Traditional and Rollover IRA basis and valuje

[jmintx]

I make just over the amount to be able to contribute to an IRA or ROTH.  Mid 2022 I deposited $5,000 into a traditional IRA as nondeductible and then had the broker recharacterize it the next day into a ROTH IRA.  Later in the year, a former company that I worked for ended their pension program and sent a check for the lump sum value of the pension in late December.  Which I had payable to the brokerage and placed it into a rollover IRA.  On Form 8606 (nondeductible IRA) Line 1 ask for the nondeductible contribution and I showed it as the $5,000.  Lines 3 and 5 also work out to be the same number.  However, line 6 asks for the value of all the traditional, SEP and SIMPLE IRA as of December 31, 2022.  My traditional IRA has 0 balance since it earned no income before it was recharacterized to a ROTH.  But do I count the rollover IRA in that total on Line 6?  Do I report anything in lines 6 through 13?

[DavidD66]

Yes.  You have to include the value of your rollover IRA in line 6 of Form 8606.  Line 8 is the $5,000 you converted to a Roth IRA.  Lines 9 through 15a are arrived by performing the arithmetic indicated on the form for each line.   Basically, by distributing your pension plan to you, it made a portion of your Roth conversion taxable, 

[jmintx]

David66:

I just want to check my understanding of your note.  The indicated $5,000 deposited into the Traditional IRA at broker 1 was after-tax money and non-deductible.  Broker 1 then made the recharacterization the following day into my Roth IRA at broker 1.  That leaves the Traditional IRA account at broker 1 with a 0 balance and a basis of 0.  Then four months later the pension program of the company that I worked for earlier is closed and a payout of pre-tax money is then deposited into a new Rollover IRA directly with a new broker 2.  Your e-mail indicated that for Line 6, I should add the value of the Traditional IRA ($0) to the Rollover IRA ($X) and report $X on Line 6.  Then for Line 8 (conversion to Roth), I should list the $5,000 that was a recharacterization from an IRS to a Roth.  Then the calculations on Lines 9 to 11 would make most of the $5,000 of after-tax money subject to tax again and set that amount as the Rollover IRA new basis (the Traditional IRA balance is $0).  Is this the correct interpretation?   (It feels like I'm paying taxes on the $5,000 twice.)

[AnnetteB6]

Your interpretation is correct, and due to the unfortunate timing of the pension plan distribution, it does diminish the advantage of your back-door Roth IRA conversion (not recharacterization).

When you take a distribution from a Traditional IRA (as you did when you converted the $5000 to the Roth IRA) and it is reported on your tax return for the year of the distribution (2022), the year-end balance of all Traditional IRA accounts must be considered regardless of whether they are maintained by the same broker.

There is a pro-rata rule with regard to distributions that essentially means that every distribution will be proportionally made up of pre-tax and after-tax money if the Traditional IRA account(s) is not 100% after-tax (non-deductible) money.  So, if your pension account is proportionally high on the pre-tax side, then more of the $5000 that was converted to the Roth will be taxed.  Mathematically, the $5000 is coming out of your total Traditional IRAs as a whole rather than the specific Traditional IRA account that only existed for the purpose of the back door Roth conversion.

If your only Traditional IRA account had been the one that was subsequently converted to the Roth IRA, then everything would have worked as planned, with a non-taxable event on your return.

Take a look at the following discussion which may further explain the situation:  

IRA Conversion to Roth & Pro-Rata Tax Obligation

@jmintx 

[jmintx]

DavidD66 / AnmetteB6:

Thanks for the responses.  Very helpful.

I have a related follow-up question associated with the rollover IRA.

When the pension plan was terminated and the bank handling it made the lump sum distributions, I received two checks and two separate 1099Rs.  The first check covered the pre-tax portion of the lump sum payment and was rolled over into a Rollover IRA.  The 1099R information indicates it was rolled over (Distribution Code G).  The second check covered the post-tax portion of the lump sum payment and was cashed.  The 1009 information for this check indicated the taxable portion as $0, that it was a total distribution, and shown as a normal distribution (Distribution Code 7).  All the 1099s information was entered into TurboTax, but I do not see any listing of that payment anywhere in the tax forms or included in any number shown in the 1040 or 8606 forms.  The 1040 line 4a information shows the $5,000 nondeductible IRA entry.  Where should this information on the post-tax distribution be showing up?

[ThomasM125]

The post-tax distribution, which is $5,000 evidently, is showing on line 4(a) and I assume not on 4(b) which would be the taxable amount. That is the only way it would be reported on your tax return. The pre-tax distribution may only show on line 4(b), for the taxable amount.