Timing the Roth IRA Conversion
CPAs should consider client and state-specific factors in IRA tax planning. It'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. 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 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 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, 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. …