Back Door Roth Conversions & the tax impact of a new Rollover from 401k plan to Traditional IRA - Now we have a TIRA with a balance & Fed Tax Due increases significantly

[JRP1]

For several years we have been doing back door Roth conversions of our non-deductible traditional IRA contributions.  The tax effect is pretty close to zero.  All of our IRAs have been fully converted to Roths for several years, and at the end of each year, the balance in all of our Traditional IRAs is 0.

Until this year - when we did a direct rollover of my spouse's 401 to a Traditional IRA with a balance of ~100K.

Now as I work through the personal income section in TurboTax, it shows correctly on the 1099R and in Turbo Tax that the money from this was not taxable.  

As I complete the 1099R area this year, it asks if either of us made and tracked non-deductible contributions to our Traditional IRAs. I say we do, but enter 0 for the basis since in the past there was no balance in our Traditional IRAs (all were converted to Roths by the end of each year). 

And now for the question(s):

In the past as I completed this activity, we had NO balance in Traditional IRAs and the Federal Tax owed didn't move up.  This year, after we rolled over my spouse's 401K to a Traditional IRA, I have to enter the year end balance for all Traditional, Simple, SEP IRAs which includes her ~100K or so from the 401k.  As soon as I do this the Federal Tax owed shoots up more than a $1000.  I assume this has to do with the interaction of the back-door Roth conversion we did of her non-deductible IRA and the fact she now has a balance in a traditional IRA???  Am I entering or thinking about this incorrectly?

I am asking not only for this year but also for next tax year I will have a my employer 401k I will be rolling over to Traditional IRA, with a larger balance, and should I expect the same tax impact?

Thanks in advance for any insights the community can provide!

[macuser_22]

That is the hazard of doing a backdoor Roth if there is any Traditional, SEP or SIMPLE IRA with a year end balance.   This so-called “back-door Roth”  method ONLY works if you have NO OTHER Traditional IRA accounts.  If you do, then the non-deductible part must be spread over ALL accounts and cannot be withdrawn by itself.  Only if you started with NO Traditional, SEP & SIMPLE IRA and ended up with a zero amount in ALL Traditional, SEP & SIMPLE IRA accounts will this Roth conversion not be taxable. You can NEVER withdraw ONLY the nondeductible part - it must be prorated over the entire value of ALL Traditional IRA accounts which include SEP and SIMPLE IRA's.   (For tax purposed you only have ONE Traditional IRA which can be split between as many different accounts as you want, but for tax purposed they are all added together).

[kpearsonpayne]

So, I had this same issue.  My financial advisor is going to move the money out, as though the contribution didn't happen.  Will this work to remove the huge tax amount that is now showing?  Essentially eliminating the 1099-R?  Can you remove contributions prior to April 15th as well as make them?

[Hal_Al]

Yes, what you will be doing is a "re-characterization" of the conversion. You actually have until Oct 15 to do a re-characterization.

However, your use of terminology hints that you might not really have the "same issue". You are not moving money "out", you are moving money "back" to the TIRA.  It is not as if "contribution" didn't happen; it's a "conversion" that didn't happen. If what you really have is an excess contribution, you should ask a new question, rather than tagging on to a question on a different subject

[kpearsonpayne]

Ok, fair enough.  Only thought the other person might also benefit by moving the money back to trad'l IRA.  To avoid the high taxable event.  I did have the same thing, with back door contributions and Turbo calculating a huge tax on the money.  This year we had to move my husbands 401k into a trad'l IRA.  Doing so created a market value as of Dec. 31, 2017 in that account.  Therefore, no longer allowing back door Roth conversions and taxing it over $1,500.  We had done that contribution and conversion to Roth before we realized we would have to move the 401k.  Now we are moving it back to traditional account, so I will mark it as recharacterized.  Thanks.

[macuser_22]

That is what most people do not realize about the so-called backdoor Roth.  It does not work unless the total value of all existing Traditional, SEP & SIMPLE IRA accounts are a zero value at the end of the tax year, otherwise the non-deductible basis must be prorated between the conversion and total year end value so only a small portion is not taxable.

[Hal_Al · Accepted solution]

Yes,  the fact she now has a balance in a traditional IRA is the reason for the tax. You  have to use the balance in all your IRAs, including rollovers in calculating the taxable portion of the conversion. That includes rollovers made in 2017.

So, for example, if you rolled over $100,000 of pretax money and made a $5500 non deductible contribution to your IRA, then converted $5500 to a Roth; only 5.2% (5500/105,500) of the conversion would be tax free. The calculations will be shown on form 8606.

This will happen every year. The rollover effectively ends the ability to do a tax free back door Roth contribution

[proveitvassar]

Hi--what about a REVERSE IRA rollover (traditional IRA into employer 401k plan)? If I move ALL traditional IRA assets into employer 401k in July 2019, such that my IRA balance then falls to zero, can I then--also in 2019--do the backdoor Roth conversion (i.e., make a $6k non-deductible IRA contribution and then, sometime thereafter, convert to Roth)? My traditional IRA balance would of course be $0 at year-end 2019, but does the fact that I began 2019 with a large balance matter? Do I need to wait until 2020 to execute my first backdoor Roth conversion? Any help MOST appreciated--thank you.

[macuser_22]

@proveitvassar 

Yes, you can do that provided that your 401(k) plan allows such a rollover - not all do.   Also note that if the IRA contains any after-tax money, that cannot be rolled into a 401(k) - only before-tax money can.  That should be done as a trustee-to-trustee transfer between the IRA trustee and the 401(k) trustee.  Be sure to keep all records because the IRS often questions IRA to 401(k) rollovers because the 401(k) plan does not report receipt of the rollover to the IRS and they often ask you for proof that the rollover actually took place.

As far as prorating any after-tax basis, the years beginning balance makes no difference, it is only prorated over any taxable distribution and the years ending total IRA value - if that value is zero then there is nothing to prorate.

[dmertz]

provitvasser, in doing so you must be careful that the amount you convert to Roth is not less than the amount of your nondeductible traditional IRA contribution as a result of investment losses, otherwise you will have impermissibly rolled to the 401(k) some money attributable to of your basis in nondeductible traditional IRA contributions even though the nondeductible contribution was made after the rollover.  While it's in the traditional IRA, leave the nondeductible contribution in an investment that cannot lose value.

[proveitvassar]

Thank you dmertz! Very helpful.

[proveitvassar]

Thank you macuser_22! So, does this seem right? Example might help:

1) July 2019: roll over ALL traditional IRA funds (100% pre-tax) into 401k plan (this is permissible for me and now complete). Traditional IRA balance now = $0.

2) August 2019: make $6k non-deductible IRA contribution from after-tax cash. Leave contribution in cash so as to avoid investment losses and thus ensure that the full $6k value of the contribution can later be converted to Roth.

3) December 2019: Convert $6k in traditional IRA (non-deductible) cash to Roth IRA, then invest.

Does that sound like the right process? MUCH appreciated.

[dmertz]

Sounds fine.  There is no need to wait until December to do the conversion, you can do it immediately following the traditional IRA contribution.

[proveitvassar]

Thank you dmertz. I appreciate your guidance. Final question if I may: regarding the idea of not producing investment losses while the $6k contribution sits in the traditional IRA, is that relevant only for this first year (the year of the reverse rollover of traditional IRA to my employer's 401k)--or should one avoid investment losses in every future year's contribution as well? That is, for future years, is there a problem if the amount converted to Roth is less than the $6k non-deductible contribution due to investment losses? Thanks so much.

[macuser_22]

And doing the conversion immediately (right after the contribution) avoids having to deal with any earnings (or losses) even if only a few cents.