The benefits of isolating ‘basis’ in an IRA

December 20, 2018

If you have been saving for retirement and are in your 60s, you may have a planning opportunity (isolating basis) that I’ll explain through a hypothetical example.

“John” will be 70 next spring (March 31, 2019), but is still working and participating in his employer’s 401(k) plan. He owns more than 5 percent of the shares of his employer’s company. John’s 401(k) permits him to transfer individual retirement account (IRA) holdings into the 401(k).

John’s 401(k) balance is $100,000; he has one IRA with a balance of $220,000. Over the years, he made $20,000 of nondeductible contributions (“basis”) to his IRA. (Remember that contributions to traditional IRAs are not deductible for all taxpayers.)

Do you see any planning opportunities?

Let’s focus on one: a tax-free conversion into a Roth IRA. Let me explain the strategy through questions I posed to the tax experts at Fairmark.com:

1. Since John has a 401(k) that accepts transfers, can he transfer all but his basis of $20,000 from his IRA into his 401(k)?

“Yes. Employer plans, such as 401(k)s, are permitted, but not required, to accept transfers from IRAs. They can accept only pretax dollars, however, so John can transfer $200,000 to the 401(k) and leave $20,000 behind in his IRA.” If John takes this action in 2018, John will have $20,000 in his IRA and $300,000 in his 401(k), assuming, for the sake of this example, no change in value in either account.

2. If John converts the remaining $20,000 in his IRA into a Roth, what are his tax consequences?

“The taxable amount in a Roth conversion is the dollar amount converted, reduced by the taxpayer’s basis in the IRA. John has removed all the pretax dollars from his IRAs, so his basis is equal to the dollar amount he converted. He’ll have to report the conversion on his tax return, but the taxable amount will be $0.”

3. What are his RMD requirements from his $300,000 401(k) in 2019?

“Although he is not yet retired, he has to begin taking distributions as of the year he attains age 70 1/2. (The distribution for that first year can be taken as late as April 1 of the following year, but failing to take a distribution in the year he turns 70 1/2 would mean having to take two years’ worth of distributions in the following year.)”

4. What if John didn’t own shares of his employer?

If John didn’t own shares of his employer’s stock (or held less than 5 percent), “the first year for which John would be required to take distributions from the 401(k) would be the year he stopped working for the company that maintained this 401(k). Here again, the distribution for that first year (the year he retired) could be delayed until April 1 of the following year.”

5. Is there any reason for John to do the transfer to his 401(k) in 2018?

“If John waits until 2019, when he turns 70 1/2, the first dollars coming out of his IRA (dollars he intends to roll over to the 401(k)) will be treated as satisfying his RMDs for the year in which he reaches that age. That portion won’t be eligible for rollover, and it will be taxable income to him.”

6. What are the benefits of doing this sort of planning?

“The chief benefit of this planning for John is to shield future investment earnings on the $20,000 in after-tax dollars in his IRA from taxation, as these earnings will be building up in a Roth IRA (where they must remain for five years if they are to come out free of tax). If John were not a 5 percent owner, the benefit would be greater, as he would also be avoiding RMDs on the amount in his IRA. Keep in mind, though, that there are other considerations, such as the quality of investments available in the 401(k).”

According to Michael Landsberg, CPA/PFS member of the American Institute of CPAs Personal Financial Planning Executive Committee, what John is doing is “considered a tax-free conversion because the entire rollover would be basis at that point. Rolling all pretax money into a 401(k) allows for the taxpayer to isolate basis and avoid having to pick up taxable income on a pro-rata basis.”

Tax planning takes awareness of opportunities and expertise, which is a must before taking any action that affects RMDs and conversions.

To find a tax expert in your area who is best suited to handle your specific needs, use the AICPA’s Find a CPA tool (https://cpapowered.org/find-a-cpa). Searches can be filtered by location, service and industry expertise to help you pinpoint the perfect professional who checks all your specific boxes.

On another note, if you are a believer in financial literacy education, as am I, you may be interested in an award that I’m sponsoring, the first annual 401(k) Champion Award. (You’ll see an ad announcing the award in the print edition of today’s paper.) My goal is to shine a light on 401(k) participants who see their 401(k)s as enabling them to retire securely. If you know anyone who “loves” his/her 401(k), please him/her to apply. For rules and deadlines, go to juliejason.com/award or email me at readers@juliejason.com.

Julie Jason, JD, LLM, a personal money manager (Jackson, Grant of Stamford) and author, welcomes your questions/comments (readers@juliejason.com). Her awards include the 2018 Clarion Award, symbolizing excellence in clear, concise communications. Her latest book, a curated collection of Julie’s columns, is “Retire Securely: Insights on Money Management From an Award-Winning Financial Columnist.” To hear Julie speak, visit juliejason.com/events.

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