help understanding Pro Rata in ROTH conversion

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fallon825
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Joined: Wed Nov 04, 2015 9:47 am

help understanding Pro Rata in ROTH conversion

Post by fallon825 »

I have an IRA that I rolled over from a 401K from a previous employer. I have not contributed to this since I rolled it over, or for the last 30 years for that matter. I also have a second traditional IRA that I contributed after $7000 tax dollars with the the intention of doing a back door ROTH conversion. I am having trouble understanding the Pro Rata rule and whether it applies to my situation. I have read the Wiki page, and I'm still a little confused. Am I allowed to do a ROTH conversion or should I just leave this $7000 where it is?
Thanks!
DSInvestor
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Re: help understanding Pro Rata in ROTH conversion

Post by DSInvestor »

You are allowed to the Roth conversion. However, IRS considers your Traditional IRA, Rollover IRA, SEP-IRA, SIMPLE-IRA assets as one big Traditional iRA. So let's say your Traditional IRA has $7000 from your non-deductible contribution and your Rollover IRA has $63,000. IRS considers you to have one big $70,000 IRA with $7000 of IRA basis (non-deductible contributions). When you convert $7000 to Roth IRA, that is a partial conversion of 10% of your IRA so IRS will prorate your basis. The non-taxable amount of the conversion will be $700 and the taxable amount will be $6300. The remaining 63000 in your Rollover iRA will have 6300 of IRA basis which carries forward to next tax year.

See IRS form 8606 for more details:
https://www.irs.gov/pub/irs-pdf/f8606.pdf

If you want to avoid the Prorata rule, consider transferring your Rollover IRA assets into your current workplace plan. Note that this may not be a good option if your workplace plan has high expenses.
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fallon825
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Re: help understanding Pro Rata in ROTH conversion

Post by fallon825 »

So from what you are saying it sounds like I will actually get taxed twice on that $7000, or at least $6300. I am retired, so I don't have an option for a workplace plan. Now I think I just have to let that $7000 sit all by itself in the traditional IRA.
DSInvestor
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Re: help understanding Pro Rata in ROTH conversion

Post by DSInvestor »

fallon825 wrote: Wed Mar 24, 2021 10:01 am So from what you are saying it sounds like I will actually get taxed twice on that $7000, or at least $6300. I am retired, so I don't have an option for a workplace plan. Now I think I just have to let that $7000 sit all by itself in the traditional IRA.
What tax year was your Traditional IRA contribution for? Were you covered by an employer plan for that year? If you had high income and were covered by an employer plan, your Traditional IRA would be non-deductible (IRA basis). If you were not covered by employer plan, then your Traditional IRA may have been deductible which means no IRA basis. IRA deduction rules are tricky.

If you have IRA basis, you are not double taxed on the conversion. This is because that IRA basis (non-deductible contribution) is tracked by form 8606. In my example, the IRA basis prorated if you do a partial conversion. The basis is consumed with each conversion or IRA withdrawal to reduce the taxable amount of the conversion or withdrawal. After the conversion, you were left with $6300 of IRA basis in the Rollover iRA which would help reduce the taxable amount of future conversions or withdrawals.

The IRA basis proration happens only if you have IRA basis. If your Traditional IRA contribution was deductible in the first place and there would be no IRA basis and no IRA basis proration. In this case, you received the $7000 deduction up front at contribution and any conversion will be taxable. The $7000 taxable conversion negates the $7000 Traditional IRA deduction.
Last edited by DSInvestor on Wed Mar 24, 2021 10:13 am, edited 1 time in total.
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wilked
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Re: help understanding Pro Rata in ROTH conversion

Post by wilked »

fallon825 wrote: Wed Mar 24, 2021 10:01 am So from what you are saying it sounds like I will actually get taxed twice on that $7000, or at least $6300. I am retired, so I don't have an option for a workplace plan. Now I think I just have to let that $7000 sit all by itself in the traditional IRA.
If you are retired why backdoor roth? You are over the income limit? If under you can just do Roth directly
nolesrule
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Re: help understanding Pro Rata in ROTH conversion

Post by nolesrule »

fallon825 wrote: Wed Mar 24, 2021 10:01 am So from what you are saying it sounds like I will actually get taxed twice on that $7000, or at least $6300. I am retired, so I don't have an option for a workplace plan. Now I think I just have to let that $7000 sit all by itself in the traditional IRA.
No, you never get taxed twice.

What happens with pro-rata is part of the conversion is some of the IRA pre-tax money, and some of the money that gets left behind in the traditional IRA is after-tax money. With each conversion or distributions, there will be a mix of pre-tax and after-tax money in proportion to the amount of each type that is in the traditional IRAs. One purpose of Form 8606 is to track what happens to the after-tax money so that it does not get taxed again.
Topic Author
fallon825
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Joined: Wed Nov 04, 2015 9:47 am

Re: help understanding Pro Rata in ROTH conversion

Post by fallon825 »

Thanks, I believe I understand now. All the IRAs are treated as one big pool. I contributed to the traditional IRA this year, and it would be considered non-deductible. So if that's the case, regardless of whether I convert it to a ROTH account, I assume I would still need to track it with a 8606 form, is that correct?
DSInvestor
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Re: help understanding Pro Rata in ROTH conversion

Post by DSInvestor »

fallon825 wrote: Wed Mar 24, 2021 10:36 am Thanks, I believe I understand now. All the IRAs are treated as one big pool. I contributed to the traditional IRA this year, and it would be considered non-deductible. So if that's the case, regardless of whether I convert it to a ROTH account, I assume I would still need to track it with a 8606 form, is that correct?
Please share the tax year that the IRA contribution applies for? Contributions made in early 2021 can be for tax year 2020 or 2021.

If 2020 tax year, were you covered by an employer plan for 2020? If yes, and you had high income, then your 2020 Traditional IRA contribution would be non-deductible. Form 8606 would be required for your 2020 tax return to track that IRA basis. The basis from 2020 tax year carries forward to the 2021 8606 form and help reduce taxes on any conversions done in calendar 2021.

If 2021 tax year, again check for employer plan coverage. If you and your spouse are not covered by employer plan for 2021 then your Traditional IRA contributions can be deductible and there would be no IRA basis to track with form 8606.
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fallon825
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Re: help understanding Pro Rata in ROTH conversion

Post by fallon825 »

The IRA contribution was made in 2021. My spouse was covered by an employer plan in 2020 and will still be covered in 2021.
DSInvestor
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Re: help understanding Pro Rata in ROTH conversion

Post by DSInvestor »

fallon825 wrote: Wed Mar 24, 2021 12:09 pm The IRA contribution was made in 2021. My spouse was covered by an employer plan in 2020 and will still be covered in 2021.
IRA contributions made in 2021 early in the year can be for 2021 or 2020 tax year. So was the contribution for the 2020 tax year or 2021 tax year? This is an important point to make because it affects which tax returns need to include the IRA contribution and associated form 8606. Contributions made in 2021 for 2020 tax year count as 2020 IRA contribution and need to be reported on the 2020 tax return. If those contributions are deemed not eligible for the 2020 IRA deduction (high income and coverage by employer plan), then the tax software should add form 8606 to track the non-deductible contributions (IRA basis) to avoid double taxation. Any basis from the 2020 form 8606 will be carried forward to future tax years and help reduce the taxable amounts of Roth conversions and IRA withdrawals in the future.

The rules for IRA deduction eligibility are tricky and if there is a chance that your IRA deduction is deemed eligible for the IRA deduction, then you can avoid the IRA basis proration altogether. If you file your tax return as Married Filing Jointly where one spouse is covered by an employer plan and one spouse is not covered, each spouse has a different MAGI limit to determine IRA deduction eligibility. See IRS page for IRA deduction limits:
https://www.irs.gov/retirement-plans/ir ... ion-limits

For 2020 tax year, the covered spouse can fully deduct TIRA contributions if MAGI is under 104K. The spouse who is not covered can fully deduct the TIRA contribution if MAGI is under 196K.

Really tricky rules.

If your MAGI is under 196K, you may be eligible for direct Roth IRA contributions. If this is the case, you can consider recharacterizing your Traditional IRA contribution to a Roth IRA contribution and sidestep the IRA basis proration issue. If your TIRA contribution was for 2020 tax year, there is still time to recharacterize it to Roth IRA contribution.
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