Pro-rata rule

Submitted by Rich Stetler on Mon, 2016-10-17 02:28

I have a traditional IRA with an Insurance company Annuity. That IRA was originally rolled over several times from a 403b account. I recently contributed $6500 to a traditional IRA with Vanguard. A few weeks later I converted it to a Roth IRA. Is this transaction exempt from the pro-rata rule since my other IRA was originally a 403b?

My 2nd question is since this contribution was made in February of 2016 and conversion was made in March would this conversion qualify for the 2015 or 2016 tax year?



Submitted by Alan - IRA critic on Mon, 2016-10-17 02:58

  • There is no exemption from the pro rata rule once the funds are in an IRA. The value of all your non Roth IRAs must be reported on line 6 of Form 8606, so the presence of the rollover IRA will cause the conversion to be partly or mostly taxable.
  • The conversion is taxable in the year of the conversion (2016), although the contribution made prior to 4/18 could have been for either 2015 or 2016. If 2015, you will need to report the contribution on your 2015 return (either deductible or non deductible). But the conversion will be on a 2016 8606 and you will get the 1099R reporting the conversion next January.
  • If you do not wish to pay taxes on this conversion, you have plenty of time to recharacterize it. In making that decision remember to factor in whether the conversion has gains or losses.

Submitted by Rich Stetler on Mon, 2016-10-17 17:56

If I count the contribution towards 2015 and take a deduction on that contribution then count the conversion in the 2016 tax year, what tax implication will that have? I know I will have pay taxes on 100% of the conversion. Will I have any additional taxes as per the pro-rata rule? Thanks!

Submitted by Alan - IRA critic on Mon, 2016-10-17 19:17

The IRA custodian has already sent out the Form 5498 reporting all 2015 contributions to you and the IRS. Therefore, you cannot change a 2016 contribution to a 2015 contribution through the custodian. The deadline to do that was 4/18/2016 which was the last day you could have made a 2015 contribution. But even if you could have done this, your 2016 conversion would be 100% taxable, although you would be able to amend your 2015 return to take a deduction which would offset the 100% taxable conversion in 2016. Once a conversion is 100% taxable, the pro rate rule no longer applies because there is no basis to pro rate, so no additional taxes would be incurred.  

  • I assume your 2016 contribution is non deductible and is the only basis you would have in your TIRA accounts. As such, if you have a plan at work that will accept an IRA rollover you could roll your pre tax IRA balance into that plan before year end, and then your 6500 conversion would be tax free. However, the costs to surrender an IRA annuity in order to complete that rollover is probably prohibitive, but you could always check into this after you first check with your plan if they will accept an IRA rollover.  The other way to avoid the tax bill is of course to recharacterize the conversion, especially if it has lost money.
  • How much is the IRA annuity?
  • Note that just because a conversion is mostly taxable and obviously not as beneficial as a non taxable conversion, it does not mean that the conversion should always be recharacterized. Perhaps you are converting at a rate that is not higher than your expected tax rate in retirement.

Submitted by Rich Stetler on Mon, 2016-10-17 20:28

I do have a 5498 from the IRA custodian for 2015 so the February 2015 contribution is definitely a 2015 contribution. Because the conversion was in March of 2015 as I understand, it has to be a 2016 conversion. I have not received an 8606 which I guess I will receive in January. My 2015 tax return was extended and is due today. I’m trying to decide if I should take the deduction on the contribution or not. Based on what you said I think I should take the deduction and pay 100% of the tax for the conversion in 2016. That will avoid the pro-rata. My conversion was only about 5% of my total IRA annuity, so I would have to pay taxes on 95% of the conversion as per pro-rata. Correct? Take the deduction? Pay 100% on the conversion next year or recharacterize?

Submitted by Alan - IRA critic on Mon, 2016-10-17 22:04

I think you have your years misstated in several places in your last post. Can you clarify? As for the 8606, you file that yourself with your tax return. The only forms you receive are a 1099R for distributions and 5498 for regular and rollover contributions. As for the deduction, if you or your spouse is covered by a retirement plan at work, your income cannot exceed a certain amount or you cannot deduct the contribution. The income limits are higher for a Roth contribution, so you would  not make a non deductible contribution and convert it if you were eligible for a regular Roth contribution in the first place. Without further info I cannot tell if you were eligible for a Roth contribution, or able to deduct a contribution for a particular year.

Submitted by Rich Stetler on Mon, 2016-10-17 23:23

Sorry – I did misstate in the last post. It should read: I do have a 5498 from the IRA custodian for 2015, so the February 2016 contribution is definitely a 2015 contribution. Because the conversion was in March of 2016 as I understand, it has to be a 2016 conversion. Both my wife and I are both retired. We both have pension plans and we make too much to contribute to a Roth which is why we used the back door. I know there is no income limit to contribute to a traditional IRA. We both had some earned income to qualify for the $6500 maximum. We are both in our 60’s. Is there an income limit to take a deduction for the traditional IRA contribution? Is there an income limit to convert to a Roth? 

Submitted by Alan - IRA critic on Tue, 2016-10-18 04:05

  • This chart explains the modified AGI income limits to deduct a 2015 IRA contribution:  https://www.irs.gov/retirement-plans/2015-ira-deduction-limits-effect-of-modified-agi-on-deduction-if-you-are-covered-by-a-retirement-plan-at-work
  • There are no income limits for conversions
  • With respect to whether a spouse is covered by a retirement plan at work or not, if there is a W-2 check the retirement plan box to see if it is checked. If you were self employed you are covered if a SEP contribution is was made in 2015 or SIMPLE IRA contributions were made. If neither of you was covered, then you can deduct the TIRA contributions. If just one of you was covered, neither of you can take a deduction for a TIRA contribution because that income limit is the same as for a Roth contribution which you said was not allowed due to your income.

Submitted by Rich Stetler on Tue, 2016-10-18 10:31

I checked our W-2’s and no boxes were checked. Our income is over the modified AGI income limits on the chart you sent, but because we are not covered by a retirement plan at work it seems we are able to deduct that $13,000 on our 2015 TIRA contribution. Correct?

Submitted by Alan - IRA critic on Tue, 2016-10-18 18:19

Correct, as long as one of you were not also self employed during that year, where you could have had a SEP IRA and no W-2. If you deduct the contributions and have no other IRA basis, your conversion will be 100% taxable. If the conversion is for the same amount as the contributions (6500 conversion for each of you), the deductions for the contributions will offset the tax on the conversion. Since the contributions were for 2015 and the conversion was in 2016, the offset may not be exact since 2 years are involved. You would save taxes in 2015 by the deduction, but pay more in 2016 due to the conversion.

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