Roth Conversion prorata rules

Submitted by Thomas Ferry on Tue, 2013-06-18 19:58

My client has no IRAs, and makes more than the Roth IRA contribution limit, so she contributed post tax in Jan, then converted it to a Roth.

Then, recently, I advised her to take an inservice withdrawal from her 401k and roll to an IRA. Is it correct that I’ve now brought on the pro rata rules and the $5k conversion will be subject to tax?

If yes, then secondly, if she had not converted, she’d have $5k basis in her IRA. From the conversion, does paying tax on the $5k somehow increase her basis in the IRA beyond the $5k by the amount of tax paid, or does the tax paid only pave the way for all the earnings made on the $5k to be distributed at 59 1/2 (and 5yrs) tax free as it’s now a Roth?

What steps can I advise her to take to somehow reverse (or at least neutralize) the tax impact? For example, should I advise that she redirect $5k of her Roth 401k contribution to her pretax 401k between now and year end?

Any way to neutralize this, or did I just create unnecesary tax for suggesting the inservice withdrawal and IRA rollover before 12/31/13?



Submitted by Alan - IRA critic on Tue, 2013-06-18 20:45

  • Yes, the conversion will now be subject to tax due to the rollover, as the year end 2013 balance for non Roth IRAs goes on Form 8606 and is used to calculate the pro rated taxable amount. The only way to erase this result is to roll the pre tax amount of her IRA back into an employer plan before 12/31. If paying tax on the conversion is not acceptable, client can also recharacterize the conversion back to the TIRA and will then have 5k of basis going forward. You might want to wait to see if the conversion generates gains or losses before deciding to recharacterize. Recharacterization is more beneficial with losses as opposed to gains. With respect to her basis going forward to 2014 if the conversion is retained, that figure will show on line 14 of the 2013 8606. For example, if the rollover was 95k, then 95% of the 5k conversion will be taxable (4,750). Basis for future years will be 5k less $250 or 4,750. since 250 was applied to the conversion.
  • Client should also check into exactly what the rollover was composed of. For example, if after tax contributions were made to the plan and if the after tax sub account was the amount distributed (generally allowed in service). that rollover might be mostly post tax with only earnings on the after tax contributions being pre tax). Many employees make after tax contributions to their plan if allowed and then convert them directly to a Roth IRA mostly tax free while still employed.  If such a rollover included after tax contributions, then that amount should be entered on line 2 of the 8606 and it will add to basis and reduce the taxable amount of the conversion.

Submitted by Thomas Ferry on Thu, 2013-06-20 12:56

Thank you.  When is the deadline for recharacterizing?  Also, just to be clear on the issue of basis, let’s use your example of a $95k rollover.   If I don’t recharacerize, what the client will have is $5k in a Roth IRA and an IRA worth $95k that has basis of $4750.  Correct?  

Submitted by Alan - IRA critic on Thu, 2013-06-20 16:54

The deadline to recharacterize a 2012 conversion is 10/15/2013 provided taxpayer filed their 2012 taxes by 4/15 OR filed an extension. You are correct about what the two IRA types would be composed of if the conversion is retained. Taxes would be due on 4,750 of the conversion and there would also be that same amount of basis remaining in the TIRA.

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