Does Pro Rata rule apply here? If it does, what are the options for my client?

Submitted by Robert Escalon on Wed, 2024-04-17 04:14

Hi everyone, I’m seeking advice on the tax implications for a client who used a Mega Backdoor Roth strategy.

Client Situation:

  • Client’s income disqualifies them for direct Roth IRA contributions.
  • As of January 1, 2023, their Form 5498 (Box 2( showed no rollover contributions.

In January 2023, they:

  • Contributed $6,500 to a Traditional IRA.
  • Immediately converted it to a Roth IRA using a Mega Backdoor Roth approach.
  • In March 2023, they rolled over an after-tax 401(k) of approximately $800,000 into a Rollover IRA.

Question:

  • What are the implications of the pro-rata rule for this situation?
  • Specifically, how does the $6,500 Mega Backdoor Roth conversion impact the tax treatment of the $800,000 rollover IRA?

Possible Solutions (Seeking Feedback):

  • Option A (Not Preferred): Convert all $800,000 to a Roth IRA and incurring a significant tax bill is not desirable.
  • Option B: Contact the old 401(k) custodian to explore rolling the Rollover IRA back into the ex-employer’s 401(k) (feasibility needs confirmation).
  • Option C: Contact the Mega Backdoor Roth IRA custodian to see if reversing the $6,500 conversion is possible (availability needs verification).
  • Option D: Perform pro-rata calculations. If so what are these calculations?

Looking for Advice:

  • What is the best course of action for my client in this situation?
  • Any insights on navigating the pro-rata rule and potential solutions would be greatly appreciated.

Thanks for your expertise and for this valuable forum.



Submitted by Robert Escalon on Wed, 2024-04-17 04:15

Sorry, there’s a correction:

In March 2023, they rolled over their pre-tax 401(k) of approximately $800,000 into a Rollover IRA.

Submitted by Alan - IRA critic on Wed, 2024-04-17 14:53

This is not a disaster, the result is only that pro rating of the conversion will result in almost all of the 6500 conversion being taxable (roughly 6,448) and that same amount of basis remaining in the IRA. The conversion was a back door Roth conversion, not a mega back door Roth since no conversion was done with after tax 401k contributions.
Since all this happened in 2023, there is no avoiding the taxable portion indicated above. However, since there is still a large basis (6448) in the IRA now, if this year the entire TIRA balance in excess of 6448 is rolled back to the 401k (option B), then the 6448 remaining can be converted this year to the Roth IRA. The rollback should be done prior to the conversion to make sure it will be acceptable.
Option A would be a tax disaster, and Option C is not allowed, leaving D as the only choice for 2023 taxes. But Option B can be explored this year to convert the IRA basis tax free to Roth, and that will salvage some of the back door benefit.

Submitted by Robert Escalon on Wed, 2024-04-17 20:49

Alan, Thank you for your detailed reply.

My client called the custodian and option B doesn’t work as they left the company
In my original message I had a typo, I meant to say 800,000 USD in a pre tax 401k. Does that change your answer?
In my client’s 1040, 4a, $6580 and 4b Taxable amount is $80 as they held it in the Traditional IRA for a few weeks before converting it to Roth IRA using the backdoor. So effectively $80 will be taxed and that’s about it.

Does the $80 look right to you? Thank you for this wonderful forum

 

 

Submitted by Alan - IRA critic on Wed, 2024-04-17 21:05

My original answer regarding the 2023 taxes for the conversion still applies. This conversion must be reported on Form 8606 and line 6 of the 8606 must show the total IRA balance on 12/31/2023, which is likely even higher than 800,000. That will make almost the entire conversion taxable, so line 4b will be just a little less than 4a. It’s clear that the rollover IRA balance was not included on line 6 of the 8606. It does not matter whether the 800,000 rollover was done into a new IRA account or into the IRA from which the conversion was done, since Form 8606 includes the balance of all TIRA, SEP IRA, or SIMPLE IRA accounts on 12/31/2023.

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