Traditional IRA, 401k Rollover, and Roth Conversions
I have a client who has been making non-deductible contributions to an IRA every year and then converting those contributions to a Roth IRA and paying the taxes on any gains. He recently moved to another company and has a sizeable 401k to rollover to a Rollover IRA. The CPA told him not to roll it over and either leave it where it is or roll it into the new company’s 401k as his cost basis in his non-deductible IRA and Roth conversion would be impacted. His basis would be pro-rated and will cause him to pay more taxes that he has when he converts his non-deductible IRA to a Roth IRA since he has to take the rollover IRA and it’s basis, which is zero, into consideration. I know that this is all true. My question is are there any work arounds or strategies that we can avoid this challenge and still be able to rollover his 401k to an IRA without impacting the annual non-deductible IRA to Roth conversion process and what he has become acustom to in only paying taxes on the gains and having a $5,000 basis is his non-deductible IRA ? Or is the only option to leave it where it is or roll into the new company’s 401k so we avoid this challenge all together?
Permalink Submitted by Alan Spross on Thu, 2012-04-12 23:16
Those options mentioned are the only ones available to avoid the pro rating using the entire balance of TIRAs.
Of course, if the 401k is large enough and the fees high enough for the better of the two plans, the tax savings by leaving the plan outside an IRA are lost.
Permalink Submitted by Todd Martin on Thu, 2012-04-12 23:34
Hi Alan,
Thank you for the response. A couple more questions. Let’s say, for simplicity, there is $100,000 in the 401k and $5,000 in the nondeductible IRA:
1. His basis is $5,000. The total value of the non-deductible and, if we rolled it over, $100,000 in the rollover IRA. If he converted would his prorated basis be based on $105,000 or $100,000? Am I correct in his basis being 4.76% at $105,000 or $238,00. Meaning he would have to show income on $4,762.00 if he converted the full $5,000 to his Roth?
2. Does this prorated basis also apply to his rollover IRA at some point? If his $100,000 rollover IRA grew to $200,000 and he starts taking his RMD, does the same prorated amount apply to his rollover? In my example at 4.76% he basis in his rollover would be $9520.00. Or does the basis end with the conversions?
3. Can I get by with converting his non-deductible IRA now before doing the rollover and avoid the proration? Once the conversion is completed, then have him do the rollover?
Permalink Submitted by Alan Spross on Thu, 2012-04-12 23:46
1) Yes, your numbers are correct.
2) The remaining basis after the conversion is 4,762 since 238 was recovered in the conversion. Should the rollover IRA value double to 200k his basis % is reduced to 2.32 without considering new non deductible contributions. There will always be basis in his TIRA accounts as long as there is a balance. Only way to eliminate the basis is to either fully distribute the account or fully convert it.
3) No, that will not work unless you delay the rollover until 2013 to allow time for the 2012 non deductible contribution to be made and converted. The pro rating done on Form 8606 is based on the year end value of the TIRA accounts. That means if the conversion were done now, and the rollover done in December, that large balance will be in the IRA on 12/31 and will make the conversion done several months earlier mostly taxable.
There are quite a few people that have rollover IRAs now that are rolling the pre tax balance into an accepting employer plan so they can continue doing these tax free conversions every year. In that case the reverse is true, if the pre tax IRA balance can be rolled into an employer plan before year end, it will not be in the IRA and will not count in the Form 8606 calculation.