I have a client who has pretax assets in both a Traditional IRA and a 401(k) plan. She would like to move both accounts to a Roth IRA.  Are there any limitations that would prevent her from doing this?

Individuals may simultaneously convert Traditional IRA assets and roll over pretax 401(k) plan assets to a Roth IRA. The transactions are relatively straightforward from a compliance perspective. Neither are subject to income restrictions or the one-per-12-month rollover rule.  Both types of transactions can be done directly, which eliminates concerns over the 60-day rule.  Individuals who must take required minimum distributions (RMDs) cannot convert or roll over an RMD, but once their RMD has been satisfied for the year, they may convert or roll over any remaining amounts.

The tax liability incurred from a conversion or pretax-to-Roth rollover could be the most significant limitation for most clients.  Because of the tax consequences that may arise, clients should speak with a tax advisor who can help them determine how much income tax they may owe as a result of the transaction. This should be considered before any assets are converted or rolled over, as recent tax law changes have eliminated the ability to ‘undo’ these transactions if individuals later determine that their resulting tax liabilities are too burdensome.  To avoid paying a large amount of tax in one year, some clients may decide to convert or roll over portions of their pretax money over multiple years, rather than doing it all as one large lump-sum.

I have a young client who is changing jobs and will be rolling over the designated Roth account balance he had in his employer’s 401(k) plan to his first Roth IRA.  He may soon take a distribution from that Roth IRA to help make a down payment on his first house.  Will he owe any taxes or penalties if he does that?

For a Roth IRA distribution to be qualified, and any earnings distributed to be tax and penalty-free, it must be made for one of the four qualified reasons (age 59½, disability, death, or first-time home purchase), and the Roth IRA owner must meet a five-year waiting period, which begins on January 1 of the year for which the Roth IRA owner made his first Roth IRA contribution.

One potential pitfall of rolling over designated Roth assets to a Roth IRA is that the designated Roth account five-year period does not carry over to the Roth IRA. If the client has not previously had a Roth IRA, the rollover will start the five-year period.  So, even though the client appears to have a qualified reason (he is a first-time homebuyer), because he did not meet the five-year period, he will be taking a nonqualified Roth IRA distribution that may in some degree be subject to income tax and a penalty tax.

Nonqualified distributions may still be taken without tax consequences, as contributions are deemed to be removed first, and they are always tax free and penalty free when withdrawn.  Earnings are deemed to be removed last, and will be subject to income tax and a potential penalty tax when withdrawn.

Designated Roth account rollovers do not have their own unique tax consequences when distributed from a Roth IRA.  The taxation of the designated Roth account assets when distributed from the Roth IRA depends on whether the designated Roth account distribution was qualified or nonqualified at the time it was rolled over.  To be a qualified distribution, the designated Roth account distribution must be made for one of the qualified reasons (age 59½, disability, or death; note that first-time home purchase does not apply to a designated Roth account) and the client must have satisfied the five-year period.

• If the designated Roth account distribution was a qualified distribution, then the entire amount rolled over is treated as contributory assets in the Roth IRA.

• If the designated Roth account distribution was a nonqualified distribution, as was the case in our example, then the amounts that the individual had contributed to the plan are treated as contributions in the Roth IRA. The earnings in the designated Roth account are treated as earnings in the Roth IRA.

Even though the client does not meet the requirements to take a qualified distribution from the Roth IRA, he can still distribute the contributory assets without paying any tax or a penalty tax.  If the client removes any amounts attributable to earnings, he must pay income tax on that amount, but because he is a first-time homebuyer, he qualifies for a penalty tax exception, up to the $10,000 limit.

I have a client who rolled over $50,000 from her 401(k) plan to a Traditional IRA last year. She just realized that $13,000 of the rollover was from her designated Roth account. What should I do?

The designated Roth account assets are not eligible to be rolled over to a Traditional IRA. You should issue a corrected Form 5498 for last year in order to reflect this. The rollover amount originally reported in Box 2 should be reduced by the designated Roth amount ($50,000 – $13,000 = $37,000), and the designated Roth amount ($13,000) should be reported as a regular contribution in Box 1.

Because this amount exceeds the statutory IRA contribution limit, your client will need to remove at least some (or possibly all) of the contribution as an excess contribution. The client should remove the excess contribution, plus the net income attributable, before the applicable deadline (generally October 15).