What is difference between non-deductible "Traditional IRA" and an "401K IRA Rollover", in the sense that that my 401K IRA was pre-tax and Traditional IRA was post tax?

[garytapperson]

I'm having difficulty with separating withdrawals for non-deductible traditional IRAs from withdrawals from withdrawals for 401K rollover IRAs. My non-deductible traditional IRAs were made after tax contributions, so they have a cost basis. My 401K rollover IRAs of course just get treated as ordinary income thus have no cost basis. I'm basically stuck on Form 8606; and I'm not clear how to complete it. The 'step by step' doesn't seem to ask the right questions; and the Form 8606 does not seem clear on this. I have balance at end of 2017 of roughly $66K in non-deductible traditional IRAs and balance at end of 2017 in 401K rollover IRAs of roughly $1,500,000. I've taken withdrawals from both in 2017.

[dmertz · Accepted solution]

There is no such thing as a nondeductible traditional IRA, only basis in nondeductible contributions that applies to all your traditional IRAs in aggregate, including your rollover IRA.  Any distribution from a traditional IRA is a mix of nontaxable and taxable amounts in the ratio that your basis for 2017 has to the total of all of your IRA year-end balances plus any regular IRA distributions that you made in 2017.  The rollover of the $1.5M to an IRA has caused nearly the entire amount of your IRA distributions made in 2017 to be taxable.  TurboTax is calculating correctly that something like 4% to 5% of your traditional IRA distributions is a nontaxable distribution of basis with the remaining 95% to 96% of the distributions being taxable.  Whatever amount of basis has not been distributed remains in your traditional IRAs (in aggregate).

I'm sure that this is not the answer that you were hoping to hear, but it is what is required under the tax code.  Rolling a large 401(k) balance into a traditional IRA when you have significant basis in nondeductible traditional IRA contributions and would like to make distributions that are largely nontaxable is not an uncommon mistake for people to make.

[asc]

I am confused by the comment in the last sentence about it being "not an uncommon mistake" to roll a large 401(k) balance into a traditional IRA with a significant basis.  While doing so would indeed dilute the percentage of the non-deductible contributions Basis within the aggregate of the now larger traditional IRAs resulting in more taxes having to be paid from the IRAs, wouldn't it identically reduce the balance within the 401(k) and resulting RMD withdrawal subject to taxes at the same time?    

Since the tax rate and distribution period is the same on both 401(k) withdrawals and on the taxable (i.e. non-Basis) component of IRA withdrawals, the net taxes would be identical whether or not the 401(k) balance had been transferred.

The only difference I see is that with 401(k)s you can defer taking the Required Minimum Distribution (RMD) withdrawals (and paying the associated taxes) beyond age 70 1/2 if you are not retired, whereas with IRAs the distributions must start at age 70 1/2 regardless of retirement.  So if you have an IRA with a significant basis are not planning to retired until after age 70 1/2, it might make sense to not roll-over 401(k) funds into the IRA so you can minimize the taxes on the IRA RMD withdrawals while you are still working.

If I'm not understanding any of the above correctly, please explain. Thank you in advance.

[dmertz]

It's a mistake in the sense that it delays the ability for the individual to access (distribute) the basis in the individual's traditional IRAs.  In the case where the entirety of the individual's IRA balance is basis, the situation described in the original question, had the individual not rolled over money from the 401(k) the individual could have performed a conversion to a Roth IRA (or a regular distribution) of the entire balance of the IRA that would have been entirely nontaxable.  Rolling over the 401(k) in the same year defeats that strategy since the Roth conversion becomes largely taxable with a large portion of the basis remaining in the individual's traditional IRAs.  The individual's traditional IRAs will always contain some basis until there is a zero year-end balance in the individual's traditional IRAs.  The result of the rollover from the 401(k) is that taxable income is pulled forward (assuming the same distributions from the IRAs).

[PEJ]

I would like to pose the question a little differently.  Going into the year my Traditional IRA taxable basis was only about 10% of the IRA values--converting to a  Roth was not attractive.  During the year I converted a 401K without basis into the traditional IRA as well after taking the required MRD on the 401K.  Following the instructions included with the Form 8606, it seems that the total value of all IRA's at year end need to be included in line 6 (the denominator).  However line 7 the numerator includes only IRA distributions (apparently the 401K distribution is excluded).  That action results in a lesser amount of nontaxable basis to offset otherwise taxable income than would have been the case had the conversion not been made.  This is illogical and causes me to wonder if there is an error in the instructions or my interpretation.  The numerator and denominator should logically be consistent.   Fortunately, the calculation will correct itself in subsequent years.  Any comment?  Does anyone maintain that the 401K MRD should be included in line 7

[Critter]

The RMD had to be taken BEFORE  you could convert the balance of the 401K into the IRA ... so that amount is NOT included in line 7.  It is NOT a distribution  from traditional, SEP, and SIMPLE IRAs since it was never in the IRA to start with.

[dmertz]

PEJ, you understand the instructions and Form 8606 correctly.  Rolling your 401(k) over to your traditional IRA has decreased the proportion of your nondeductible traditional IRA contributions to the overall value of your traditional IRAs, resulting in a decrease in the nontaxable proportion of your RMD and more of your basis remaining in your traditional IRA(s) to be applied to future distributions.  This result is dictated by law.