Did the Roth Conversion Tax Rules Change?

Submitted by Jim Shope on Tue, 2014-09-23 19:19

I seem to remember that a person with a traditional IRA could convert part of their TIRA one year, pay the taxes due on the amount converted, then in a future year, repeat. Again, only paying taxes on the converted amount.

If you Google this “Psst…the Backdoor Route to a Roth IRA” and read the article that comes up from wsj.com, you will see the following sentence: “That’s because in conversions, earnings and previously untaxed contributions in traditional IRAs are taxed—and that tax is figured based on all your traditional IRAs, EVEN ONES YOU AREN’T CONVERTING.”

So if a client has a $100,000 TIRA, a $15,000 TIRA, and the spouse has a $25,000 TIRA and the two smaller TIRAs are converted to two Roths (one of each spouse), the WSJ article leads me to believe that taxes would be owed as if they converted the entire $140,000 of IRAs.

Is this true and did the law change on this?

Also, if the $100,000 TIRA is rolled into the employee’s 401(k) plan on, say, September 30th, can they then, between 10/1/14 and 12/31/14, convert the two smaller TIRAs into Roth IRAs and only pay the taxes due on the $40,000 that was converted? To be more clear, does the timing of this matter?

Thank you.



Submitted by Alan - IRA critic on Tue, 2014-09-23 19:33

  • You are misinterpreting the wsj article. The article refers to how Form 8606 works, specifically that line 6 of the 8606 must contain the total value of all non Roth IRA accounts. But that total value is only used for pro rating after tax contributions to determine the taxable amount. You can still convert any small amount you wish and pay taxes on that amount only. But if you made after tax contributions in the past, the amount you can apply to reduce the tax on the amount you chose to convert must include pro rating based on the total values.
  • Your second question is now moot, but if do make non deductible TIRA contributions, and roll the pre tax balance of all your IRAs into an accepting employer plan, you can then convert the non deductible amount tax free. The non deductible contribution and conversion can be done either before or after the pre tax rollover to the employer plan as long as the pre tax balance is eliminated before the end of the year of the conversion.
  • To summarize, if your IRAs are fully pre tax (no basis from non deductible contributions), you simply convert the amount you want to pay taxes on. The article does not apply in this situation.

Submitted by Jim Shope on Tue, 2014-09-23 19:51

  • Hi Alan, thanks for the response.
  •  Let me provide some more details.  
  • 1.  The $100,000 TIRA is a rollover IRA from a 401k and is all pre-tax.  2.  The $15,000 TIRA is almost all contributions that were NOT deducted, 3.  The $25,000 IRA consists of about $10,000 in earnings and pre-tax 401k contributions that were transferred to the TIRA, the other $15,000 is in non-deductible contributions.     
  • The client earns too much to make Roth IRA contributions, so we are trying to use the back-door method.  The goal is to convert the two smaller TIRAs to Roth IRAs and only pay taxes on about $10,000.  We would be leaving the $100,000 IRA alone.  In the future we would still try to fund the TIRA, then convert to Roth with little to no tax consequence.  Can we do this with out having to worry about the $100,000 TIRA?
  • -Jim

Submitted by Alan - IRA critic on Tue, 2014-09-23 20:46

  • No, you cannot ignore any IRA and this is exactly what the article was referring to. Each spouse’s IRA is kept totally separate from the other when it comes to determining the taxable amount of a conversion. Each spouse must file Form 8606 for every year that a non deductible contribution is made in order to track the basis. The total non deductible amount for each spouse is NOT attached to any one IRA, and therefore it does not matter which account receives these contributions OR which account is used to fund the conversion. All IRAs of each spouse is viewed a one larger combined IRA account.
  • Client IRAs total 115,000, but client needs to have most recent 8606 show the total of non deductible contributions. Let’s say it is 4k made to the 15k IRA. Total client basis is therefore 4k, which is 3.5% of the total value of 115k. If client converts any amount, 96.5% will be taxable and only 3.5% non taxable.
  • Spouse’s IRA has 15k in non deductible contributions which must have been recorded on Form 8606 for the year made.  Basis is 60% of total value, therefore any amount converted will be 40% taxable and 60% non taxable. Best to convert spouse’s IRA first since spouse has a much higher % of basis and more dollars can be converted with fewer taxes compared to client.
  • If client could roll over his entire pre tax IRA balance of 111k to their employer plan, the IRA would be left with only 4k, all basis. That 4k could be converted to Roth tax free since 100% of all IRAs is basis. Otherwise, the 100k IRA cannot be omitted from the 8606 calculations. It needs to be eliminated by rolling to employer plan in order to ignore it for pro rating purposes. But if client is going to roll it over to employer plan, they might as well roll the other 11k of pre tax value as well.
  • In any case, both spouses need to have correct 8606 forms filed to document their basis or all conversions will be 100% taxable. If they were not properly filed, they can be filed retroactively with the IRS.

Submitted by Jim Shope on Wed, 2014-09-24 12:06

  • As always Alan, you are extremely informative and helpful.  This is the first time that I have seen it explained with the ratios and such.  Slightly complicated, but it makes sense.
  • The client’s smaller IRA is almost all contributions.  Our plan will be to roll the larger IRA into the client’s 401k and, thus, not have to worry about it.
  • The spouse does not work and does not have a 401k to roll the pre-tax amount into.  The goal was to convert the two smaller accounts, paying tax on the pre-tax amount in the spouse’s IRA.  We want to avoid including the larger IRA, so I will recommend that the larger IRA gets transferred into the client’s current 401k plan – after they get approval from their accountant.
  • Thank you again, so much!
  • Jim

 

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