Bob,
Only the IRA would be part of the calculation, but if the 401k was rolled into an IRA before the end of 2010, it would then be IRA money and would be included in the pro rate factor. Since most 401k assets are pre tax, the added value would dilute the ratio of basis to total and make the 2010 conversion mostly taxable. Therefore, the 401k rollover would have to wait until 2011, but would then affect the pro rating for every year thereafter. As long as the 401k plan is kept with the employer, it does not affect the IRA conversion taxable calculation.

There are a few potential options:
1) Leave the 401k where it is for awhile, at least until 2011 after the 2010 conversion and 12/31/2010 8606 calculation is complete.
2) If client gets a new job, determine if the new plan will accept a direct rollover from the old plan. This will keep the money out of the IRA for an extended period.
3) If client does roll the money to an IRA, it should be kept in a conduit or “Rollover” IRA that might be able to be rolled over to a future employer plan. IRA pre tax dollars that are rolled into a current employer plan will not be included in the year end IRA balance and therefore kept out of the pro rate calculation.
4) If the client has after tax dollars in the 401k, wait a few months for the IRS to clarify if those dollars can be rolled directly to a Roth IRA without going through a TIRA or Form 8606. But the pre tax dollars would still have to go to a TIRA and those would dilute future IRA conversion calculations.

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