Trying to avoid (or calculating) the Pro Rata Rule

[user2424123]

Say you have money in a traditional IRA and attempted to do the Backdoor Roth conversion (put post-tax money into that Traditional IRA, then convert it to a Roth IRA). In this case, you would be subject to the Pro Rata rule since there was already money in the traditional IRA.

Let's use the amounts $15k originally in traditional (pre-tax) and added $5k (post-tax). If you move $5k into the Roth IRA, that means $3.75k (75%) was pre-tax and $1.25k (25%) was post-tax, meaning you would need to pay taxes on the $3.75k. The remaining money in your traditional IRA is $15k (11.25k pre-tax, 3.75k post-tax).

However, later on in the same year, you want to avoid / minimize the taxes from the Pro Rata rule, since the rule is based on the balance on your traditional IRA on Dec 31. Given that $5k was already "rolled over" into a Roth IRA earlier in the year:

1. If you put the rest of the Traditional IRA ($15k) into the Roth IRA, does it matter that it happened in 2 separate transactions in the same year?  Would you just be taxed on the 15k the same as if it was all done in one transaction, and do any gains affect this?
2. Since you already moved $5k into the Roth IRA, is it too late to roll the pre-tax funds into an employer 401k to bring the traditional IRA balance down to $0?

[Critter-3]

1. If you put the rest of the Traditional IRA ($15k) into the Roth IRA, does it matter that it happened in 2 separate transactions in the same year?  Would you just be taxed on the 15k the same as if it was all done in one transaction, and do any gains affect this?   It doesn't matter since it was all converted in the same tax year. 

      2. Since you already moved $5k into the Roth IRA, is it too late to roll the pre-tax funds into an employer                    401k to bring the traditional IRA balance down to $0?  Don't know on this ... let us see if @dmertz  can                    weigh in on this matter. 

[dmertz · Accepted solution]

1.  I agree with Critter-3 on this question.  It doesn't matter that the conversion was don in two separate parts.

2.  For tax purposes, the distributions from the traditional IRA are treated as if they occurred simultaneously on December 31.  If the 401(k) will accept a rollover of the remaining balance in the traditional IRA with the distribution from the traditional IRA occurring before year-end, all of the $5k converted to your Roth IRA will consist of your $5k of basis in after tax contributions because your traditional IRA balance at year end will be $0.  None of the money rolled over to the 401(k) will be after-tax basis.  The important thing is that the amount you converted to Roth is no less than your total basis in nondeductible traditional IRA contributions, otherwise rolling the balance of your traditional IRAs over to the 401(k) will impermissibly include some of your basis.  By first doing a Roth conversion of an amount equal to your basis, you've guaranteed that no basis is rolled over to the 401(k).

[user2424123]

Thanks so much for taking the time to weigh in @Critter-3 and @dmertz! 🙏

So to clarify, let me know if this makes sense and the statements at the end are correct:

1. Start of 2020 - There is $15k in a traditional IRA.
2. A few months later - $5k is contributed to the traditional IRA through a 2019 (prior year) nondeductible contribution. (Not sure if it matters that the contribution was for 2019 vs 2020 tax year)
3. On the same day as in step 2) - $5k is transferred from the traditional IRA into a separate Roth IRA.
4. Later in 2020 - Your traditional IRA increases from investments by $1k.
5. Later in 2020 - You rollover all of the money in the traditional IRA ($16k) into an employer's traditional 401K.
6. Dec 31, 2020 - There is $0 in all of your traditional IRAs.
7. Dec 31, 2020 - The Roth IRA now has $5010 after interest (I don't think this is relevant).
8. For 2020 Tax year - For tax purposes when filling out Form 8606, you need to pay $0 for the $5k that gets put into the Roth IRA. You don't need to pay anything for the Pro Rata Rule because the $5k contributed to Roth is seen as 100% post-tax. The $16k pre-tax that was transferred to the traditional 401k is now treated as a normal money in a traditional 401k.

Let me know if this makes sense!

[dmertz]

All correct.  The $5,000 nondeductible traditional IRA IRA contribution is reported on 2019 Form 8606.  The $5,000 that appears on line 14 of the 2019 Form 8606 transfers to line 2 of the 2020 Form 8606.  The 2020 Form 8606 will also show $0 on line 6 and $5,000 on line 8, resulting in all $5,000 of basis being applied to the $5,000 conversion.