Pro-Rata Trap?
I opened an IRA in February 2014. Due to income limits, I made a non-deductible contribution for the 2013 tax year and immediately converted it to a Roth. I had no existing IRAs at that time.
Fast forward to March 2014, I rolled my 401k to an IRA. By doing so, did I just step into a Pro-Rata situation on my Roth conversion? If so, can I go back an recharacterize to avoid taxation?
Permalink Submitted by Alan - IRA critic on Sat, 2014-03-15 21:16
Yes, your 401k rollover will make your Roth conversion mostly taxable per Form 8606. You can recharacterize the conversion as late as 10/15/2015 so there is no rush. If your conversion has a nice gain you may want to retain it. Also, if you have a current 401k that accepts rollovers from IRAs, and you rolled your pre tax IRA balance into that plan before year end, then your conversion would be non taxable.
Permalink Submitted by Renee Lewis on Sat, 2014-03-15 23:06
Thanks for your response. I’m trying to determine how much gain I would have to see to make the conversion beneficial. I converted $6500 to a Roth. The IRA rollover was about $500k. So would the pro-rata calculation be 6500/506500, making 1.3% is not taxable? Therefore, 6500 x.987=$6415.15 is taxable. 28% tax rate x 6415.15=$1796 taxes owed. So I would have to earn more than $1796 for the conversion to benefit me? I think I’m missing something?
Permalink Submitted by Alan - IRA critic on Sat, 2014-03-15 23:33
Generally, for conversions to be of benefit, the tax rate paid for the conversion should be less than or equal to your estimated tax rate in retirement on the higher RMDs you would have have if you did not convert. But gains on your conversion reduce the effective tax rate you pay, eg a gain of 1796 would reduce your effective tax rate on the conversion to 22% from 28% making it more likely that 22% would be less or equal to your rate in retirement. Since such projections are highly subjective, you should look for tax diversification by having a balance of pre tax and post tax IRAs. If this is your only Roth and you have a half million in the pre tax rollover IRA, you should err on the side of increasing your Roth allocation. If you have a loss you would almost certainly recharacterize.