Timing the Roth IRA conversion.CPAs should consider client and state-specific factors in IRA Ira, in the Bible Ira (ī`rə), in the Bible. 1 Chief officer of David. 2, 3 Two of David's guard. IRA, abbreviation IRA. tax planning Tax planning Devising strategies throughout the year in order to minimize tax liability, for example, by choosing a tax filing status that is most beneficial to the taxpayer. . It's it's 1. Contraction of it is. 2. Contraction of it has. See Usage Note at its. it's it is or it has it's be ~have obvious the federal tax consequences should weigh heavily in any taxpayer's decision to convert a traditional IRA Traditional IRA An IRA that is not a Roth IRA or a SIMPLE IRA. Individual taxpayers are allowed to contribute 100% of compensation (Self-employment income for Sole proprietors and partners) up to a specified maximum dollar amount to their Traditional IRA. to a Roth IRA Roth IRA An individual retirement plan that bears many similarities to the Traditional IRA. Contributions are never deductible, and qualified distributions are tax-free. A qualified distribution is one that is taken at least five years after the taxpayer established his/her first . 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 spreadsheet Computer software that allows the user to enter columns and rows of numbers in a ledgerlike format. Any cell of the ledger may contain either data or a formula that describes the value that should be inserted therein based on the values in other cells. programs allow taxpayers to estimate their federal tax liabilities from converting, those programs usually ignore state tax laws. CPAs can provide value-added val·ue-add·ed adj. Of or relating to the estimated value that is added to a product or material at each stage of its manufacture or distribution: 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 sur·round tr.v. sur·round·ed, sur·round·ing, sur·rounds 1. To extend on all sides of simultaneously; encircle. 2. To enclose or confine on all sides so as to bar escape or outside communication. n. past and future Roth IRA conversions Roth IRA Conversion A reportable movement of assets from a Traditional, SEP or SIMPLE IRA to a Roth IRA. The movement of assets may be taxable. Notes: A conversion may be accomplished by a rollover of assets directly between the trustees of the Traditional and Roth IRAs, . While conventional wisdom is that taxpayers should base their conversion decisions on when they plan to retire and their expected future tax brackets Tax Bracket The rate at which an individual is taxed due to a particular income level. Notes: Each income class is taxed at a different level. Generally, the more you make the more you are taxed. , 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 CIRCUMSTANCES, evidence. The particulars which accompany a fact. 2. The facts proved are either possible or impossible, ordinary and probable, or extraordinary and improbable, recent or ancient; they may have happened near us, or afar off; they are public or CPAs and their clients can determine the effect of state taxes on Roth IRA conversions using prepackaged pre·pack·age tr.v. pre·pack·aged, pre·pack·ag·ing, pre·pack·ag·es To wrap or package (a product) before marketing. Adj. 1. 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. KEEPING WITH TRADITION Generally, a traditional IRA provides the taxpayer with an upfront tax deduction Tax deduction An expense that a taxpayer is allowed to deduct from taxable income. tax deduction See 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 non·de·duct·i·ble adj. Not deductible, especially for income-tax purposes. Adj. 1. nondeductible - not allowable as a deduction deductible - acceptable as a deduction (especially as a tax deduction) IRA contributions now and withdraw principal and interest tax-free tax-free adj. Not subject to taxation; tax-exempt. tax-free Adjective not needing to have tax paid on it: a tax-free lump sum Adj. 1. after age 59 1/2 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 A graphic element in an application or on a Web page that changes its color or shape when the pointer is moved (rolled) over it. See JavaScript rollover. See also n-key rollover. triggers taxable income Under the federal tax law, gross income reduced by adjustments and allowable deductions. It is the income against which tax rates are applied to compute an individual or entity's tax liability. The essence of taxable income is the accrual of some gain, profit, or benefit to a taxpayer. . In 1999 and later years, the Years, The the seven decades of Eleanor Pargiter’s life. [Br. Lit.: Benét, 1109] See : Time 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, page 75, 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 ILLUSTRATION OMITTED] 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 Weber, river, United States Weber (wē`bər), river, c.125 mi (200 km) long, rising in the Uinta Mts., N central Utah, and flowing north and northwest to join the Ogden River at Ogden. The combined stream flows to the Great Salt Lake. has $250,000 in a previously untaxed Adj. 1. untaxed - (of goods or funds) not taxed; "tax-exempt bonds"; "an untaxed expense account" tax-exempt, tax-free nontaxable, exempt - (of goods or funds) not subject to taxation; "the funds of nonprofit organizations are nontaxable"; "income exempt 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 stout, alcoholic beverage: see beer. and Robert L. Barker barker a term for an animal that does not usually bark which makes a violent respiratory effort, often during a convulsion, accompanied by a sound which roughly resembles a dog's bark. (see JofA, Aug. 98, page 59) to calculate net aftertax values for 1998 Roth IRA conversions and for values of (jargon) for values of - A common rhetorical maneuver at MIT is to use any of the canonical random numbers as placeholders for variables. "The max function takes 42 arguments, for arbitrary values of 42". "There are 69 ways to leave your lover, for 69 = 50". 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 tax costs n. a motion to contest a claim for court costs submitted by a prevailing party in a lawsuit. It is called a "Motion to Tax Costs" and asks the judge to deny or reduce claimed costs. is relatively straightforward. Exhibit 2, page 75, 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 California (kăl'ĭfôr`nyə), most populous state in the United States, located in the Far West; bordered by Oregon (N), Nevada and, across the Colorado River, Arizona (E), Mexico (S), and the Pacific Ocean (W). , 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. California
resident Washington
* 8% interest rate Federal tax State resident
in both the traditional rate of 28%. Federal tax
and the Roth IRAs. State tax rate of 28%.
rate of 9%. No state taxes.
* 15 years until
distributions begin.
Keep traditional IRA $499,617 $570,990
Convert to Roth IRA in $521,352 $587,439
1999 or later.
(*) Results stated as the net aftertax balance in an IRA at the date of distribution. AGI (Artificial General Intelligence) A machine intelligence that resembles that of a human being. Considered impossible by many, most artificial intelligence (AI) research, projects and products deal with specific applications such as industrial robots, playing chess, 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 for·go also fore·go tr.v. for·went , for·gone , for·go·ing, for·goes To abstain from; relinquish: unwilling to forgo dessert. income to meet the eligibility requirements. For example, exhibit 3, page 77, 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 $10,000 Less federal and state taxes (combined income taxes of 37%) 3,700 Net income forgone $6,300 Opportunity cost of forgone income (future value of $6,300 at 8% for 15 years) $19,985 Net aftertax future value of 1999 conversion Net aftertax future value of Roth $521,352 IRA converted in 1999 Net aftertax future value of traditional IRA 499,617 Increase in IRA value from conversion $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, page 78, 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 Net Aftertax 28%; state rate 9%). Value of IRA(*) Live in California in 1999 Convert in 1999 tax year $521,352 Convert in some later tax $587,439 year after move to Nevada California Residents Who Converted in 1998 Move to Nevada in 2000 tax year $577,367(1) Move to Nevada in 2001 tax year $563,192(2) Move to Nevada in 2002 tax year $550,077(3) (*) Results stated as net aftertax balance in IRA at date of distribution. (1) Assumes 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. (2) Assumes the taxpayer moves to a tax-free state in 2001 and thus pays California taxes in 1998, 1999 and 2000. (3) Assumes 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 Net Aftertax (federal rate 28%; no state tax) Value in IRA(*) Live in Nevada in 1999 Convert in 1999 tax year $587,439 Convert in some later tax year $521,352 after move to California Nevada Residents Who Converted in 1998 Move to California in 2000 tax year $581,896(1) Move to California in 2001 tax year $596,061(2) Move to California in 2002 tax year $609,176(3) (*) Results stated as net aftertax balance in IRA at date of distribution. (1) Assumes 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. (2) Assumes the taxpayer moves to California in 2001 and pays only one year of California taxes (2001). (3) Assumes 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 dis·ad·van·ta·geous adj. Detrimental; unfavorable. dis·ad  van·ta . 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 Louisiana (ləwē'zēăn`ə, l  ē'–), state in the S central United States. It is bounded by Mississippi, with the Mississippi R. and New York New York, state, United StatesNew York, Middle Atlantic state of the United States. It is bordered by Vermont, Massachusetts, Connecticut, and the Atlantic Ocean (E), New Jersey and Pennsylvania (S), Lakes Erie and Ontario and the Canadian province of 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 or·di·nar·i·ly adv. 1. As a general rule; usually: ordinarily home by six. 2. In the commonplace or usual manner: ordinarily dressed pedestrians on the street. 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 Illinois, river, United States Illinois, river, 273 mi (439 km) long, formed by the confluence of the Des Plaines and Kankakee rivers, NE Ill., and flowing SW to the Mississippi at Grafton, Ill. It is an important commercial and recreational waterway. 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 1/2 or older, New York excludes up to $20,000 of IRA income reportable for federal tax purposes. North Carolina North Carolina, state in the SE United States. It is bordered by the Atlantic Ocean (E), South Carolina and Georgia (S), Tennessee (W), and Virginia (N). Facts and Figures Area, 52,586 sq mi (136,198 sq km). Pop. excludes up to $2,000 of the rollover from a traditional to a Roth IRA. Nonrecognition of Roth IRAs. Under current law, Arkansas Arkansas, river, United States Arkansas (ärkăn`zəs, är`kənsô'), river, c.1,450 mi (2,330 km) long, rising in the Rocky Mts., central Colo. does not recognize Roth IRAs. In effect, Arkansas treats Roth and traditional IRAs like any other taxable savings account Savings Account A deposit account intended for funds that are expected to stay in for the short term. A savings account offers lower returns than the market rates. Notes: 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 de·fer 1 v. de·ferred, de·fer·ring, de·fers v.tr. 1. To put off; postpone. 2. To postpone the induction of (one eligible for the military draft). v.intr. 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 out·weigh tr.v. out·weighed, out·weigh·ing, out·weighs 1. To weigh more than. 2. To be more significant than; exceed in value or importance: The benefits outweigh the risks. 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 7072 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 (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. 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 Long-term Three or more years. In the context of accounting, more than 1 year. long-term 1. Of or relating to a gain or loss in the value of a security that has been held over a specific length of time. Compare short-term. effects of the decision and the interplay in·ter·play n. Reciprocal action and reaction; interaction. intr.v. in·ter·played, in·ter·play·ing, in·ter·plays To act or react on each other; interact. between retirement plans and the timing of the conversion. Missed Opportunities According to according to prep. 1. As stated or indicated by; on the authority of: according to historians. 2. In keeping with: according to instructions. 3. 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. Everything You Need to Know ... CPAs who visit www.rothira.com, the Roth IRA Web site home page, will find an exhaustive list of links to the latest news, articles, books, seminars, software, IRS An abbreviation for the Internal Revenue Service, a federal agency charged with the responsibility of administering and enforcing internal revenue laws. updates and other resources. The site is designed to provide technical and planning information on Roth IRAs for practitioners and consumers. RELATED ARTICLE: 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 DePaul University[1] is a private institution of higher education and research in Chicago, Illinois, USA. in Chicago. His e-mail address See Internet address. e-mail address - electronic mail address is kstevens@wppost.depaul.edu. NANCY THORLEY HILL, CPA, CMA CMA - Concert Multithread Architecture from DEC. , PhD, is associate professor of accountancy at DePaul University. Her e-mail address is nhill@wppost.depaul.edu.3 |
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