Converting Part of a Traditional IRA to a ROTH
I have a Tradtional IRA in which I have a post-tax cost basis (from non-deductible contributions in past years). I’d like to convert some, if not all, of my account to a ROTH IRA. I’ve not yet calculated the full tax consequences, but I know I will have to pay taxes on the pre-tax amounts as normal income in 2011 and 2012. My question is for now (until I’ve calculated the full tax hit) can I simply instruct my brokerage firm to transfer (rollover) just the amount that is my basis or does the IRS view this amount like a distribution (consisting of both pre and post-tax dollars)?
Permalink Submitted by Alan Spross on Tue, 2010-04-06 17:44
When your IRA has basis as documented on Form 8606, a distribution is taxed subject to pro rate rules regardless of how much is distributed. Since a Roth conversion is nothing more than a distribution followed by a rollover to the Roth, this also holds true for conversion taxation. Your basis % and therefore the amount of conversion income will be determined as of 12/31/2010. That income will then be split between 2011 and 2012. There are no basis adjustments for this conversion recalculated in 2011 or 2012.
Therefore, in determining how much to convert, you will have to estimate the investment performance for the rest of 2010 on any parts of the TIRA that you do NOT convert, since that value will continue to change through year end. Remember, you can always recharacterize part of your conversion if you overshoot and do not like the tax bill that is generated.
Permalink Submitted by Bill Barcheck on Tue, 2010-04-06 18:13
So the percentage is based on the value of all Traditional IRA accounts? Does the the source of the funds in the account matter? EXAMPLE: Only $20K of the contributions came from direct contributions to my Traditional IRA ($10K of which was non-deductible), $150K came from rollovers from 401Ks from past employers? It doesn’t seem fair to be penalized for taking charge of managing old 401Ks… Would I have to consider the value of mine and my wife’s current employer 401K plans as well?
On a related note, I’ve yet to make my non-dedcuctible $5K contribution for 2009. Should I make this contribution to this same Traditional IRA (commingling the funds), or does establishing a separate new account provide any advantages?
Permalink Submitted by Alan Spross on Tue, 2010-04-06 18:50
The source of the funds does not matter, and you must you the total of your TIRA accounts including any SEP IRAs and SIMPLE IRA accounts. This is outlined on Form 8606.
But you do not consider the amounts still in your 401k accounts. Because doing a 401k rollover will dilute your basis (unless your 401k has more % basis than your IRA), you must be careful when you do these rollovers. Some people with IRA basis are now planning to roll the pre tax amounts in their IRA into their current employer’s 401k plan in order to be able to convert the basis remaining in the IRA tax free. Some plans will not accept IRA rollovers and other plans will accept them only if they come from a rollover IRA, not a contributary IRA account.
Each spouse’s IRA is kept separate as is each spouse’s non IRA retirement plans. Form 8606 only holds one SSN so they are individual forms even when part of a joint return. If each spouse has 401 K and IRA accounts, it makes sense to convert the account with the highest % of basis first because that gets more dollars into a Roth per tax dollar incurred for the conversion. Direct conversions can now be done from employer plans without first rolling the funds to a TIRA.
Regarding a 2009 non deductible IRA contribution, it does not matter which TIRA account you use for the contribution since they are all considered as one account on your 8606. If you make the contribution for 2009 (and 2010 for that matter), the added basis will be reflected on your 2010 8606 and reduce the taxable portion of your conversion.
But if you are going to try to roll your pre tax IRA amounts back to your current employer plan, do that first since it will probably determine how much you will convert. You do NOT show on the 8606 any amounts you roll into an employer plan, so these amounts are excluded from the %s.
Permalink Submitted by Bill Barcheck on Tue, 2010-04-06 19:01
Uggh… I just rolled a couple of big 401Ks into our IRAs this year. I wish I would have known… Unfortunately, I comingled the 401K distributions with our direct contributions in the same account (one for me and one for my wife). If I’m fortunate enough that either my current employer’s 401K or my wife’s current employer’s 401K plan will accept pre-tax contributions into their plans, is it possible for me to go back and withdrawl the amount that was contributed (rolledover) from old 401Ks? if so, would I just transfer the total amount that was rolled over or is it again subject to some percentage (pre-tax post-tax calculation)?
Permalink Submitted by Alan Spross on Tue, 2010-04-06 19:21
First, you must determine if your current plan or you wife’s current plan will accept IRA rollovers into the plan. This is optional for any plan. If so, the pro rate rules do NOT apply here because these plans cannot accept after tax IRA dollars by law. If they receive after tax dollars from an IRA, they will have serious corrective measures to take or the plan could even be disqualified. This is the reason that some plans will only accept rollover IRAs that came from an employer plan in the first place. But you should check into this and roll as much of the IRA pre tax balance as you can back to each spouse’s employer plan. Obviously, your own plan and IRA dollars must be kept totally separate from your spouse’s and vice versa. If only one of your employers will accept an IRA rollover, then that spouse’s IRA will be the one you will convert after the rollover is done, or at least convert before the other spouse.
That said, all this would probably not be worth the hassle for only 10k of basis, but since you plan to add 5k of non deductible contributions each year to the IRA, you will eventually be able to convert much more than 10k tax free. However, if the 401k is not a good plan re investment options or expenses, you may not want to roll large amounts into such a plan because it would cost you more than the tax advantage you would receive. If you are going to make 5k non deductible contributions indefinitely, then the 401k will have to hold those funds indefinitely also. If there is a job change, one 401k can transfer to another in many cases, if one of you changes jobs to an employer with a better plan.