Back Door IRA and Pro-Rata Rule
In February 2016, I took $6500 of earned income and started a Vanguard Traditional IRA. Two weeks later I used the back door to convert all $6500 to a Roth IRA. I just read your Back Door Guide to Roth IRA and think I may have the Pro-Rata Rule complication which I was not previously aware of. I have an annuity with an insurance company worth $270,000. It was originally a 403b thru my employer which I rolled over to this annuity. It is now classified as a traditional IRA. Will I have to pay taxes on $6300 of this Roth conversion as per the Pro-Rata rule? Is so would I be still be able to recharacterize or declare an excess contribution if I act before October 15th of 2016?
– Rich
Permalink Submitted by Alan - IRA critic on Mon, 2016-09-05 00:30
Yes, as things stand now you will have to pay taxes on most of your Roth conversion. You have until 10/15/2017 (not 2016) to recharacterize this conversion and eliminate the tax bill. Another possibility is to roll your annuity TIRA into any current employer plan before the end of this year. Then your Roth conversion would be non taxable. Of course, you would have to surrender the annuity to do this and there could be a large penalty depending on when you purchased it, so this will probably not work. Finally, since you have another year to decide about recharacterizing you could wait and see if this conversion generates gains or not. A large gain on your conversion might make it worth retaining the conversion despite the taxes, but it depends on what your marginal tax rate on the conversion will be vs. what you expect it to be in retirement.
Permalink Submitted by Rich Stetler on Mon, 2016-09-05 02:16
What if I declare an excess contribution?- Rich
Permalink Submitted by Alan - IRA critic on Mon, 2016-09-05 02:38
You could do that also if you want the original contribution returned to you. In that case, you would recharacterize the conversion and when completed request a return of your contribution with allocated earnings. If there are net earnings, you would be taxed and penalized (if under 59.5) only on the earnings. Note that you do not have an excess contribution since you can legally make the non deductible contribution, but a return of contribution is handled the same way with the same result – your contribution is returned with an earnings adjustment. If you did both the recharacterization of the conversion and a return of contribution, you would report them both on your tax return with an explanatory statement. If there were gains, the gains are also reported on line 15b of Form 1040.