Backdoor Roth – IRA Basis rolled over to 401K

Submitted by Daniel Levin on Wed, 2023-12-13 03:02

I’ve made a mistake in regards to my backdoor Roth and don’t know how to correct the problem.

I had a Simple IRA for a couple of year with my employer. During those two years, I continued to do backdoor Roth. Due to having the Simple IRA and completing a backdoor Roth, I’ve accumulated a IRA basis on form 8606 (a little over $10K).

Last year, my employer switched over to a 401K (Fidelity) from the Simple IRA. Earlier this year, after having the Simple IRA for 2 year, I was eligible to rollover the Simple IRA over to my current 401K. The rollover process from the Simple IRA administrator was made very complex and took many phone calls and forms. I was finally able to rollover the Simple IRA to the 401K but with all the hassle with the old administrator I forgot about the IRA basis and rolled over the full amount to the 401k as before tax contribution, this was done last month, mid November.

Now I was getting ready to do another backdoor Roth, I realized I didn’t move the IRA basis (a little over $10K) over to my traditional IRA (with Vanguard). My understanding was that I should have moved the IRA basis to my traditional IRA and when I did the backdoor Roth this year, I should have also moved the IRA basis to the Roth IRA and would have a $0 basis on form 8606.

But now that IRA basis is in the 401K, I don’t know how to correct this situation. I wanted to try to fix the situation in the short time before the end of the year. I would appreciate any advice on how to handle this situation. What do I need to do in order to not have issues in the future with the backdoor Roth.
Thanks in advance.



Submitted by Alan - IRA critic on Wed, 2023-12-13 16:45

  • This situation is near impossible to correct. Since the process to correct this is beset with reporting problems (eg. your return would not correspond to the 1099R forms issued by either the IRA custodian or the plan) and plan administrators not  knowing how to process a corrective distribution or report it correctly on Form 1099R, those in your position have given up half way through the attempted corrective process after spending many hours on the process with uncooperative custodians. In other words, the 1099R from the IRA custodian, the 1099R from the plan, and your tax return must all sync up. If one of them is incorrect, filing will be problematic and burdened with the Form 4852 (substitute 1099R forms that YOU must issue). Therefore, you will probably be better off to do nothing, report the G coded direct rollover 1099R as issued and just accept the fact that the amount rolled into the plan will be treated as pre tax by the plan administrator and eventually will be taxed again. But you will still have the current IRA basis in your IRA for future use. 
  • Why proper corrective treatment typically fails: Your IRA custodian is not going to change their direct rollover 1099R. To be technically correct, when you tell them that IRA basis was included in the rollover they should issue a 1099R for the pre tax amount only as a direct rollover and another 1099R for the basis distributed to you. But almost surely they will refuse. If you have a 60 day rollover available you could then roll the second 1099R (basis) back into your IRA. Problem is, you need a firm agreement with the IRA custodian to issue this (highly unlikely) because you will probably not get the actual 1099R forms until the 60 day rollover deadline has passed in mid January.
  • Next problem: When you tell the plan that they received IRA basis, no telling what the reaction will be. Some with ignore it.  What they should do is distribute the basis with allocated earnings to you and issue a 1099R coded E denoting a corrective distribution of an excess amount. Any corrective distribution code they use (E or some other code) will not be eligible for rollover so the rollover you report back to the IRA will be for the second 1099R from the IRA custodian (if by chance they agreed to issue as such). The corrective 1099R from the plan will be separately reported on line 5 of your return with no rollover reported for that amount. You would use other money you have to complete the 60 day rollover in time, and the corrective distribution from the plan funds would replace the money you used to complete the rollover. 
  • Others in your shoes had a TIRA rather than a SIMPLE IRA. But the process is the same either way. They were not able to get cooperation from either the IRA custodian or the plan. They typically gave up at some point and decided to just report the single 1099R they received as issued and deal with the double taxation many years down the road. 

Submitted by Daniel Levin on Wed, 2023-12-13 20:59

This mistake is turning out to be pretty complicated.  If I’m reading your comment right, you suggestion is to leave the money in the 401K and take the double taxation hit.  I guess I can do that, the sum is not that large.But now I have a question regarding the IRA basis reproted on last years 8606. What do I do about that?  When I do the backdoor Roth for this year, do I ignore the IRA basis and complete the backdoor as if I had no IRA?  Will the IRS question what happened to the IRA basis?

Submitted by Alan - IRA critic on Wed, 2023-12-13 22:26

If your 2022 8606 showed 10k on line 14, just bring that forward to line 2 of your 2023 8606 as you ordinarily would. Your 2023 ND contribution would then add to that basis, and the 2023 conversion would apply that basis to the conversion, still leaving you with around 10k on line 14 of the 2023 8606. In other words, your 8606 would look the same as it would have if you had enough pre tax funds in the IRA to fund the rollover, and the 8606 will be what the IRS would expect it to be. You can have IRA basis in excess of your IRA value, but that is typically caused by investment losses.  

Submitted by Daniel Levin on Wed, 2023-12-13 22:35

Sorry, I’m not very well versed in form 8606, I usually follow a guide online to help me fill out the proper prompts in turbo tax. So will the 10K basis carry forward every year indefinitely? If so, any way to get it ot $0?  Will I run in to issues with pro-rata rule and taxes? (I guess not since my tIRA value would be $0).  

Submitted by Alan - IRA critic on Wed, 2023-12-13 23:01

  • You should check your 2022 8606. It sounds like the SIMPLE IRA balance has been correctly pro rated, which resulted in your prior back door conversions being mostly taxable. Since only a small amount of your basis was applied to these conversions, your basis built up to what had been about 10k.  Line 14 shows the amount that is entered on line 2 of the following year 8606, in other words it’s unused basis that carries over to the following year. Your 2023 8606 would just follow suit.
  • Regarding the ultimate recovery (use) of this excess basis. Either it would be partially applied to all future IRA distributions or conversions for life, or to use it sooner if you had an employer plan from which you could do a partial rollover equal to your basis, you could then convert the entire IRA to a Roth IRA tax free, and that would eliminate the basis. But in order to do that, you generally must have a prior 401k or 403b which allows partial distributions, just enough to equal the IRA basis, currently around 10k. After you convert that 10k, the following January you could roll over the rest of that old plan since your IRA basis will be gone. Yet another way is to use the basis is to make the usual ND TIRA contributions for a few years, but hold the conversions until the gains on those contributions eventually match the basis. You can then convert the entire TIRA tax free. So there are ways, but they take time and planning. 

Submitted by Daniel Levin on Thu, 2023-12-14 00:15

I am still confused about doing the backdoor Roth this year.  Yes, you are correct, line 14 of the 2022 8606 shows the $10k.  Let’s assume I don’t do anything and leave the IRA basis in the 401K, when I do the backdoor Roth in a few days, will I end up paying any taxes on the conversion due to the IRA basis? Or is the basis just an accounting item now that I will need to keep track of?Regarding the recovery, I will have to check with Fidelity if they will do in service distribution of the $10k.  If this is something Fidelity will do, will it need to be completed this year? or does the timing not matter?  Can you give more info on the second option?  Are you saying that I can contribute after tax dollars into my traditional IRA and not do the conversion to the Roth IRA and let it earn investment gains? And then continue to do this for a number of years until the investment gain reaches the $10k basis and then do the Roth conversion?  If that’s the case, assuming Fidelity doesn’t allow in service withdrawal, this seems to be the path of least resistance (albeit I’ll have to wait 5-7 years). Please let me know if my understanding is correct.Thanks for all the assistance. 

Submitted by Alan - IRA critic on Thu, 2023-12-14 01:38

  • No taxes on the conversion because you will have the 10k of basis increased by your 6500 2023 ND contribution to 16,500. With the conversion being far less than the basis, it will be entirely tax free, and you still will have 10k basis left on line 14 to carry forward to 2024. Continuing 8606 forms will keep track of your remaining basis.
  • You can ask Fidelity, but remember that when your tell them that the 10k must be removed because it was IRA basis, be prepared for any reaction. If they agree, ask them how they will code it on Form1099 R and be sure that the taxable amount will be limited to any gains. Remember if they show the 10k as taxable (any earnings since November would correctly be taxable and added to the distribution) you are even worse off as the second taxation will be immediate. And even if Fidelity were to cooperate, I wouldn’t start there. I would start with the IRA custodian who would have to issue 2 1099Rs as explained above. The problem is that if both custodians do not produce coordinating forms, your return will only reflect one end of the correction and you will still have a problem. Another part of the challenge is once you divulge thed info you have no control of how they will react, and they certainly will not coordinate between them. The burden is on you to explain this so that they will clearly understand the issue and know how to correct it. The average CSR would not understand the problem.
  • If FIdelity would correctly return the excess amount with any gains, it could be done after year end, but that would then affect your 2024 return because you would not get the 1099R until Jan, 2025.
  • With respect to using your IRA basis, your understanding is correct. You would have to generate pre tax dollars in the IRA to equal the basis, then you could convert tax free, eliminating that basis. This could take longer than 5 years depending on when you can get pre tax dollars into the IRA.  A low income year would allow you to deduct your TIRA contribution, and that would add the pre tax dollars pretty fast.

 

Submitted by Daniel Levin on Thu, 2023-12-14 02:44

Based on your comments, its appears the last bullet point is the best option, would you agree? Assuming I contribute $6.5k anually with 6% returns, it seems it would take 7-8 years to gain $10k in investment income on a pre tax dollar. At which point I would convert the full tIRA over to the Roth IRA.I don’t see being able to directly contribute pre tax dollars to a tIRA any time soon. So I’ll have to wait. 

Submitted by David Mertz on Thu, 2023-12-14 13:58

I think the idea of treating the basis as having been retained in the traditional IRAs despite the balance in the traditional IRAs being zero makes sense.  Consider that the result would have been similar had a $10,000 investment been retained in the traditional IRAs at the time of the rollover instead of being rolled over to the 401(k) (in-kind) but that investment became worthless by the end of the year.

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