Question on 401K Roth Conversion, Earned Income and IRA Deduction

[bobandsherry]

I understand with no earned income I am unable to take any deduction for IRA. I am considering doing an in-plan Roth conversion for a small portion ($30K) of my 401K this year. As I understand the Roth conversion ($30K) will be reported as "gross income", would that then qualify as "earned income" for purpose of taking IRA deduction? I think not but thought I'd ask.

 

[pb4uski]

No.

 

[Sunset]

With no earned income is there some other income that causes you to limit it to only $30K ?

 

[bobandsherry]

With no earned income is there some other income that causes you to limit it to only $30K ?

I had originally included more info and then edited down to pertinent info/question. So here's additional background.

My wife and I both retired last year. I turned 55 in the year I retired. My 401K is still with my ex-employer. My plan allows partial Roth rollover as well as partial distributions (yep, a nice plan). Our income is from interest, dividends, capital gains and required distribution from 401K Sup plan.

Limit of $30K as I want to stay below MAGI 400% cap for health care subsidy. I would repeat this over next few years.

I figure converting small portion to Roth would still be relatively low tax rate and then any earnings would be tax free. Additionally, Roth withdrawal in future won't count in my MAGI (for health care subsidies and Medicare, depending on what the government does with each).

Do you see any flaw in my logic? Always looking to learn more (and be taxed less).

 

[Sunset]

Just wondered why the limit of 30K on conversion, but it makes sense now.

 

[Senator]

I understand with no earned income I am unable to take any deduction for IRA. I am considering doing an in-plan Roth conversion for a small portion ($30K) of my 401K this year. As I understand the Roth conversion ($30K) will be reported as "gross income", would that then qualify as "earned income" for purpose of taking IRA deduction? I think not but thought I'd ask.

The only way to make that earned income, so you can take an IRA deduction, is to issue yourself a 1099 MISC.

You then pay 15.3% self employment tax on that money, and what is left you pay income tax (again) and make a IRA contribution.

 

[bobandsherry]

The only way to make that earned income, so you can take an IRA deduction, is to issue yourself a 1099 MISC.

You then pay 15.3% self employment tax on that money, and what is left you pay income tax (again) and make a IRA contribution.

Is there a reason to issue 1099 MISC vs. filing Schedule C?

 

[SecondCor521]

I'd probably try to find some way to just earn some or all of the $13K ($6.5K x 2, assuming wife is >50) instead of voluntarily paying the additional taxes on the Roth conversion.

Or I'd forgo the IRA contribution. Why try to stuff more money into tax-deferred at the same time you're trying to get it out?

 

[PatrickA5]

The only way to make that earned income, so you can take an IRA deduction, is to issue yourself a 1099 MISC.

You then pay 15.3% self employment tax on that money, and what is left you pay income tax (again) and make a IRA contribution.

I'm confused, what would the reason be to issue yourself a 1099misc? Wouldn't you need some kind of self employment income?

 

[bobandsherry]

I'd probably try to find some way to just earn some or all of the $13K ($6.5K x 2, assuming wife is >50) instead of voluntarily paying the additional taxes on the Roth conversion.

Or I'd forgo the IRA contribution. Why try to stuff more money into tax-deferred at the same time you're trying to get it out?

My original question was if Roth conversion would be reported as earned income, thinking it wouldn't and received confirmation. My thought was if the Roth conversion event was reported as earned income I'd offset the tax partially by putting money into IRA, including a Retirement Savings Tax Credit (possible 50% of contribution).

Since my answer to original question is "no" there's no benefit to the IRA so I'll be passing on that as offsetting option for Roth.

 

[pb4uski]

I had originally included more info and then edited down to pertinent info/question. So here's additional background.

My wife and I both retired last year. I turned 55 in the year I retired. My 401K is still with my ex-employer. My plan allows partial Roth rollover as well as partial distributions (yep, a nice plan). Our income is from interest, dividends, capital gains and required distribution from 401K Sup plan.

Limit of $30K as I want to stay below MAGI 400% cap for health care subsidy. I would repeat this over next few years.

I figure converting small portion to Roth would still be relatively low tax rate and then any earnings would be tax free. Additionally, Roth withdrawal in future won't count in my MAGI (for health care subsidies and Medicare, depending on what the government does with each).

Do you see any flaw in my logic? Always looking to learn more (and be taxed less).

No, I think that makes perfect sense... in fact, I think you could over convert a bit and then recharacterize any excess over 400% FPL when you finalize your tax return.... that is what I do except my target is the top of the 15% tax bracket rather than 400% FPL. I'm guessing that you'll pay little to no tax on the $30k conversion depending on the character of your other income.

 

[Senator]

The OP has already answered their question, but I will respond to the questions directed at me.

I'm confused, what would the reason be to issue yourself a 1099misc? Wouldn't you need some kind of self employment income?

You can pay yourself any amount you want. The IRS doesn't care if you declare additional earned income. It may not make sense, but you can do it. Taking passive income from a pre-tax 401K will incur a 15.3% self employment tax, plus any income taxes that you would pay anyway.

If you are willing to take a 15.3% self employment tax hit, you could squirrel money away into an tIRA or Roth IRA as you now have earned income.

Is there a reason to issue 1099 MISC vs. filing Schedule C?

You are correct. A Schedule C would do it too, with or without a 1099. If you pay yourself more than $600, you may be required to issue a 1099. If you made $10K from various people on the street, no 1099 would be given.

 

[PatrickA5]

The OP has already answered their question, but I will respond to the questions directed at me.


You can pay yourself any amount you want. The IRS doesn't care if you declare additional earned income. It may not make sense, but you can do it. Taking passive income from a pre-tax 401K will incur a 15.3% self employment tax, plus any income taxes that you would pay anyway.

If you are willing to take a 15.3% self employment tax hit, you could squirrel money away into an tIRA or Roth IRA as you now have earned income.



You are correct. A Schedule C would do it too, with or without a 1099. If you pay yourself more than $600, you may be required to issue a 1099. If you made $10K from various people on the street, no 1099 would be given.

Thanks Senator,

I might add there is one area that the IRS does NOT want you to make up income, and that involves Earned Income Credit and Child Tax Credit. They are cracking down on made up small businesses in order to get to the "sweet spot" on EIC. Back in my tax prep days, I used to have people come in with hand written 1099misc that just happen to hit the exact maximum for EIC and CTC. I'd ask for proof of any of the income and of course, they'd didn't have any. Also, they never had any expenses (how odd?) Now, all you have to do is get Turbo Tax, make up some income and wait for your 5-10K refund check (depending on how many kids you claim).

 

[jebmke]

"The IRS doesn't care if you declare additional earned income." Yes they do. They audit Schedule Cs from time to time - especially to find phantom income that is used to optimize EITC or other tax benefits.

 

[Sunset]

"The IRS doesn't care if you declare additional earned income." Yes they do. They audit Schedule Cs from time to time - especially to find phantom income that is used to optimize EITC or other tax benefits.

You would also think they care, to stop folks from claiming some income to earn SS credits.

 

[gauss]

You would also think they care, to stop folks from claiming some income to earn SS credits.

Yes - that is my understanding also.

I think there was a ruling back in the 1950s explicitly stating that all business expenses must be claimed.

The case was in the context of someone increasing their income artificially for the purpose of goosing their SS base late in their career.

-gauss

 

[PatrickA5]

Yes - that is my understanding also.

I think there was a ruling back in the 1950s explicitly stating that all business expenses must be claimed.

The case was in the context of someone increasing their income artificially for the purpose of goosing their SS base late in their career.

-gauss

Actually, including false income is on the IRS's Dirty Dozen list of tax fraud scams (see below). I'm not sure if claiming fake income in order to qualify for a contribution to an IRA would count or not.


Dirty Dozen
IR-2017-29, Feb. 13, 2017 ***WASHINGTON — The Internal Revenue Service today continued issuing its annual list of common tax scams by warning taxpayers to avoid schemes to erroneously claim tax credits.

This year’s “Dirty Dozen” includes falsifying income to claim tax credits.

“Taxpayers should ensure all the information they provide on their tax return is accurate,” said IRS Commissioner John Koskinen. "Falsifying income to claim tax credits is against the law. Taxpayers are legally responsible for all the information reported on their tax returns.”

The “Dirty Dozen,” a list compiled annually by the IRS, describes a variety of common scams that taxpayers may encounter. Many of these schemes peak during filing season as people prepare their returns or hire others to help them.

Don’t Make Up Income
Some people falsely increase the income they report to the IRS. This scam involves inflating or including income on a tax return that was never earned, either as wages or self-employment income, usually to maximize refundable credits.

Much like falsely claiming an expense or deduction you did not pay is not right, claiming income you did not earn is also inappropriate. Unscrupulous people do this to secure larger refundable credits such as the Earned Income Tax Credit and it can have serious repercussions. Taxpayers can face a large bill to repay the erroneous refunds, including interest and penalties. In some cases, they may even face criminal prosecution"