pro rata rule
The following question and answer were posted on the Slott Report:
Question:
My husband recently opened a non-deductible IRA and contributed $6,500 for 2014, and $6,500 for 2015. Because our income exceeds that which is allowable for a Roth IRA, he used the backdoor approach to a Roth. He is retiring from his career as a teacher in 30 days and is preparing to rollover his pension lump sum ($162,000) and 403(b) ($30,000) into an IRA. This collective sum of $192,000 is pre-tax money. What tax consequences, if any, will this rollover have on the Roth?
Answer:
The amount that he converts will be mostly taxable because of the pro-rata tax rule. That rule states that all of his IRAs this year, including the $192,000 rollover amount, are included when calculating the percentage of pre-tax and tax-free money in his IRAs. Assuming most of the $192,000 rollover funds are pre-tax, then most of the Roth IRA conversion this year will be taxable. He can always recharacterize (undo) the conversion up until October 15 of the year after the conversion if the tax bill is too high or he changes his mind.
My question is, if husband converts the entire non-deductible IRA this year before he rolls the pension lump sum and 403(b) to a rollover IRA [so that he has no other IRA yet at the time of conversion], does the IRS apply the pro-rata rule to include the rollover IRA anyhow?
Permalink Submitted by Alan - IRA critic on Fri, 2015-05-08 21:41
Yes, the pro rata rule will still apply. The 12/31/2015 total non Roth IRA value is used to complete line 6 of Form 8606 which computes the taxable amount of distributions. The balance at the time of the conversion is immaterial. Perhaps the rollover should wait until 2016.
Permalink Submitted by Ben Meyer on Sun, 2015-05-10 06:07
It might be useful to maintain the 403(b) for a while if the non-deductible IRA or the pension plan contain a substantial nontaxable basis. A rollover can be performed of only the taxable portion of the IRA into the 403(b) plan, leaving the IRA with only nontaxable basis. The IRA can then be converted to Roth with payment of little or no tax. Then, if desired the 403(b) can be rolled over to a TIRA in a later year. Assuming that the 403(b) offers reasonable investment alternatives, and assuming that a rollover from an IRA would not trigger new fees or exit charges in the 403(b), this can be a useful alternative. Most 403(b) plans will now accept a pre-tax rollover from an IRA. IRS ordering rules for rollovers from an TIRA to a 403(b) allow taxable funds to be rolled over before nontaxable funds.