Beware of this Roth IRA Conversion Tax Wrinkle

anti botox brigadeSome very clever folks have looked at the 2010 Roth IRA conversion facts, including the ability to spread the tax over tax years 2011 and 2012, and have discovered a unique situation… What would happen if I did the Roth conversion in 2010, elected to be taxed half in 2011 and half in 2012, but during 2011 I withdrew all of the funds from the account?  This way, you’d effectively have access to 100% of the funds while only paying tax on half of them.  (This assumes that your Roth IRA is otherwise qualified – e.g., you’re over age 59½ and the account has been in place for five years.) Hold on there, cowboy!  There’s a problem with your kooky little scheme – the IRS has planned for just such an eventuality.  Effectively, any amount that you withdraw from your Roth IRA that is not previous contributions or conversions, will be subject to tax in the year that you withdraw it, until you’ve paid the tax on the conversion.  This is in addition to the amounts that you owe tax on during that year due to your election to spread the tax.  Gobbledygook, right?  Right – howza bout an example?

An Example

You have an IRA worth $100,000, and in 2010 you decide you’d like to convert it to a Roth IRA.  You have an existing, five-year-old Roth IRA, with $20,000 in it.  In 2011, you withdraw $30,000 from the Roth IRA.  At the end of the year, instead of owing tax on $50,000 (half of the conversion amount of $100,000), you actually owe tax on $60,000. This is calculated as:  your withdrawal was $20,000 from earlier contributions, and $10,000 from the conversion.  That $10,000 must be added to the previously-agreed-upon $50,000 amount that you knew you’d owe tax on for 2011.  And then in 2012, you will owe tax on the remaining $40,000 from the conversion. So, in other words, the IRS has determined that this two-year tax deferral is not going to be used as a tax-free method for achieving tax-free withdrawals from your IRA – once the amounts have remained in the account until 2012, any amount can be withdrawn without tax.  But of course, you’ve already paid the tax on the conversion by that point (or rather, you will by tax day in 2013). So what happens if you withdraw the funds in 2010 after converting earlier in the year?  Effectively this is treated as a distribution from your original IRA (actually recharacterized from the Roth conversion), so you’d owe tax on that amount in 2010, and the remaining amount would be split between 2011 and 2012.

The “Hole”

I suppose that technically there is a time period where you could have access to 100% of the funds having paid zero tax:  between January 1, 2012 and April 15, 2012, when the tax bill is due for the first half of your conversion amount.  So you have three and a half months to unleash your devilish scheme on the world… not sure what you’ll do with this information, but perhaps there is some advantage that you might receive by leveraging the amount.  I doubt there’s much advantage to be had, especially given the loss of deferral if you withdraw the funds, but maybe you have a plan.  Go to town!
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Post from: Getting Your Financial Ducks In A Row IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment). Roth IRA Conversion Tax Payment Wrinkle Share and Enjoy: Digg del.icio.us Facebook Google Bookmarks email LinkedIn MySpace StumbleUpon TwitThis Live Technorati Tipd Yahoo! Buzz

About the author

Jim Blankenship, CFP®, EA

Jim Blankenship is the founder and principal of Blankenship Financial Planning, Ltd., a financial planning firm providing hourly, as-needed financial planning and advice. A financial services professional for over 25 years, Jim is a CFP professional and has earned the Enrolled Agent designation, a designation that qualifies him as enrolled to practice before the IRS. Jim is also a NAPFA-registered financial advisor, which designates him as a Fee-Only Financial Advisor.

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