From the September 2007 issue of Boomer Market Advisor • Subscribe!

An incredible tax savings opportunity, Pt. 2

For individuals with existing IRAs who meet the income limitations for a Roth conversion, the tax law is clear; you can roll the after-tax assets from your qualified retirement plan into an IRA. However, you cannot convert your after-tax contributions to a Roth IRA without converting and paying taxes on a pro-rata portion of your tax-deferred assets.

If you have $400 that are taxable and $100 that are nontaxable in an IRA (the IRS considers all IRA money as one pot) and you take out five dollars, four dollars of the distribution are taxed and one dollar is not.

You still might want to roll the after-tax money from the qualified retirement plan into an IRA, but you will need to figure out if a Roth IRA conversion is feasible, so consider converting as much as you are willing to pay taxes on.

For example, assume you have a traditional IRA of $10,000 (fully taxable) and $30,000 in the after-tax or nondeductible portion of your 401(k). You roll the $30,000 into a nondeductible IRA. If you were to convert both the deductible ($10,000) and the nondeductible ($30,000) IRAs to a Roth IRA, you only have to pay tax on converting the $10,000. You end up with a $40,000 Roth IRA, and you have only paid income tax on $10,000.

Beginning in 2008, the tax law permits direct rollovers from qualified plans to Roth IRAs. If your plan lets you segregate and rollover only the basis portion of your plan, it will be a great way to avoid taxation on the Roth IRA conversion, even if you have another IRA. I should note the IRS has yet to confirm this tax-free treatment. It is possible that the IRS will rule that the Roth conversion be taxed as if it came from a traditional IRA. Thus, its basis will be diluted.

Retired employees that can take a lump-sum distribution from their qualified plan might benefit from the change in the tax law in an even more substantial way. Since 2002, it has been permissible to roll both pre-tax and after-tax portions of a qualified plan into an IRA. Once in an IRA, these after-tax amounts can continue to grow tax-deferred, just as they had inside the plan. Later, if you decide to convert your traditional IRA to a Roth IRA, the after-tax portion reduces your tax, but you have the same problem; you can't restrict your conversion to the after-tax portion of the IRA. Therefore, converting to a Roth IRA is unlikely to be desirable to participants with large qualified plan balances.

Assume your client has $500,000 in his plan, of which $50,000 is basis. If the retiree wanted to make a $500,000 conversion, only $450,000 would be taxed, but few will want to this -- the taxes are simply too high.

Many retiring employees prefer to withdraw and spend the after-tax money from their plans up front. There is no income tax and there are new retirement activities to pursue. However, if there are other funds to spend, and if there is no compelling need to use that money, retirees may have a better path. Consider the following:

A participant with both pre-tax and after-tax money in a qualified plan rolls the entire amount into a traditional IRA. The IRA may also have its own basis from non-deductible contributions. If the retiree then goes back to work for an employer with a qualified plan, or becomes self-employed, and sets up a qualified plan like a one-person 401(k), the taxable amounts from the traditional IRA can be rolled into the new qualified plan. The tax laws allow rollovers from IRAs to qualified plans, but require the tax-free basis portion to stay in the IRA.

The result? All that remains in the traditional IRA are already-taxed dollars, which can be converted to a Roth IRA without tax. The amount rolled back into the new qualified plan will grow tax deferred. This is the best of both worlds -- a free Roth IRA conversion and the taxable balance in a qualified plan.

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