Conversion of a traditional IRA to a Roth IRA represents a tax opportunity, a tax cost—and a tax trap. The IRS is now focusing on the trap.

The Opportunity:

Funds held in a traditional IRA, after valid conversion to a Roth IRA, can be withdrawn free of income tax, if certain conditions, including a five (5) year holding period, are met. The strategy is to convert in order to exempt future growth in the IRA from income tax when withdrawn later, which could be by a later generation.

The Tax Cost:

Conversions to Roth IRAs are subject to income tax. The amount then in the traditional IRA that would be subject to income tax if withdrawn at that time is hit with an income tax on the conversion. However, one would not pay the 10% early withdrawal tax imposed on IRA account holders who are younger than age 59½.

The IRS Trap:

A conversion to Roth IRA is invalid if the taxpayer has more than $100,000 of (modified) adjusted gross income in the year the conversion is attempted. There are tax penalties for this: a 6% tax penalty for an excess IRA contribution and, for taxpayers under age 59 1/2, a 10% penalty for premature IRA withdrawal.

The "new, kindler, gentler" IRS has gone to great lengths to help taxpayers facing this trap, through liberal rules and deadlines allowing faulty conversions to be unraveled. But a recent memorandum from an IRS Service Center shows an intent to enforce the penalty against taxpayers who fail to satisfy its liberal conditions.

Careful Planning is Required:

Conversion to Roth IRA is about the trickiest thing an IRA owner can do with what may be his or her largest asset. A conversion can fail if the taxpayer is later found to have gone over the $100,000 limit because of overlooked income or denial of a deduction. This makes it crucial that income (modified Adjusted Gross Income) be accurately determined for the year of conversion.

For further information, contact Diane M. Pearson, CFP™ at (412) 635-9210 or legend@legend-financial.com