(Nest) Egg on My Face!

Dear Readers,
Mea Culpa! I goofed! Many thanks to those of you who brought this to my attention. On more than one occasion I've mentioned that you can get in trouble by using logic to apply the tax code. This time, I was the one who got tripped up.

Here's the situation: You're retiring from your company and have both pre-tax and after-tax money in your 401(k) plan. You plan to roll this money into IRAs, but are wondering if you can simply earmark the after-tax money for a Roth IRA. Can you do this?

First, thanks to the 2001 Tax Act, it is possible to move retirement assets from one type of account to another ? provided the receiving account will allow this. For instance, if you were changing jobs, you could (theoretically) transfer your 403(b) assets into your new employer's 401(k) plan. In addition, you can (theoretically) roll IRA assets into your 401(k). And, of course, you've always been able to roll the money in your company plan into an IRA when you leave your employer.

So, it is perfectly fine to roll both your pre-tax and after-tax 401(k) contributions to an IRA. However, due to a quirk in the tax code, ALL assets have to go into a traditional IRA first. Then you can convert all or part of this amount to a Roth IRA, paying any income tax due at the time of the conversion.

But here's the catch: you cannot isolate your after-tax money and decide to convert just those dollars to a Roth. I know what you're thinking (so was I): since I already paid tax on this money, there won't be any additional tax due upon conversion.

Won't work.

If you want to convert money in a traditional IRA to a Roth, you're required to add up the assets you have in ALL of your traditional IRAs. Then, if you have any after-tax contributions, you have to figure out what portion of your total traditional IRA assets this represents. This will be applied against the amount you convert to a Roth so that you're only taxed on the pre-tax portion.

Let's say you have $100,000 in your traditional IRA. $20,000, or 20 percent, came from after-tax contributions you made.

Now assume that you want to convert $20,000 worth of your IRA to a Roth IRA. To eliminate the taxes you have to pay, it would be advantageous to specify that the entire $20,000 consists of money you already paid tax on.

No dice.

Instead, only 20 percent of this amount will be considered as coming from after-tax contributions. The remaining 80 percent — $16,000 — will be considered pre-tax money. That's what you'll owe income tax on.

A thousand apologies for leading anyone astray.

If you have already initiated an IRA conversion involving after-tax money, you've got two choices: re-calculate the tax you owe based on the above and incorporate this into your 2004 tax return, or undo the conversion before filing your return. (Latest date for that is Aug. 15, 2005, so there's plenty of time.)

Reversing an IRA conversion is called "re-characterizing" your IRA. It's simple and does not require you to submit any paperwork to the IRS (although you mut reflect it on your federal income tax return). Just contact your IRA custodian to see what's required — all have slightly different rules, but this is not a complicated procedure.

Humbly,

Gail

Hi Gail,

My mom died earlier this year, leaving her Roth IRA to my dad. He doesn't need the money and would rather it go to the four of us kids, who are named as contingent beneficiaries.

The only wrinkle is that my mom's Roth IRA is only 3 years old.

What's the best way to arrange for this money to pass to me and my siblings?

Thanks,

Mary

Dear Mary —

This is more complicated than most people realize! First of all, withdrawals from a Roth IRA are not always tax-free. Certain Roth withdrawals are subject to tax if the account is not at least 5 years old. In addition, instead of dealing with your own Roth IRA, it's an inherited Roth.

Instead of going into all of the conditions and exceptions, I'm going to lay out the choices available in your particular situation.

If you and your siblings are willing to wait, here's the way you can end up with the most amount of money. Have your dad roll over your mom's Roth IRA into one in his own name. As the new owner of this Roth IRA, he never has to touch the money if he doesn't need it. That's because, unlike owners of traditional IRAs, Roth owners are not required to take minimum withdrawals when they reach age 70 1/2.

When your dad rolls over the Roth, he can name his children (including you) as the beneficiaries of this IRA. The assets in it will continue to grow on a tax-free basis until your dad dies.

When you and your siblings inherit this IRA, you can split the Roth IRA into four separate accounts, one for each of you.

Since only a spouse who inherits an IRA can roll it into his/her own name, you are not allowed to change the ownership on these accounts. Instead, your dad's name will remain on the accounts as the deceased "owner," with one child per account named as the beneficiary.

Even though the money will usually come out of an inherited Roth IRA tax-free, non-spouse beneficiaries must begin withdrawing the assets. You can either take just a minimum amount each year based on your own life expectancy, or completely drain the Roth within 5 years. In your case, each child could decide what she wants to do with her portion of your dad's IRA.

Withdrawing just the minimum each year is known as "stretching" the IRA over the life of the beneficiary. Clearly, the longer the money is allowed to remain in the Roth- where it has the potential to continue to accumulating earnings tax-free- the greater the ultimate payout is likely to be.

For instance, let's assume your dad's Roth IRA is worth $200,000 at his death. Each of his 4 children is a 25-percent beneficiary. After dividing his Roth into four "beneficiary" IRAs, you decide to cash in right away, while your brother decides to stretch.

Assuming the Roth has been open at least 5 years (counting the years your mother owned it), you walk away with $50,000 — tax-free. Pretty tempting. Until you see what your brother gets.

Let's say he's 50 years old, which gives him a life expectancy of just over 30 years. His first withdrawal will be 1/30th of the IRA — tax-free. The next year, he'll take out 1/29th — again, tax-free. By just taking out a small fraction of the IRA value each year, your brother is getting mega-bang for his buck: during the early years, most of the assets remain in the Roth where they can continue to compound.

If we assume an 8-percent annual rate of return on this inherited Roth IRA, your brother will have stretched $50,000 into $300,000 over those 30 years. And every cent will be tax-free.

So that's one way to handle your Mom's Roth IRA.

The other option is for your dad to simply "disclaim" the IRA. In other words, as the primary beneficary, he declines to accept it. (A disclaimer must be made within 9 months of death and you'll want to have a lawyer draft the paperwork.) In that case, your mom's Roth IRA will pass to the contingent beneficiaries — her children. Once again, each of you has the choice of either stretching out her inherited portion or completely emptying it within 5 years.

Now, here's where it gets complicated. If you take withdrawals from an inherited Roth IRA that isn't at least 5 years old, you have to pay income tax — but just on the portion of the withdrawal that's considered "earnings." There's no tax on the amount that comes from the annual contributions your mom made or from converted dollars.

Your Mom's Roth IRA probably has some earnings in it, so that means you'll end up paying tax on part of the $50,000 you receive. But since the Roth has only had three years to generate returns, in all likelihood earnings will make up just a small portion of the total.

Once again, though, your brother comes out ahead by stretching out instead of cashing out. That's because money withdrawn from a Roth IRA is subject to an "ordering" rule. It's assumed that the first dollars taken out come from annual contributions. Once that amount is used up, the next dollars are assumed to be from a conversion. Once all converted dollars are withdrawn, then you start dipping into the earnings in the account.

But according to CPA Ed Slott, author of "The Retirement Savings Time Bomb and How to Defuse It," this won't be a problem for your brother. Since he's just taking out the minimum amount each year, it's going to take him years before he starts withdrawing earnings. And by then the Roth IRA will be more than 5 years old, the point at which earnings can be withdrawn tax-free. (You can visit Slott's website here).

Here's a compromise for you: Instead of cashing out right away, just take the required minimum withdrawal for two years. After that, the Roth will reach the 5-year milestone (including the 3 years your mom owned it.) At that point, all of the money can be taken out tax-free, whether you're "stretching" or withdrawing a lump sum.

Hope this helps!

Gail

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