Nondeductible IRA mixed with rollover 401k

[jeremy10]

Starting in 2018 my income was too high for either a Roth IRA or a Traditional IRA

In 2018 I contributed to both an Roth IRA and Traditional IRA. I then in 2019 recharacterized the Roth contribution from 2018 as a Traditional IRA contribution (I realized that I made a mistake by contributing to the Roth but I didnt know about the Deductible Traditional IRA income limit at this point in time). I just checked my 2018 taxes and I did not claim any deductions associated with my IRA, I also didnt file a form 8606 with my taxes.

In 2019 I contributed to a Traditional IRA. Also in 2019 I rolled over my old work Traditional 401k into my Traditional IRA. Now that the Traditional 401k and Traditional IRA money is mixed in the IRA account I don't want to roll over everything into a backdoor Roth IRA since that will be a large tax hit. 

For the 2019 money I can remove it with only paying a 6% fee on my gains. What are my best options to deal with the 2018 contributions? I would prefer to get this dealt with and not need to worry about it for years since inevitably I'll forget about this in 30 years and I'll pay double taxes on the 2018 contributions.

[fanfare]

You will pay ordinary income tax on gains from 2019 Roth removal, not 6%.

Since your 2018 money is in a Traditional IRA, you can file an amended return to either

a) take the deduction

b) file 8606 to make it a non-deductible contribution.

In either case, attach an explanation of what you did. 

[jeremy10]

For 2019 my income is too high to take the deduction and I already paid taxes on the money I contributed

For the 2018 money I want to avoid deductible traditional IRA money mixed with non-deductible traditional IRA money so I would like to take the money out of the IRA or even just send that portion to a roth. Since I didnt claim the deduction I already paid taxes on the money. My questions is whats the best approach to do this while minimizing fees

[dmertz · Accepted solution]

You need to correct your failure to file the required 2018 Form 8606.  Line 14 of the 2018 Form 8606 will carry forward to line 2 of your 2019 Form 8606 to be used in calculating the taxable amount of any traditional IRA distributions, including Roth conversions, made in 2019.

The only way under the law to "unmix" your basis in nondeductible traditional IRA contributions from the pre-tax money in your traditional IRAs is to roll over all of the pre-tax money in all your traditional IRAs to a qualified retirement plan like a 401(k), then convert the basis to Roth.  Rollovers from a traditional IRA to a qualified retirement plan can only be from the pre-tax money in your traditional IRAs, so this rollover leaves only the basis in your traditional IRAs.  The result must be that at year-end you have $0 in traditional IRAs.

The other option is to just convert every thing to Roth over the next few years.  With 30 years until retirement, the long-term benefit of tax-free growth in the Roth IRA instead of taxable growth in the traditional IRA is likely to far outweigh the deferring of the taxable income.  You also have a relatively short time until the tax rates now in effect revert to what they were before 2018.

[jeremy10]

Thank you. Spreading the conversion Traditional IRA to Roth IRA conversion between now and 2025 sounds like the best solution for me.

Since I am never sure of my modified adjusted gross  until I do my taxes,  what is the best way for one to backdoor Roth the maximum maximum they can in a year without jumping to a new tax bracket? Should I just do the conversion late every December and guess what my final income for the year is going to be?

[dmertz]

Certainly in December you'll have a better idea of where you are in your current tax bracket and be able to adjust your Roth conversions to try to top that out.  Going over a bit usually isn't too terrible since only the portion of the income that is in the next tax bracket gets taxed at the higher rate.  Still, because of various potential side effects of an increase in AGI you'll want to experiment to find the actual marginal tax rate on each increment of income.  You might find that the marginal tax rate goes up for one increment and goes back down some for the next increment.  People who receive Social Security income and have not reached the income lever where the maximum 85% of Social Security income is taxed experience this, but there are other ways this can happen.  Don't wait until the last minute in the year to do a Roth conversion, though, especially if your custodian is not one who generally processes transactions like this the same day or the next day.

You could do several conversions during the year, doing one final conversion late in the year to get close to your target.

TurboTax is usually working well enough by mid-December to get a pretty good estimate, but the CD/Download version provide much more flexibility to experiment than does the online version.  The CD/download version also allows overriding values that have not had their calculations updated for the new year.  For example, despite the amounts having been known for well over a year, the developers always seem unable to get the HSA contribution limits updated until mid- to late-December, but overrides can deal with that.

[kfink85]

Does completing the transactions this way avoid the pro-rata rule and therefore no taxes need to be realized upon moving the non-basis Traditional IRA funds to the 401k and converting the basis to the Roth (backdoor conversion)?

[dmertz]

With all of the pre-tax money moved to the 401(k) and converting all of the after-tax money to Roth, leaving a zero balance in traditional IRAs at year-end, result on Form 8606 be $0 taxable.

[pookybeary123]

Hi there, sorry for replying to an older thread. I ran into a similar situation and need to do the same as well. When you say pre-tax does that include the earnings from the non-deductible contribution basis?

[dmertz]

Yes, the earnings in a traditional account are pre-tax.