This relevant article is from the February 01, 2010, issue of Spidell's California Taxletter®.

California conformity: Roth IRA conversions in 2010 
Consider state tax and making separate elections to reduce tax.

By Lynn Freer, EA

California conforms to the TIPRA ’05 change that allows taxpayers to convert a traditional IRA to a Roth IRA in 2010 without regard to income level. This means California conforms to:

• The AGI limit eliminated in taxable years beginning on or after January 1, 2010 (IRC §408A(c)(3)(B)); and
• The election to report income on conversion in 2010, rather than over a two-year period beginning in 2011. (IRC §408A(d)(3)(A)(iii))

A taxpayer may make a separate election for California purposes under R&TC §17024.5. Thus, a taxpayer may elect to report all the income to California in 2010, or ratably in 2011 and 2012, independent of what the federal election is.

Reasons to make separate elections include differences in:

• Tax rates;
• Income levels;
• Availability of NOL deductions;
• Depreciation and basis differences;
• A move into or out of California; and
• Credits.

Here are some examples of reasons to make different elections in 2010. In each case, assume the taxpayer converted $20,000 from a traditional IRA to a Roth IRA, unless otherwise noted.

Social Security considerations — Del and Bryn Mar are married and both are over age 65. Their income is:

• Interest and dividends: $10,000
• Social Security: $24,000

If they report the $20,000 from the Roth conversion on their federal return, their tax will be $1,413 because the $20,000 creates taxable Social Security income.

Assuming their income stays the same, if they wait and report 50% in 2011 and 50% in 2012, the increase in income is small enough to prevent their Social Security from being taxable.

For California purposes, they may report the $20,000 from the conversion in 2010 and owe no tax because their income is under the minimum filing requirement (California does not tax Social Security).

NOLs — Bay Bridge is single with no dependents. His federal AGI is $200,000. He has a California NOL of $250,000. If he reports the $20,000 for California, he will use his NOL and have no 2010 tax liability.

He expects his income to drop to $100,000 or less in 2011 and 2012. So, he elects to wait to report the Roth conversion in 2011 and 2012 on his federal return.

Basis issues — Al Catraz has one IRA with $20,000 in it. He has a California basis of $19,000 due to California limitations in deductibility between 1982 and 2000 when he made the contributions. He converts the IRA to a Roth in 2010.

For federal purposes, he elects to report the $20,000 ratably in 2011 and 2012.

For California, he elects to report the $1,000 on his 2010 return because he knows what the tax cost will be and the addition to income is small. He also avoids a possible California rate increase.

Change in residence — A taxpayer who changes residence may be the perfect candidate for making a different federal election. So, a client moving into or out of California should consider making a separate election if the California tax would be less.

(Note: To make a separate election, the taxpayer must be subject to California tax in the year of the election). (R&TC §§17024.5(c), 23051.5(e)

We believe California cannot tax the nonresident on the IRA income for two reasons:

• California and federal laws prohibit states from taxing pensions received by nonresidents. This prohibition generally applies to all qualified plan distributions, IRA distributions, and certain distributions from nonqualified plans. (R&TC §17952.5)
• When a taxpayer changes from resident to nonresident or vice versa, all carryovers must be recalculated as if the taxpayer had always been what he is for the current taxable year. (R&TC §17041)

A taxpayer who is a resident of California in 2010 but who contemplates moving out in 2011 or 2012 may want to consider postponing recognition of the income for California purposes.