Query about tax consequences of roth conversion (with a rollover IRA)

[Anonymous]

I performed the following actions recently: 

I switched jobs in October 2019, rolled over my 401k to a rollover IRA.

In February, 2020, I learned about backdoor roth, so I opened a traditional IRA, contributed 6000 (after tax money) for 2019 and immediately converted it to a roth, assuming there wouldn't be any further tax consequences related to the roth conversion. However, it seems I am wrong as per the pro-rata rule, and I would probably be taxed on my conversion to roth again. 

Now, while filing my taxes for 2019:

- I reported the 401k rollover (through my broker's 1099-R).

- I reported traditional IRA contributions where required. however, the conversion to roth I did in February was not requested anywhere. 

My question:

Will the conversion to Roth be reported in 2021 when I file my tax return for 2020?

How will I figure out what fraction of my 6k conversion to roth is taxable and at what rate.

Thanks for helping. Pardon the length of my 1st post :).

[macuser_22 · Accepted solution]

You analyzed the  situation very well.

You will receive a 2020 1099-R for the conversion to be reported on 2020 tax return.

Unfortunately, you are correct that the non-deductible  basis must be pro-rated between the 2019 distribution and the 2019  years end total value of all IRA accounts, so depending on the value that the 401(k) added, only some of the conversion will be not taxable.

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 If you do, then the non-deductible part must be spread over ALL accounts and cannot be withdrawn by itself.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 purposes you only have ONE Traditional IRA which can be split between as many different accounts as you want, but for tax purposes they are all added together).

For example using rough figures: if you had $60K of nondeductible contributions in an IRA with a total value of $600K (10:1 ratio), then when you take a $60K distribution from any IRA account $6,000 would be nontaxable and $54,000 would be taxable (same 10:1 ratio) , with the remaining $54K of basis staying in the IRA for future distributions. As long as there is any money in the IRA, there will be some basis.

TurboTax will ask for your non-deductible "basis" and then the *Total Value* of *all* Traditional IRA, SEP and SIMPLE accounts as of Dec 31, of the tax year. That is so the prorating of the basis can be properly proportioned between the current years distribution and the remaining IRA value. That is done on the 8606 form.

[Anonymous]

Thanks a lot for the response. This is very helpful.

I guess if i have two choices:

- roll-in my rollover-IRA back to my present 401k, which leaves me with only 1 traditional IRA of 6000

- Just pay the tax on almost 6000 that is converted to roth. 

I will probably go with the latter,  may end up with a small tax bill on the 6000, but have more freedom to invest in IRA compared to company 401k plan.

Thanks again!

[dmertz]

There is nothing that you can do now to change the tax liability resulting from the 2019 Roth conversion since the calculation of the taxable amount is based on your December 31, 2019 balance in your traditional IRAs.  Rolling the pre-tax portion of your traditional IRA back to a 401(k) in 2020 will only help with Roth conversions in 2020 and beyond.

[Anonymous]

Thanks for the response. I am not sure if that's correct in my case, the sequence of events was like this:

1. Contributed to 2019 traditional IRA (6000)

2. Converted the 2019 traditional IRA to Roth BUT, did this conversion in 2020 (not 2019). Apparently for Roth conversion, its the year you do the conversion you handle the tax consequences. This is coming out of my research on the web, but I will probably need to confirm it with some expert. Given that I will receive 1099-R for my Roth conversion at the end of the year also reaffirms the above statement.

Following is the related paragraph from one of the references I read: (I am unable to share the link but it was a newsletter article from google search on pro-rata rule)

"To make things even trickier, you can’t calculate the exact pro-rata percentage until the end of the tax year. The pro-rata calculation is not based on the balances in the IRAs on the date of the conversion. The total value of all IRAs used in the pro-rata rule include the account values as of December 31st of the year the conversion is made. Any growth (or loss) in the funds remaining in your IRA from now to the end of the year will have an impact on the pro-rata calculation"

[Anonymous]

That said, it probable makes sense to bite the bullet and pay the tax for the conversion instead of rolling-in IRA back to 401k. I have come to like the freedom and the choices that a rollover-IRA has (compared to a 401k, where the number of funds are limited). 

Thanks everyone for helping!

[dmertz]

Thanks for the follow-up, I misunderstood and thought you did a the Roth conversion in 2019.  Yes, if you roll the pre-tax funds back to a 401(k) before the end of 2020, you can cause your entire basis in nondeductible traditional IRA contributions to be applied to your 2020 conversion by having a $0 in traditional IRAs at the end of 2020.  But as you said, there can be other reasons to just leave the money in the IRA.  You'll eventually pay tax on the pre-tax money either way; you'll just be paying now instead of later (and we are currently in a period of lower tax rates scheduled to revert to previous levels in 2026).