Backdoor Roth Question

[radchad3]

Hi everyone! I know there are a fair amount of Roth IRA questions but I need yet another answered. My wife and I are over the income limitations for a direct Roth contribution so I have been making backdoor contributions for a couple of years. However, my wife has had a SIMPLE IRA for several years so we have not been contributing a backdoor for her yet. She just started a new job that has a 401k so now we are in the process of rolling over her SIMPLE into her new 401k. She also has a Traditional IRA with nondeductible contributions with a basis of about 10k. She currently has earnings of about 6K for a total TIRA value of $16k.

1. Is there anyway of transferring only the basis to her Roth IRA and then transferring her capital gains ($6K) to her 401k to avoid paying taxes on the gains. I am thinking this is not possible but worth asking.

2. If I have to convert all of her money ($16K) into her Roth I assume this would be LTCG (15%) on the $6k or is that taxed at my income tax rate?

3. I assume I fill out form 8606 for these conversions correct?

Thank you all for the taking the time to respond!

Chad

[Duckie]

1. Is there anyway of transferring only the basis to her Roth IRA and then transferring her capital gains ($6K) to her 401k to avoid paying taxes on the gains. I am thinking this is not possible but worth asking.

She rolls the entire basis (~$10K) into the Roth IRA. This is a conversion and she will have to file IRS Form 8606. She rolls the remainder (~$6K) into her new 401k. In order to avoid the pro-rata rule, these have to happen in the same calendar year, so she probably won't get it done by 12/31 because IRA to 401k rollovers take a little while.

2. If I have to convert all of her money ($16K) into her Roth I assume this would be LTCG (15%) on the $6k or is that taxed at my income tax rate?

Conversions are taxed at your regular rate. Sorry.

[radchad3]

Thank you for the reply! So if I can do #1 then #2 shouldn't come into play and I wont have to pay the taxes on the gains correct?

I agree, getting this done by the end of the year will be tough to do!

[radchad3]

Also, another question came to mind! My wife has not been working the whole year up until this month so her earned income will be <$2K. If we file are taxes jointly, I can still contribute to here TIRA for conversion to a Roth once I complete the transactions above correct?

Thank again! Chad

[Alan S.]

You can still start the rollover process to the 401k now. If it does not get done as it probably won't, then it will be completed in early January.

You can then complete whatever non deductible TIRA contributions for yourself and a full spousal contribution for her (uses your income) right after the 401k has accepted her rollover. Then the conversion to a Roth should be done for the remaining IRA basis ASAP. If you want it to be tax free, you also have to roll over the 6k pre tax IRA amount. Or perhaps for just 6k, she leaves it in the IRA and will have a larger conversion but 6k will be taxable. Be sure your respective non deductible contributions have been reported or will be reported on separate 8606 forms.

If you need to take longer to make the 2012 contributions, you have until 4/15. On the other hand, if you can handle both the 2012 and 2013 contributions, you could make them both and convert them together.

The major gaffe you need to avoid is converting now and then not having the 401k rollover done in time. But doing it next year is just about as good. You would probably be doing this every year anyway, ie making the non deductible contributions and then converting right away.

[Duckie]

So if I can do #1 then #2 shouldn't come into play and I wont have to pay the taxes on the gains correct?

Correct. Since it sounds like her plan allows a SIMPLE IRA to 401k rollover, then I'm sure she can do a Traditional IRA to 401k rollover.

My wife has not been working the whole year up until this month so her earned income will be <$2K. If we file are taxes jointly, I can still contribute to here TIRA for conversion to a Roth once I complete the transactions above correct?

As long as you are filing MFJ she can contribute $5K to her TIRA for 2012. (If you were filing MFS she could only contribute ~$2K. See here.) She can make it a non-deductible contribution which will increase her current basis. She can make this contribution any time up to mid-April 2013.

[Alan S.]

It is possible that her plan will accept a SIMPLE IRA rollover because a SIMPLE IRA must contain only pre tax amounts, but not accept a rollover from her TIRA for the 6k because this is a contributary IRA, and plans are not allowed to acquire IRA basis since there are major consequences of that happening. While not likely, this is always a possibility. Therefore, it would not be wise to roll her SIMPLE into her TIRA before starting the rollover because there is then a risk that the plan would not accept any of it. Best to find out first if the plan will accept SIMPLE IRA rollovers and also if it will accept rollovers from contributary IRA accounts.

[radchad3]

If you want it to be tax free, you also have to roll over the 6k pre tax IRA amount. Or perhaps for just 6k, she leaves it in the IRA and will have a larger conversion but 6k will be taxable. Be sure your respective non deductible contributions have been reported or will be reported on separate 8606 forms.

Thanks Alan for the reply. I just want to be clear though that this $6k is not pretax. It is simply the gains made from the original $10k nondeductible amount that was originally contributed to her TIRA.


Thanks!

[radchad3]

Thanks Alan! I know they will accept SIMPLE IRA rollovers as the papers have been signed and in progress. What has piqued my interest is that once the SIMPLE has been rolled over and done with; can I then take the $6k in gains and also roll it over into the 401k (if the plan allows) and consequently convert the 10K in basis to the Roth without having to pay any taxes on the $6k in gains?

[Alan S.]

Yes, the conversion will be tax free if you can also roll the 6k over to the 401k plan.

Note that the 6k is pre tax even though it was not a contribution. Earnings on after tax contributions such as the 6k are pre tax since they have never been taxed. For purposes of these rollovers they are treated the same as if they had been a pre tax contribution in the first place.

If you converted with the 6 tax still in the TIRA, the 6k would be taxed. Another option you have here is if the SIMPLE IRA rollover is accepted before year end, and if your tax rate is lower this year because your wife did not work, it may be worthwhile to just convert the 6k than roll it over to the 401k. It would increase her Roth in a year when taxes would be lower than usual and 6k is a small amount of additional taxable income.

[Default User BR]

The plan can but is not required to accept the traditional IRA rollover. As Alan says, check on that first. I wouldn't try to get that done this year. Check on it, then plan the conversion/rollover for January, with the added bonus that you can do the 2013 contribution then as well.


Brian

[Epsilon Delta]

Even if you can't roll the 6k earnings into your 401(k) paying the taxes on 6k lets you put 16k in the Roth directly and enables back door Roth contributions in 2012, 2013 and possibly future years. This is a small cost for a large benefit. By all means investigate doing the rollover, but don't let the search for perfection be the enemy of a good plan.

[radchad3]

That all makes sense! So the two scenarios I see are:

1. SIMPLE IRA rollover to 401k. Then $6k pretax sent to 401k. Then $10k converted to Roth IRA

2. SIMPLE IRA rollover to 401k. 401k won't allow for Trad IRA rollovers so $16k converted to Roth IRA with $6k being taxed at my nominal tax bracket.


Will have my wife call on the 401k details tomorrow!

Chad

[radchad3]

So I just got a response from my CPA regarding the $6k in pretax going into the 401k. Here is her response:

"Unfortunately, the rules do not allow you to “identify” the $6,000 earnings as the portion you are rolling into the company 401k. The full balance has to be prorated…. so if you are rolling 25% into the 401k then 75% of the earnings will become a taxable."


Does this make sense to anyone? WIth the research I have done it seems that I should be able to but I certainly don't want to break any rules as that would be a HUGE headache.

Thoughts?

Thanks! Chad

[Default User BR]

So I just got a response from my CPA regarding the $6k in pretax going into the 401k. Here is her response:

"Unfortunately, the rules do not allow you to “identify” the $6,000 earnings as the portion you are rolling into the company 401k. The full balance has to be prorated…. so if you are rolling 25% into the 401k then 75% of the earnings will become a taxable."

Does this make sense to anyone? WIth the research I have done it seems that I should be able to but I certainly don't want to break any rules as that would be a HUGE headache.

Your CPA is ignorant of the law. Show her the relevant sections in IRS Publication 590.

Brian

[liztax44]

Sorry, but the CPA is correct. Please review IRS Form 8606. In Part I you list the value of ALL trad, SEP & Simple IRAs, then calculate % on Line 10. Non-taxable amount converted to Roth(s) is calculated on Line 11. This amount is entered in Part II, Line 17. IRS rules require that basis (non-taxable amount) be pro-rated. You cannot selectively distribute, roll-over or convert the non-taxable portion.

[Default User BR]

Sorry, but the CPA is correct. Please review IRS Form 8606. In Part I you list the value of ALL trad, SEP & Simple IRAs, then calculate % on Line 10. Non-taxable amount converted to Roth(s) is calculated on Line 11. This amount is entered in Part II, Line 17. IRS rules require that basis (non-taxable amount) be pro-rated. You cannot selectively distribute, roll-over or convert the non-taxable portion.

That is not the question at hand. This is in regards to rolling funds into a qualified plan.

"Unfortunately, the rules do not allow you to “identify” the $6,000 earnings as the portion you are rolling into the company 401k. The full balance has to be prorated…. so if you are rolling 25% into the 401k then 75% of the earnings will become a taxable."

Pro-rata does not apply in this situation, nor does form 8606. The CPA is wrong.


Brian

[Epsilon Delta]

Sorry, but the CPA is correct. Please review IRS Form 8606. In Part I you list the value of ALL trad, SEP & Simple IRAs, then calculate % on Line 10. Non-taxable amount converted to Roth(s) is calculated on Line 11. This amount is entered in Part II, Line 17. IRS rules require that basis (non-taxable amount) be pro-rated. You cannot selectively distribute, roll-over or convert the non-taxable portion.

That is not the question at hand. This is in regards to rolling funds into a qualified plan.

"Unfortunately, the rules do not allow you to “identify” the $6,000 earnings as the portion you are rolling into the company 401k. The full balance has to be prorated…. so if you are rolling 25% into the 401k then 75% of the earnings will become a taxable."

Pro-rata does not apply in this situation, nor does form 8606. The CPA is wrong.


Brian

FWIW I agree with Brian.

[Alan S.]

Refer her Pub 590. p 18 for explanation of the "special rule" that overrides pro rating of basis when an IRA transfer is made to a qualified plan:

http://www.irs.gov/pub/irs-pdf/p590.pdf

[radchad3]

Thank you all for the replies. I have sent an email off to my CPA with the above link. We shall see what she says. Thanks! Chad