Converting a traditional individual retirement account to a Roth IRA can be a smart tax move to save money, but in some cases the move can lead to higher state taxes for the account holders, advisors say.

Depending on the state, income taxes could be potentially due at conversion, Also, advisors warn, the income from the conversion can top certain thresholds and cost clients state tax exemptions on such other retirement holdings as pensions.

“The federal side should be the driver. The state is where the nuance is,” said Morris Armstrong, an enrolled agent and RIA at Armstrong Financial Strategies in Cheshire, Conn.

A client’s tax liability at conversion is based on the taxable income generated by the conversion and by the client’s tax rate. Another factor is the types of contributions that have been made to all of the client’s traditional IRAs: pre- or after-tax.

“The federal government does tax a Roth IRA conversion if the [converted] IRA has pre-tax contributions and earnings. Any portion of the rollover attributable to after-tax contributions is not includible in income,” said Richard Pianoforte, managing director of tax at Fiduciary Trust International in New York. “The same rules apply to most states. If the traditional IRA has pre-tax contributions along with earnings, the amount converted to the Roth could be taxable and push the client into a higher bracket for that state or limit their itemized deductions, depending on the state.”
Residents in Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming are exempt from state taxes on conversions since these states do not impose income taxes. In New Hampshire taxes are levied on interest and dividends, but IRA distributions remain untaxed, Pianoforte said. “Pennsylvania residents enjoy a tax-free environment for Roth conversions,” he added. “In Iowa, individuals aged 55 and [older] can exclude up to $6,000 of retirement income, with Roth conversion income qualifying for this exclusion. In states like Massachusetts or California, where an additional tax is imposed on income exceeding $1 million, larger Roth conversions may trigger this additional tax,” he said.

If your client has made only deductible contributions to a traditional IRA, the amount converted is taxable income. (Earnings are always taxable when converted.) Nondeductible contributions to a traditional IRA create what some term “basis” in a traditional IRA; the amount of these contributions is not included in taxable income for purposes of a Roth IRA conversion. The IRS says clients can’t convert only non-deductible contributions to avoid taxes.

“A person in a state that doesn’t allow a deduction for IRA contributions will need to make sure that the basis is correctly reported to the state,” Armstrong said.

He added that clients considering a conversion and move from a state should learn the treatment of income conversion in their new state.

State-recognized income can also trigger problems with other retirement income.

“Be careful using your federal and state marginal tax bracket,” said Gail Rosen, a CPA in Martinsville, N.J. “For instance, in New Jersey, taxpayers 62 or older may qualify to exclude all their pension income as income if their gross income doesn’t exceed $100,000, and there’s a phase out of the exclusion if their income is $100,001 to $150,000. If a New Jersey taxpayer who has always had the benefit of excluding their pension income suddenly does a Roth conversion, they can be in for a rude awakening.”

“In Connecticut, we had pension tax exemptions if your AGI was $100,000 or less. Now they have step-ups to $150,000 for Married Filing Jointly [filing status], which is better,” Armstrong said. “I’ve seen people taking more out of an IRA, either for Roth conversions or to fill a tax bracket and then wind up losing the Connecticut exemption. Other states may have similar issues.”