Back door Roth: did I miss some steps?

[ut2sua]

Hi all,
I am new to this forum. I have looked at many Roth's related discussions but didn't find my answer. So I ask it here...
Before Roth became law, I was given the guidance to put some after tax $ into an IRA. The plan was to convert to Roth using the back door method (my income was too high to qualify for any direct Roth funding). I did just that, but when I did the conversion, Turbo tax surprised me...
What happened: I put about $20K each for both DW and myself into a separate after tax IRA (total of $40K for both of us thru multiple years).
Our situation: We did have other pre-tax IRA accounts having ~$500K back then.
When I did my conversion, Turbo tax appeared to take my total IRA $ into account. When I tried to convert the $40K after tax account into Roth using the back door method, Turbo tax wanted me to pay tax on ~90% of that monies. I was expecting not to pay tax on that $40K since that was after tax $ that I put into a separate IRA. I guess was that my other pre tax IRA accounts interfere with the back door conversion (but I was never sure).
Did I miss something, or did Turbo tax not understood my input?
Do I need to take certain steps to allow the conversion to take place without the extra tax (on after tax IRA $)?
Many thanks for any insight/response

 

[SecondCor521]

Welcome to the forum!

It sounds like you're running into what's called the pro-rata rule.

If an individual has pre-tax and after-tax IRAs and then does a conversion to a Roth IRA, tax law and the IRS treats the conversion as coming from both pre-tax and after-tax, prorated by the relative amounts in each category.

This is true even if the individual keeps the pre-tax and after-tax money in separate IRAs. For IRS purposes, traditional IRAs are generally lumped together logically to create one traditional IRA per person, regardless of how many accounts they have. So the separation you were hoping would do what you wanted does not, in fact, do what you wanted.

Since you've already done the conversions, there is nothing you can do for that $40K. There are no do-overs for conversions currently. You'll have to pay taxes according to the pro-rata rule. You can look at the Form 8606s that Turbotax generates and see how the math works.

What you can look into in the future is rolling all of your pre-tax traditional IRA into your 401(k) or other workplace plan if they will let you. Then Roth conversions will only take into account the balance in your after-tax traditional IRA, because that's the only IRA you will have.

All of the above is on an individual basis, so you can do the same things on a parallel track with your wife's accounts if she is hitting, or will hit, the same situation.

 

[ut2sua]

Welcome to the forum!

It sounds like you're running into what's called the pro-rata rule.

If an individual has pre-tax and after-tax IRAs and then does a conversion to a Roth IRA, tax law and the IRS treats the conversion as coming from both pre-tax and after-tax, prorated by the relative amounts in each category.

This is true even if the individual keeps the pre-tax and after-tax money in separate IRAs. For IRS purposes, traditional IRAs are generally lumped together logically to create one traditional IRA per person, regardless of how many accounts they have. So the separation you were hoping would do what you wanted does not, in fact, do what you wanted.

Since you've already done the conversions, there is nothing you can do for that $40K. There are no do-overs for conversions currently. You'll have to pay taxes according to the pro-rata rule. You can look at the Form 8606s that Turbotax generates and see how the math works.

What you can look into in the future is rolling all of your pre-tax traditional IRA into your 401(k) or other workplace plan if they will let you. Then Roth conversions will only take into account the balance in your after-tax traditional IRA, because that's the only IRA you will have.

All of the above is on an individual basis, so you can do the same things on a parallel track with your wife's accounts if she is hitting, or will hit, the same situation.

Thank you very much SecondCor521. This is the best explanation I have heard for my situation. I did back out of my Roth conversion back then, so the after tax $ was still in an regular IRA (not ROTH). I will try to see if I can roll my IRA into my 401K (I don't seem to remember if my 401K plan will allow that). If my 401K plan doesn't allow the roll-in of my IRA accounts, then I guess I am stuck then(?)
Much appreciated

 

[timbervest]

I will try to see if I can roll my IRA into my 401K (I don't seem to remember if my 401K plan will allow that). If my 401K plan doesn't allow the roll-in of my IRA accounts, then I guess I am stuck then(?)

This is exactly correct. Roll the TAXABLE portion of your tIRA in your 401(k) leaving only post tax basis in the tIRA and then convert that to a Roth (that is the true backdoor). If you cannot do this, you are stuck.

 

[SecondCor521]

Your 401(k) might.

There are other options, but I don't think they're very great:

1. Do the conversions and pay the taxes on a pro-rated basis. If you do this then you need to keep track of your remaining basis via your Form 8606s from tax year to tax year.

2. Get a different job which has a 401(k) which allows incoming rollovers. Seems pretty extreme, but maybe.

3. Don't do conversions / backdoor Roths at all. Live with the situation as is.

 

[ut2sua]

This is exactly correct. Roll the TAXABLE portion of your tIRA in your 401(k) leaving only post tax basis in the tIRA and then convert that to a Roth (that is the true backdoor). If you cannot do this, you are stuck.

OK. Thanks Timbervest

 

[ut2sua]

Your 401(k) might.

There are other options, but I don't think they're very great:

1. Do the conversions and pay the taxes on a pro-rated basis. If you do this then you need to keep track of your remaining basis via your Form 8606s from tax year to tax year.

2. Get a different job which has a 401(k) which allows incoming rollovers. Seems pretty extreme, but maybe.

3. Don't do conversions / backdoor Roths at all. Live with the situation as is.

SecondCor521, Your #3 is what I have been living with. It is interesting that now I learn from this forum that I could potentially convert some of my pre tax IRA $ into Roth once I am FIRED (and thus having lower income), but this after tax IRA $ will force me to do more math every time I want to convert some pre tax $ to ROTH. I would probably won't do any of this had I understood the implication earlier.
Update: my 401K plan seems to allow "roll-over IRA" to get rolled in, but not other IRA. I have some of boths

 

[SecondCor521]

Talk to your HR person / 401(k) administrator and see what they say. I was able to roll my non-rollover IRA into my 401(k) even though it wasn't clear that was the plan's intent.

(Rollover IRAs are usually created when you leave a company and roll your 401(k) into an IRA. They're also called conduit IRAs. Other than being able to be rolled into a new employer's 401(k), they function exactly like "regular" IRAs.)

 

[ut2sua]

Talk to your HR person / 401(k) administrator and see what they say. I was able to roll my non-rollover IRA into my 401(k) even though it wasn't clear that was the plan's intent.

(Rollover IRAs are usually created when you leave a company and roll your 401(k) into an IRA. They're also called conduit IRAs. Other than being able to be rolled into a new employer's 401(k), they function exactly like "regular" IRAs.)

Will do. Another thing I picked up from this forum is one can have access to 401K at 55 (instead of 59 and 1/2), so there is some extra benefit for me to roll over.

 

[SecondCor521]

Will do. Another thing I picked up from this forum is one can have access to 401K at 55 (instead of 59 and 1/2), so there is some extra benefit for me to roll over.

As long as you separate from service in the year in which you turn 55 (or later), yup.

The one tradeoff that sometimes comes up is that 401(k) fees are sometimes higher than IRA fees, but that sort of depends on the specifics.

 

[ut2sua]

So I have the pro-rata problem as explained by SecondCor521 in post #2. My follow up question is: can I do the back door conversion to Roth in the same year that I roll all my pre-tax IRA account $ into my individual 401K account? In other words, do I need to wait for the IRA $ to get rolled out of my pre-tax IRA account in one year, then I can do the back door conversion on the remaining (after tax) IRA account the next year, or can I do both in the same tax year (roll pre-tax IRA to 401k, and back door Roth on after-tax IRA)?
Hope I am making some sense. Thanks in advance for your answer.

 

[SecondCor521]

I understand the question. I believe you can do both in the same tax year, however double check that by reading Form 8606 and looking at the questions it asks regarding your end of year IRA balances.

Two cautions:

1. I waited until my 401(k) administrator successfully received my rollover before I did my backdoor Roth. I didn't want to have a glitch in that rollover process screw me over.

2. When looking at Form 8606, there will be a year in the upper right hand corner of the form. Make sure you either (a) get the correct version of the form for the year you are considering these transactions or (b) mentally adjust all of the calendar years on the form as appropriate. For example, if you're looking at a 2018 version of Form 8606 and it asks what your end of 2018 balances were, then the 2019 version of the form will probably ask what your end of 2019 balances were.

 

[ut2sua]

I understand the question. I believe you can do both in the same tax year, however double check that by reading Form 8606 and looking at the questions it asks regarding your end of year IRA balances.

Two cautions:

1. I waited until my 401(k) administrator successfully received my rollover before I did my backdoor Roth. I didn't want to have a glitch in that rollover process screw me over.

2. When looking at Form 8606, there will be a year in the upper right hand corner of the form. Make sure you either (a) get the correct version of the form for the year you are considering these transactions or (b) mentally adjust all of the calendar years on the form as appropriate. For example, if you're looking at a 2018 version of Form 8606 and it asks what your end of 2018 balances were, then the 2019 version of the form will probably ask what your end of 2019 balances were.

Thanks SecondCor521. Do you know if a solo 401K (or individual 401K) account is as good as a company 401K account to roll over for what I am trying to do (to avoid the pro-rata issue). I will follow your advice on the other points.

 

[SecondCor521]

Thanks SecondCor521. Do you know if a solo 401K (or individual 401K) account is as good as a company 401K account to roll over for what I am trying to do (to avoid the pro-rata issue). I will follow your advice on the other points.

I'm not an expert, but I believe it should be fine as long as it accepts the incoming rollover and isn't a SEP, SIMPLE, or traditional IRA. See the definition on line 6 of Form 8606.

Also, I just noticed the description on line 8 of Form 8606 where it mentions conversions done in the current tax year, and that seems to affect the pro-rata situation. So I amend my earlier answer that you can do it in the same year - it may be that you have to wait for the next year.

 

[ut2sua]

I'm not an expert, but I believe it should be fine as long as it accepts the incoming rollover and isn't a SEP, SIMPLE, or traditional IRA. See the definition on line 6 of Form 8606.

Also, I just noticed the description on line 8 of Form 8606 where it mentions conversions done in the current tax year, and that seems to affect the pro-rata situation. So I amend my earlier answer that you can do it in the same year - it may be that you have to wait for the next year.

Thanks SecondCor521. I guess I can play with some of these scenarios in my newly purchased TurboTax 2019. I will definitely keep an eye on this one.