November 02, 2010
Basis In IRAs - How Massachusetts Rules May Differ
As taxpayers weigh the pros and cons of converting a conventional IRA to a Roth IRA, there are two major income tax considerations:
- the amount of taxable income realized as a result of the conversion, and
- the option to defer payment of tax.
Determination of taxable income with respect to an IRA to Roth IRA rollover and an outright distribution are the same; the option to defer recognition of 2010 income to 2011 and 2012 (and payment of tax) is specific to a Roth rollover.
IRA funds may come from a variety of sources: direct taxpayer deductible or non-deductible contributions, a rollover from an employer provided retirement plan including a 401(k) plan, a self-employed retirement plan or from a decedent. For purposes of determining taxability of an IRA distribution, all IRA accounts are aggregated, regardless of the source of funds or the specific account from which the distribution is made.
For federal income tax purposes, if non-deductible IRA contributions were never made, distributions from an IRA are fully taxable because no federal income taxes were paid on the initial contributions (regardless of the source of the funding), the income earned or the asset appreciation. In other words, a taxpayer has no basis in the IRA.
If non-deductible contributions were made, however, a taxpayer has basis in the IRA to the extent of the after-tax contributions made. In general, a taxpayer’s basis is reported on IRS form 8606 (Nondeductible IRAs) and this is a good time for you to review your most recent form 8606 for accuracy. If the entire IRA is distributed, only the distribution in excess of basis is taxable at ordinary income rates (if the amount distributed is less than the basis, the loss in excess of basis may be claimed as a federal income tax deduction on Schedule A, subject to the 2% floor). If the entire IRA is not distributed, taxable and non-taxable portions of the distribution are determined under the Internal Revenue Service annuity rules.
For Massachusetts income tax purposes, the tax treatment differs. Massachusetts does not allow an income tax deduction or exclusion for IRA contributions and, except as explained below, Massachusetts does not allow an income tax deduction or exclusion for contributions to a self-employed retirement plan. Accordingly, Massachusetts income tax has already been paid on amounts that a taxpayer has personally contributed. In other words, a taxpayer has Massachusetts basis to the extent that contributions were made from after tax dollars and IRA distributions are not subject to Massachusetts income tax until all Massachusetts basis has been recovered. Unlike the federal basis recovery rules, Massachusetts deems IRA distributions as allocable first to basis.
That said, note that for years prior to 1998 a self employed person, including a partner in a partnership, may have excluded from Massachusetts source income contributions to a 401(k) plan. Massachusetts Department of Revenue (Directive 08-3) ruled that for tax years beginning on or after January 1, 2008 contributions to a 401(k) plan by self employed persons, including partners, no longer are deductible for Massachusetts tax purposes. A 401(k) contribution may have been excluded either by separately stating the exclusion or, with respect to a partner in a partnership, may have been deducted in arriving at Massachusetts partnership on form 3K-1 (Massachusetts partnership K-1). Again, contributions to an IRA directly or by rollover that were not subject tax are not part of basis.
Regardless of an ultimate decision to retain an IRA in its current status or to do a Roth roll over, it is useful to determine IRA basis while historical records are still available.
There are still a few things to keep in mind. For taxpayers under age 59 1/2, any distribution that is not rolled over (i.e., funds held back for payment of tax due on the roll over) may be subject to a federal 10% penalty tax on early distributions (in addition to regular income tax). Therefore, it would be advantageous to roll over the entire amount of the distribution.
For the year 2010 only, an IRA distribution rolled into a Roth IRA may be included in taxable income in 2010 or, alternatively, an option is available to include 50% of the taxable distribution in 2011 income and 50% in 2012 income. The final decision may be postponed until the 2010 tax return is filed (by which time the proposed extension of tax cuts due to expire in 2010 should be resolved).
Bear in mind that fourth quarter 2010 estimated tax payments and 2010 extension payments should reflect an allowance for contingencies.