doing so?

February 17, 2021
Question of the Week 2/10/21: Can my client transfer funds from his traditional IRAs to a backdoor Roth and what are the tax consequences of doing so?

Q: What are the tax consequences for a client with large traditional IRA balances making a “backdoor” Roth IRA conversion if he has made non-taxable contributions?

Oliver is in his mid-50s and has large balances in a few traditional IRAs. He’s starting to worry about the required minimum distributions he’ll have to take in the future. He and his spouse have combined AGI of over $250,000, well over the limit for making a Roth IRA contribution. He has heard about a “backdoor Roth” and would like to know more about it.

Can my client transfer funds from his traditional IRAs to a backdoor Roth and what are the tax consequences of doing so? Could he withdraw the tax due on transfers from the IRAs too? One of the IRAs has only after-tax contributions. Could he transfer funds only from that IRA to avoid tax? Also, Oliver wants to know how soon he can take money out of the Roth tax-free.

A: If the client has basis in his traditional IRAs, conversion amounts are partly taxable and partly non-taxable. A Roth IRA conversion is subject to a five-year holding period.

The term “backdoor Roth” is a term that refers to funding a Roth IRA by converting funds from a traditional IRA to a Roth IRA. Unlike direct contributions to a Roth IRA, there are no AGI limits that apply to the conversion. Also, even if Oliver could make direct contributions, he would still have his large IRA balances and required minimum distributions (RMDs) to deal with in the future.

Oliver may convert funds from his traditional IRAs to one or more Roth IRAs, regardless of his AGI. Roth conversions may be a good way for him to reduce future RMDs.

Here are some tax consequences for him to consider. Keep in mind that under the TCJA, once a Roth conversion is made it cannot be re-converted or recharacterized back to a traditional IRA.

Roth IRA conversions are subject to tax

A conversion of traditional IRA funds to a Roth IRA is subject to tax. For that reason, although Oliver could transfer his entire traditional IRA balance to a Roth, he might consider transferring funds over several years and so avoid paying all of the tax in one year. Any traditional IRA withdrawal made for the purpose of paying taxes is itself a taxable distribution and subject to the 10% additional tax unless an exception applies.

Oliver has made nondeductible or after-tax contributions, which represent his basis in his traditional IRAs. The conversion, or any other traditional IRA distribution, will therefore be partly taxable and partly non-taxable using a pro-rata formula.

Figure the non-taxable part of a 2021 conversion by multiplying the conversion amount by Oliver’s basis over his traditional IRA balance as of December 31, 2021.

For example, if basis is one-quarter or 25% of the balance and Oliver converts $40,000 to a Roth IRA, then $10,000 ($40,000 × 25%) of the conversion is non-taxable and the remaining $30,000 is subject to tax.

Notice that the ratio is based on Oliver’s basis in all of his traditional IRAs over the total balance of all of his traditional IRAs. He cannot simply convert after-tax contributions to a Roth IRA to avoid tax on the conversion.

Also, the $10,000 non-taxable portion of the 2021 conversion reduces Oliver’s basis in conversions made in future years.

Holding periods apply to Roth IRAs

If Oliver intends to withdraw funds from his Roth IRA after the conversion is made, he should be aware that holding periods apply before a withdrawal is treated as a qualified distribution, i.e. a distribution that is fully tax-free and not subject to the 10% additional tax (penalty).

A qualified Roth distribution is one that is:

  1. Made after the five-year period beginning with the first day of the year of the contribution, and
  2. Made on or after the date the taxpayer reaches age 59½, or made because the taxpayer is disabled, or paid to a beneficiary or estate after the taxpayer’s death, or eligible for the first-time homebuyer exception.

The holding period applies on the first day of the year that the conversion is made. The five-year period for a 2021 conversion would therefore run through December 31, 2025. Any withdrawal made before the holding period ends is not a qualified distribution.

Under the Roth IRA ordering rules, any withdrawal that is not a qualified Roth distribution is treated as:

  • First, distributed from regular contributions, then
  • Distributed from conversion and rollover contributions, then
  • Distributed from earnings

Applying these ordering rules, and assuming Oliver hasn’t made any regular contributions in the past, if he takes money out of his Roth IRA the withdrawal will be treated as a distribution of conversion contributions.

Continuing with the example, suppose that after making the $40,000 conversion this year he takes a $5,000 distribution from the Roth IRA in 2022.

The distribution is not taxable because he already paid tax on the conversion. However, since the five-year holding period is not up and Oliver is not yet 59½, the distribution would be subject to the 10% additional tax unless one of the other exceptions applies.

This restriction prevents taxpayers from trying to avoid a penalty on a traditional IRA distribution by making a Roth IRA conversion and immediately withdrawing the funds. A new holding period applies each year that Oliver makes Roth IRA conversions.

Once he turns 59½, the 10% additional tax won’t apply. However, although not likely given the ordering rules, any earnings withdrawal before a five-year holding period is up is subject to tax.

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