Timing the Roth IRA Conversion

CPAs should consider client and state-specific factors in IRA tax planning.
BY KEVIN T. STEVENS AND NANCY THORLEY HILL

EXECUTIVE SUMMARY
  • CPAs CAN PROVIDE VALUABLE ASSISTANCE TO THEIR clients by alerting them to the significant state tax implications of converting traditional IRAs to Roth IRAs. CPAs also should advise clients who converted in 1998 to consider the tax consequences of moving to another state within the next three years.
  • MOST STATES FOLLOW THE FEDERAL TAX TREATMENT of a Roth IRA conversion. Others have special rules CPAs need to understand if they have clients who live in those states. Nine states have no state income tax at all.
  • IN PLANNING FOR A ROTH IRA CONVERSION, CPAs should consider carefully whether, when and to which state clients plan to move. For example, converting in 1999 or later may be advantageous for clients who plan to move in the year 2000 or later from a high-tax state to a state without an income tax.
  • SOME TAXPAYERS FACE SPECIFIC STATE ISSUES concerning eligibility to file separate returns and the need to pay state taxes on a conversion even if they move to another state.
  • WHILE IT IS GENERALLY WORTHWHILE FOR AN ELIGIBLE taxpayer to convert a traditional IRA to a Roth IRA, the effect of state taxes can change this. It is up to CPAs to make certain clients get good advice on this important decision by asking the right questions.
KEVIN T. STEVENS, CPA, DBA, is professor of accountancy at DePaul University in Chicago. His e-mail address is kstevens@wppost.depaul.edu .

NANCY THORLEY HILL, CPA, CMA, PhD, is associate professor of accountancy at DePaul University. Her e-mail address is nhill@wppost.depaul.edu .

t’s obvious the federal tax consequences should weigh heavily in any taxpayer’s decision to convert a traditional IRA to a Roth IRA. What may be less clear—even to some CPAs—is that the decision may have state tax consequences as well. While several widely available tax software and spreadsheet programs allow taxpayers to estimate their federal tax liabilities from converting, those programs usually ignore state tax laws. CPAs can provide value-added advice to conversion clients by alerting them to the existence and complexities of state laws. Even taxpayers who converted in 1998 need to consider the perhaps unexpected state tax consequences of moving to another state during the four-year amortization period of the taxes due on conversion. Thus, all taxpayers need to understand the varying state tax policies surrounding past and future Roth IRA conversions.

While conventional wisdom is that taxpayers should base their conversion decisions on when they plan to retire and their expected future tax brackets, in some cases failure to consider state income taxes can lead clients to convert to Roth IRAs when they should not. Our survey of state tax departments found that many states planned to mirror the federal tax treatment of the conversion. This means in some circumstances CPAs and their clients can determine the effect of state taxes on Roth IRA conversions using prepackaged tax software or spreadsheet models by simply adding the applicable state tax rate to the federal rate in calculating total tax liability. In states with unique tax features, however, CPAs will need to make special calculations to make sure clients get the right advice.

Missed Opportunities

According to industry estimates, as of December 1998 only about 5% of those eligible to switch their traditional IRAs to Roth IRAs had converted. Taxpayers who failed to convert in 1998 missed out on a one-time four-year amortization of the taxes due on conversion.

KEEPING WITH TRADITION

Generally, a traditional IRA provides the taxpayer with an upfront tax deduction in exchange for taxation of withdrawals in later years. The Roth IRA, in effect, takes the opposite approach. Eligible taxpayers (those filing joint or single returns with adjusted gross incomes below $160,000 or $110,000, respectively) may make nondeductible IRA contributions now and withdraw principal and interest tax-free after age 59 12 if the accounts are at least five years old. Eligible taxpayers who plan to contribute to IRAs should take advantage of Roth rather than traditional IRAs as Roth IRAs provide tax-free rather than tax-deferred returns.

In addition, taxpayers (whether married or single) can roll over existing traditional IRAs to Roth IRAs if their AGIs in the year of conversion are less than $100,000. The rollover triggers taxable income. In 1999 and later years, the entire tax is due in the year of conversion. However, when the client should convert depends on the tax laws not only in the state in which they currently reside but also in the state in which they expect to reside. This means taxpayers who converted in 1998 should consider the effect of state taxes if they plan to move to other states within the next three years.

THE IMPACT OF STATE TAXES

Exhibit 1 shows the state-by-state tax treatment of Roth IRA conversions. Most states impose an income tax and plan to follow the federal tax treatment for converting to a Roth IRA. However, converting has varying tax implications depending on the state-specific tax rates and other state tax regulations.

Exhibit 1: State Taxation of Roth IRAs

The left-hand column lists the states that mirror federal tax treatment most closely. For example, Minnesota reports it follows exactly the federal taxation of converting to a Roth IRA—recognize the same amount of income in the same years with the same limitation on income and filing status. The middle column highlights the states with Roth state tax considerations of which taxpayers may be unaware. The right-hand column lists the nine states that do not impose a personal income tax. While taxpayers who live in those nine states may believe state taxes play no role in their decision of when to convert, many taxpayers move between states, as discussed below. Thus, the decision on when to convert should be based in part on comparing not only what tax bracket the taxpayer is in and expects to be in but also which state the taxpayer lives in and which state he or she expects to live in in the future.

IRA CONVERSION ALTERNATIVES

While taxpayers who have traditional IRAs must decide whether and when to convert these accounts to Roth IRAs, the focus in this article is not whether a taxpayer should convert but when he or she should do so. The examples below highlight the impact state taxes have on the timing of a conversion.

Carol Weber has $250,000 in a previously untaxed IRA and sufficient cash in non-IRA accounts to pay the taxes due on conversion to a Roth IRA. We used the worksheet developed by Gary R. Stout and Robert L. Barker (see JofA , Aug.98, page 59) to calculate net aftertax values for 1998 Roth IRA conversions and for values of traditional IRAs for money kept on account for 15 years at 8% interest.

We developed a similar worksheet to calculate the aftertax value for 1999 IRA conversions since these allow for no amortization of taxes. For taxpayers who plan to remain in the states in which they currently reside, determining the state tax costs is relatively straightforward. Exhibit 2 compares the aftertax (federal and state) consequences to Carol Weber of continuing to hold a traditional IRA to the aftertax value of converting to a Roth IRA. It also highlights the impact of state taxes by comparing a state with a relatively high tax rate, California, to a nontaxing state, Washington. Converting to a Roth IRA yields more money than keeping funds in a traditional IRA. The value of an IRA to a California taxpayer who converts to a Roth IRA in 1999 or later would be over $20,000 more in 15 years than the value of a traditional IRA ($521,352 vs. $499,617). The tax benefit is less but still substantial in nontaxing states as well (for Washington, or other no-tax states, $587,439 vs. $570,990).

Exhibit 2: Aftertax IRA Values* for Traditional and Roth IRAs
Assumptions:
  • $250,000 current fair market value of a traditional IRA.
  • 8% interest rate in both the traditional and the Roth IRAs.
  • 15 years until distributions begin.

California resident
Federal tax rate of 28%.
State tax rate of 9%.

Washington State resident
Federal tax rate of 28%.
No state taxes.
Keep traditional IRA

Convert to Roth IRA in 1999 or later.

$499,617

$521,352

$570,990

$587,439

*Results stated as the net aftertax balance in an IRA at the date of distribution.

AGI conversion limits. Some taxpayers may not be eligible to convert in 1999 or future years because their AGIs exceed $100,000. This provides an opportunity for tax planning. CPAs should advise clients who are close to meeting the AGI limitation in a particular year to delay recognition of income or to accelerate expenses. Indeed, in some cases, clients would be better off forgoing income to meet the eligibility requirements. For example, exhibit 3 demonstrates that California taxpayers with AGIs of roughly $110,000 who forgo $10,000 in income to be eligible to convert will be better off by approximately $2,000. (The amount of income a taxpayer should forgo varies due to differing state tax rates and should be calculated state by state.)

Exhibit 3: Forgoing Income to Convert to a Roth IRA—California Taxpayer
Opportunity costs of forgone income

Income forgone to meet $100,000 AGI limitation for conversion
Less federal and state taxes (combined income taxes of 37%)
Net income forgone

Opportunity cost of forgone income (future value of $6,300 at 8% for 15 years)

Net aftertax future value of 1999 conversion

Net aftertax future value of Roth IRA converted in 1999
Net aftertax future value of traditional IRA

Increase in IRA value from conversion

$ 10,000
3,700
$ 6,300

$521,352
499,617

$ 19,985


$ 21,735

Under current federal tax law, taxpayers must include in their AGIs distributions from traditional IRAs. When a distribution is the primary source of income, including the distribution may make an otherwise eligible taxpayer unable to convert to a Roth IRA. However, these taxpayers need to be aware that the Taxpayer Relief Act of 1997 provides them a future opportunity to convert to a Roth IRA. For tax years after 2004, distributions from traditional IRAs will not be included for purposes of determining the $100,000 AGI limitation.

MOVING TO ANOTHER STATE

Taxpayers who move between states may trigger unexpected state tax consequences. This can have an impact on when to convert to a Roth IRA—for those who have not yet done so—as well as for taxpayers who converted in 1998. Using the example from above, panel A of exhibit 4 illustrates the effect on IRA net aftertax values for taxpayers who correctly time the conversion to a Roth IRA. Assume Carol Weber lives in California and plans to move to a tax-free state, such as Nevada. Delaying the conversion until after her move to Nevada will increase the value of Carol’s Roth IRA by over $65,000 ($587,439 vs. $521,352). Also notice from table 4, panel A, that for taxpayers in high tax states who have already converted, the four-year amortization of taxes makes it better to move sooner rather than later. The longer Carol continues to reside in California, the lower the value of her IRA, because each additional year of residence results in another year of California state taxes.

Exhibit 4: Aftertax Roth IRA Values—Taxpayer Changes State of Residence
Panel A
Assumptions:
  • $250,000 current fair market value of a traditional IRA.
  • 8% interest rate in both the traditional and the Roth IRAs.
  • 15 years until distributions begin.
  • Taxpayer resides in California (federal rate 28%; state rate 9%).

Net Aftertax Value of IRA*

Live in California in 1999

Convert in 1999 tax year
Convert in some later tax year after move to Nevada

California Residents Who Converted in 1998

Move to Nevada in 2000 tax year
Move to Nevada in 2001 tax year
Move to Nevada in 2002 tax year

$ 521,352
$ 587,439

$577,367 1
$563,192 2
$550,077 3

*Results stated as net aftertax balance in IRA at date of distribution.

1Assumes the taxpayer moves to a tax-free state in 2000 and therefore only the 1998 and 1999 California taxes are paid. Since conversion occurred in 1998, federal and state taxes due at conversion are amortized over four years. The longer the taxpayer resides in California, the more years state taxes will have to be paid.

2Assumes the taxpayer moves to a tax-free state in 2001and thus pays California taxes in 1998, 1999 and 2000.

3Assumes the taxpayer moves to a tax-free state in 2002; therefore, all four years of amortized California taxes are paid. The 1998 conversion in California with the four-year amortization of taxes results in a greater IRA value than if conversion in California is delayed until 1999 or later.

Panel B
Assumptions:
  • $250,000 current fair market value of a traditional IRA.
  • 8% interest rate in both the traditional and the Roth IRAs.
  • 15 years until distributions begin.
  • Taxpayer resides in Nevada (federal rate 28%; no state tax)
Net Aftertax Value in IRA*

Live in Nevada in 1999

Convert in 1999 tax year
Convert in some later tax year after move to California

Nevada Residents Who Converted in 1998

Move to California in 2000 tax year
Move to California in 2001 tax year
Move to California in 2002 tax year

$587,439
$521,352

$581,896 1
$596,061 2
$609,176 3

*Results stated as net aftertax balance in IRA at date of distribution.

1Assumes the taxpayer moves to California in 2000 and pays two years of California taxes (2000 and 2001). Since conversion occurred in 1998, federal and state taxes due at conversion are amortized over four years. However, the longer the taxpayer resides in Nevada, the fewer years of California taxes he or she will have to pay.

2Assumes the taxpayer moves to California in 2001 and pays only one year of California taxes (2001).

3Assumes the taxpayer moves to California in 2002 and thus pays no California taxes. The amortization period occurs while the taxpayer lives in Nevada.

Consider the opposite scenario—the implications of moving from a no-tax state to a high-tax state. Clearly, taxpayers who are planning to move from Nevada to California should convert in Nevada and save roughly $65,000. However, what is also of interest are the tax consequences of the four-year amortization of income for those who converted in 1998 while living in a tax-free state. Notice from panel B that for taxpayers in tax-free states who already have converted, the four-year amortization of taxes means it is better to move later rather than sooner. The longer a taxpayer resides in Nevada, the greater the value of the IRA, because each additional year of Nevada residence results in avoiding an additional year of California state taxes.

OTHER STATE-SPECIFIC FEATURES

Taxpayers considering a Roth IRA conversion—depending on where they live—also may need to take other state-related factors into account.

Filing issues. Several states allow taxpayers to file joint federal returns and separate state returns. However, taxpayers should be aware that if they converted in 1998 and live in states that exactly follow the federal Roth IRA provisions, they are required to file joint federal and state returns for 1998 through 2001, which could prove disadvantageous. For example, it is generally better for a two-earner married couple living in Montana to file separate state tax returns. However, while Montana follows the federal rules on eligibility for a Roth IRA conversion, CPAs need to consider the state’s unique filing requirements. In particular, married couples who converted in 1998 must continue to file joint state tax returns until 2001. Furthermore, taxpayers who convert in later years also are required to file a joint state tax return in the year of the conversion.

Ongoing state tax liabilities. CPAs need to consider whether special rules apply to taxpayers who move to another state after a Roth IRA conversion. Some states plan to hold taxpayers liable for the four years of state taxes due from a 1998 Roth IRA conversion, even if they move to different states during the four-year amortization period. Louisiana and New York warn taxpayers who converted in 1998 that they still owe state taxes even if they move out of state. For example, New York taxpayers who converted in 1998 ordinarily would include only one-quarter of the conversion income for state tax purposes. However, if the taxpayer moves out of New York during 1999, the remainder of the conversion income must be included immediately in New York taxable income.

Tax-free conversions. Illinois tax law adds another dimension to CPAs’ tax planning. Illinois taxpayers have long enjoyed a unique IRA advantage; the state follows federal law on deductibility of contributions to traditional IRAs but does not follow it in taxing withdrawals. Illinois specifically excludes from state taxable income the distributions from previously tax-favored traditional IRAs. Furthermore, Illinois does not follow the federal tax law on taxing the conversion of a traditional to a Roth IRA. The amount included in an individual’s federal AGI from a conversion is excluded from Illinois taxable income.

Limited exclusions. Several states exclude from income certain portions of distributions from or rollovers to Roth IRAs. For example, for taxpayers age 59 12 or older, New York excludes up to $20,000 of IRA income reportable for federal tax purposes. North Carolina excludes up to $2,000 of the rollover from a traditional to a Roth IRA.

Nonrecognition of Roth IRAs. Under current law, Arkansas does not recognize Roth IRAs. In effect, Arkansas treats Roth and traditional IRAs like any other taxable savings account and imposes a tax on the earnings of all IRA accounts.

ANSWER THE RIGHT QUESTIONS

Obviously, many factors—some of which are easily incorporated into spreadsheet solutions (including estimated time to retirement, future tax rates and projected rates of return)—affect a taxpayer’s decision to convert to a Roth IRA. CPAs can provide valuable tax advice to their clients by considering these questions:

  • Can the client defer or forgo income or accelerate expenses in any one year to meet the strict $100,000 AGI limitation and qualify for a conversion?
  • Does the client plan to move? When and to which state?
  • Where does the client plan to retire?
  • For married taxpayers, do the advantages of conversion outweigh any possible disadvantages of being required to file a joint return in the year of conversion (or for 1998 to 2001 for those who converted in 1998)?
  • In the client’s home state, do special rules apply to taxpayers who change residence status?
  • Are the other benefits of Roth IRAs (taxpayers do not have to begin distributions from Roth IRAs at age 70 12 as required for traditional IRAs) more important to the client in making the decision than simply comparing the dollar differences among the alternatives?

The examples shown here provide guidance for a number of scenarios that show that differing state tax laws dramatically affect net aftertax IRA values. Clients should consider federal and state tax rates in deciding when and whether to convert. A CPA can provide insights on unique state laws that will increase the aftertax value of a client’s IRA. In particular, the CPA can advise the client to think of the long-term effects of the decision and the interplay between retirement plans and the timing of the conversion.

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