Natalie Choate answers reader questions about Roth conversion rules as they relate to inherited IRAs and profit-sharing plans.
Natalie Choate will be speaking at a location near you if you live in Waltham, Mass. (6/1/12); Hartford, Conn. (3/6/12); Las Vegas (4/26/12); St. Paul, Minn. (6/4/12); Chicago (5/1/12); Cincinnati (2/10/12); Overland Park, Kan. (5/3/12); Spokane, Wash. (5/8/12); Evansville (11/16/12), Indianapolis (6/8/12), or South Bend (9/20/12), Ind.; or Atlanta (10/19/12). See all of Natalie's upcoming speaking events at http://www.ataxplan.com/seminars/schedule.cfm.
Question: "Rose" has $20,000 in her traditional IRA, of which $16,000 is aftertax money (representing her nondeductible annual contributions over the years). She also owns, as beneficiary, an inherited IRA (left to her by her grandmother), from which she is taking annual minimum required distributions over her life expectancy. There is no aftertax money in the inherited IRA, which is now worth $100,000. Rose would like to convert her $20,000 traditional IRA to a Roth, if only the $4,000 pretax portion of that account would be taxable. But someone told her "all IRAs are aggregated." If she has to consider her own IRA and the inherited IRA as if they were one aggregated single account, then only a small portion of any Roth conversion would be considered a tax-free conversion of aftertax money. Must the inherited IRA be aggregated with her own for this purpose?
Answer: No. "Your own" IRA(s) must all be aggregated (treated as one) for purposes of determining how much of any distribution (or Roth conversion) from any one of them is taxable. In other words, the aftertax portion of your own IRAs is deemed to be spread ratably over all of your IRAs--it is not "attached" to the particular IRA account that you actually made the nondeductible contributions to. However, inherited IRAs are NOT aggregated with your own IRA(s) for this purpose.
This rule applies for minimum distribution purposes as well as for purposes of determining what portion of any distribution is taxable. Rose must take minimum required distributions attributable to the inherited IRA from the inherited IRA. Distributions from her own IRA would not count toward the distribution requirement applicable to the inherited IRA. And IRAs inherited from one decedent are not aggregated with IRAs inherited from any other decedent!
Question: "Wally" is retiring soon. His company's profit-sharing plan maintains two accounts for him, the "pre-1987 money" account and the "post-1986 money" account. The pre-1987 account contains aftertax money as well as pretax money. The post-1986 account is all pre-tax money. Can he convert the pre-tax money, by itself, to a Roth IRA?
Answer: Generally, a retirement plan cannot distribute the aftertax money in an employee's account separately from the pretax money. That's because retirement plan distributions are generally governed by § 72 of the Code. Since 1986, § 72 has applied a general rule that all plan distributions are deemed to contain proportionate amounts of the pre- and aftertax money in the account being distributed. Sometimes called the "cream in the coffee rule," this means that, if the total account contains 25% aftertax money, only 25% of each distribution will be deemed to be a tax-free distribution of aftertax money. Distributions will generally be 75% taxable and 25% tax-free.
However, § 72 does have some exceptions to this "cream" rule. One exception is in the nature of a grandfather rule: "In the case of a plan which on May 5, 1986, permitted withdrawal of any employee contributions before separation from service, subparagraph (A) shall apply only to the extent that amounts received before the annuity starting date (when increased by amounts previously received under the contract after December 31, 1986) exceed the investment in the contract as of December 31, 1986." Translated into English, this exception allows a "grandfathered" employee to withdraw his pre-1987 aftertax contributions tax-free, separately from all post-1986 balances and separately from the earnings on the pre-1987 contributions. If Wally's plan has properly kept track of these balances and is willing to distribute the pre-1987 aftertax contributions to him ahead of time, he should indeed be able to convert this aftertax money separately, tax-free, to a Roth IRA.
Needless to say there are not many people who can take advantage of this, because few of today's retirees have aftertax contribution accounts from 25 years ago still in their plans. Also, there is little or no IRS guidance on this "grandfather rule," so plans may or may not be willing to implement it.
Resources: For how to compute the taxable portion of any retirement plan distribution, see ¶ 2.2.01, "Road Map: Tax-free distribution of participant's basis," and ¶ 2.2.07, "Beneficiary's basis in an inherited IRA," in the book Life and Death Planning for Retirement Benefits (7th ed. 2011; www.ataxplan.com) by Natalie B. Choate. For minimum distribution rules on aggregation, see ¶ 1.3.04 ("Taking distributions from multiple plans") and ¶ 1.5.09 ("Aggregation of inherited accounts for MRD purposes").