Planning for Individual NOLs: Converting to a Roth IRA

In tax years when an individual incurs negative taxable income, he or she faces the possibility of permanently losing the tax benefits of nonbusiness deductions, to the extent that such deductions exceed nonbusiness income. This may present an opportunity to convert a traditional IRA to a Roth IRA, thus capturing the benefits that would otherwise be permanently lost.

Individual NOLs

In computing taxable income for a tax year, a taxpayer can deduct, under Sec. 172(a), an amount equal to the aggregate of the net operating loss (NOL) carryovers and carrybacks to the tax year. This is known as the “NOL deduction.” Under Regs. Sec. 1.172-1(b), this deduction is determined by calculating the NOL for any preceding or succeeding tax year from which an NOL may be carried over or back.

Even though an NOL can potentially exist in any tax year in which a taxpayer’s allowable deductions for that year exceed his or her income, the determination of whether (and in what amount) an NOL was actually incurred for the tax year requires the taxpayer to consider modification of deductions listed in Sec. 172(d). Regs. Sec. 1.172-3(a)(1) disallows a deduction for personal exemptions, capital losses in excess of capital gains and nonbusiness deductions in excess of nonbusiness income.

For this purpose, nonbusiness deductions and nonbusiness income cannot be attributable to, or derived from, a taxpayer’s trade or business; wages and salary attributable to the trade or business would be business income, according to Regs. Sec. 1.172-3(a)(3)(i).

In part, the Regs. Sec. 1.172-3(a) modifications permanently disallow the potential tax benefit of itemized deductions (other than casualty losses and employee business expenses) to the extent such deductions exceed nonbusiness income; see also Regs. Sec. 1.172-3(e) and IRS Pub. 536, Net Operating Losses (NOLs) for Individuals, Estates, and Trusts.

Example 1: In 2004, C has $310,000 in gross income and $410,000 in allowable deductions; her allowable deductions would exclude an NOL deduction or any deduction on account of a sale or exchange of capital assets. Her gross income includes $10,000 of ordinary nonbusiness income; her deductions include $35,000 of ordinary nonbusiness deductions. She has no other items of income or deduction to which Sec. 172(d) applies; for simplicity’s sake, the personal exemption is ignored. As a result, C has a $75,000 NOL in 2004, calculated as shown in Exhibit 1 below.

Example 1 illustrates how the potential tax benefit associated with the disallowed deduction for excess nonbusiness deductions can become permanently lost without tax planning. Individuals facing such a situation may seek to accelerate nonbusiness income and/or defer nonbusiness deductions. In such contexts, an election to roll over a traditional IRA to a Roth IRA is a viable consideration. A Roth IRA conversion may serve not only to accelerate nonbusiness income and minimize lost tax benefits, it may also maximize an individual’s after-tax wealth, by capitalizing on the opportunity to subject traditional IRA distributions to a low (or zero) tax rate.

Roth IRA Conversion

Secs. 408 and 408A govern the tax treatment of traditional and Roth IRAs, respectively. The traditional IRA generally allows an individual to make a deductible investment contribution and realize tax-deferred earnings on the investment balance. In contrast, contributions to a Roth IRA are not deductible, but investment growth and distributions are tax free if the taxpayer meets certain requirements.

Subject to Sec. 408A(c)(3)(B) restrictions (discussed below), a traditional IRA may be converted to a Roth IRA via a qualified rollover contribution. The rollover is included in gross income in the distribution year, under Secs. 408A(d)(3)(A) and (B). Although a Roth IRA conversion decision has many variables, one rule is that it results in greater net assets (i.e., after-tax dollars) when an individual’s marginal tax rate at retirement equals or exceeds the rate in the conversion year (for a thorough examination of the relevant factors, see, e.g., Lange, “IRAs After the TRA ’97—What Hath Congress Roth?,” TTA, May 1998, p. 318). This relation is likely to hold in a tax year when an individual faces a potential NOL, thus making the Roth conversion desirable. In fact, the marginal tax rate on conversion will be zero to the extent of the individual’s excess nonbusiness deductions, provided that characterizing the income recognized under Sec. 408A(d)(3)(A) as nonbusiness is proper (discussed below).

Example 2: The facts are the same as in Example 1, except C rolls over her traditional IRA to a Roth IRA in 2004, generating $25,000 in nonbusiness income; see Exhibit 2 below.

As Example 2 illustrates, the $25,000 taxable IRA distribution increases C’s taxable income from $(100,000) to $(75,000), but her NOL remains unchanged, because the excess of nonbusiness deductions over nonbusiness income is now zero.

Nonbusiness Income

No direct guidance exists on how to characterize income recognized on a Roth IRA conversion. Regs. Sec. 1.172-3(a)(3)(i) defines nonbusiness income as income not attributable to, or derived from, a taxpayer’s trade or business. Similarly,  IRS Pub. 536 defines it as “income that is not related to your trade or business or your employment,” and provides as examples annuity income, dividends, interest on investments and an individual’s share of nonbusiness income from partnerships and S corporations. Because converting a regular IRA to a Roth IRA is unrelated to a taxpayer’s trade or business, characterizing the resulting income as nonbusiness appears appropriate.

The same conclusion may be reached by considering how nonbusiness deductions are defined. According to Regs. Sec. 1.172-3(a)(3)(i), they are deductions not attributable to, or derived from, a taxpayer’s trade or business. IRS Pub. No. 536 defines them similarly and provides as an example “contributions to an IRA or other self-employed retirement plan.” (Emphasis added.) If the contribution that gives rise to the IRA investment balance is properly characterized as a nonbusiness deduction, for consistency, income attributable to assets arising from the nonbusiness contribution should
be characterized as nonbusiness income.

Other Considerations

Sec. 408A(c)(3)(B) prohibits an individual from making a qualified rollover contribution to a Roth IRA from a traditional IRA if, for the tax year of the distribution to which such contribution relates, (1) the taxpayer’s modified AGI (MAGI) exceeds $100,000 or (2) he or she is married filing separately. For tax years beginning before 2005, any amount recognized as income as a result of a Roth conversion is excluded from the $100,000 limit, under Sec. 408A(c)(3)(C)(i). Although it is likely that an individual who incurs negative taxable income will meet the $100,000 MAGI threshold, that is not necessarily the case, because the MAGI computation does not consider personal exemptions or itemized deductions. Thus, individuals should exercise caution in assessing whether the MAGI limit is binding for the tax year of conversion.

Taxpayers need also to consider the alternative minimum tax (AMT) and state and local income tax implications. For example, certain nonbusiness deductions (e.g., real estate taxes in Examples 1 and 2) may not be allowed in computing alternative minimum taxable income (AMTI), thus reducing, for AMT purposes, the amount by which nonbusiness deductions exceed nonbusiness income. Because the income recognized on a Roth conversion is includible in both regular and AMTI, failure to consider the extent to which AMT nonbusiness deductions exceed AMT nonbusiness income could unwittingly subject an individual to AMT. Similarly, states and/or localities may impose income tax based on Federal AGI; thus, excess nonbusiness deductions may not be available to offset the income recognized on a Roth conversion.

From David W. Randolph, CPA, Ph.D., University of Dayton, Dayton, OH (Not affiliated with Baker Tilley International)