TRADITIONAL, NON-DEDUCTIBLE AND ROTH IRA CONVERSION

Submitted by Rene Nourse on Mon, 2019-12-30 20:47

Have a client who several years ago rolled over her 401k into an IRA – it now is worth $1.1M; she has also been contributing to a non-deductible IRA for several years as well, which now has a value of little less than $150K. According to last year’s 8606, out of the $93K she has contributed, only $7133 would be considered a non-taxable portion of distributions. Does it make sense to convert this non-deductible account to a Roth and if so, would that mean that all would be taxable except that $7133?



Submitted by Alan - IRA critic on Mon, 2019-12-30 21:47

  • Since all owned IRAs are treated as one combined account, her basis of 93k accounts for 7.44% of the total value. Therefore, any conversion amount selected would be 7.44% non taxable and 92.56% taxable. Conversion of the small account would generate a taxable amount of 138,840. 
  • Conversions are beneficial if the marginal rate paid is less than, or in some cases no more than equal to the expected average marginal rate in retirement, so an analysis must be made based on the best guess for the retirement rate, although the current rate can be determined accurately. Considering basis of 7.44% will be converted tax free, for comparison purposes, the current tax rate can be reduced by 7.44%. If the current actual rate is 25%, reducing that by 7.44% produces an effective rate of 23.14%, which makes it more likely to be lower than the average rate later on and therefore more beneficial.
  • There is a good solution for those still working with a 401k plan that accepts IRA rollovers. If client were in this situation she could roll the 1,157k pre tax IRA amount into her 401k leaving only the 93k basis in the TIRA. She could then convert that 93k totally tax free to her Roth IRA. The year following she could roll that pre tax money out of the 401k back to her IRA if she wished, but she cannot do it the same year as the conversion or the conversion will again be mostly taxable.
  • Not sure where your figure of 7133 came from.

 

Submitted by Rene Nourse on Mon, 2019-12-30 22:07

The client is still working, so I will suggest that she do so, since she has been contributing to this non-deductible IRA for many years. I have a copy of the client’s 8606 and the $7133 was on line 13; very strange since line 13 is the addition of lines 11 and 12 – both of which had no numbers on it. Line 13 represents the non taxable portion of all distributions. Additonally, on line 15a and 15 c, $2867 was listed as a taxable amount–Was this input incorrectly? 

Submitted by Alan - IRA critic on Mon, 2019-12-30 22:32

The 8606 for 2018 is definitely incorrect. These figures suggests she probably either converted 10k or just took a 10k distribution from the small IRA, and the large IRA was completely ignored. If the small IRA was worth around 130k last year (gained 20k this year), the incorrect basis of 7133 makes sense. However, if a conversion was done, lines 16-18 should also have been completed on the 8606. If she hasn’t heard from the IRS, she still might. Line 14 of the 2018 8606 should show the remaining basis carried over to 2019. But this needs to be corrected before attempting any rollover to the 401k because a 401k plan cannot accept any IRA basis. If they do it is a violation and the plan would have to distribute it back out. But she has plenty of time to look into this, and will have to for any 2019 8606 to be correct because the line 14 figure carried forward. Sounds like someone else should be doing her tax returns.

Submitted by Rene Nourse on Mon, 2019-12-30 23:25

She did do a conversion in 2018 for $10K to the Roth from the smaller IRA which was worth about $130K as of the end of 2018. However, to your point, lines 16-18 were not filled out. On line 6 where it asks for the value of all  traditional, SEP, etc accounts – it simply shows “Statement 20”- but no figures. She made a non-deductible contribution for $6500 in 2018, which adjusted her total basis to $93K. Line 9 which requests, totals of values, distribtuions and conversions are all blank… So it appears that the form needs to be updated – additionally, just to be clear, since the contributions have all been after tax, can those funds be transferred to a Roth anyway?

Submitted by David Mertz on Tue, 2019-12-31 00:15

I suspect that Statement 20 shows the calculation done using Worksheet 1-1 from IRS Pub 590-B instead of on lines 6 through 12 of Form 8606 because there were both distributions and nondeductible contributions in 2018.  You would need a copy of Statement 20 from the client’s tax return to see the actual calculation.

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