Made Roth IRA contribution mistake - Prorata rule issue

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Planner01
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Made Roth IRA contribution mistake - Prorata rule issue

Post by Planner01 »

Contributed the funds for 2021 to a Roth IRA, the backdoor way, like we do every year. This year however is going to be different. Next month a six figure check for a lump sum pension will be disbursed and will be deposited until a rollover IRA. No, we cannot add it to a new employer 401k or anywhere else because they won’t accept pension check.

I understood that we could recharacterize the funds back to traditional but Fidelity said that we will likely be stuck with the prorata rule because even if we take the money back and put it in traditional or a brokerage account, we still have to fill out the 8606 form.

How to fix this?
lakpr
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Re: Made Roth IRA contribution mistake - Prorata rule issue

Post by lakpr »

Your 401k plan cannot accept pension check, okay ... but do they accept rollovers from a Traditional IRA?

Put the pension check into the Traditional IRA and then roll it over to the 401k plan before the end of the year ...

I am not sure Fidelity rep is correct that you can undo the Roth conversion (the second step of the Backdoor Roth).
Topic Author
Planner01
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Re: Made Roth IRA contribution mistake - Prorata rule issue

Post by Planner01 »

lakpr wrote: Tue Jun 22, 2021 6:57 am Your 401k plan cannot accept pension check, okay ... but do they accept rollovers from a Traditional IRA?

Put the pension check into the Traditional IRA and then roll it over to the 401k plan before the end of the year ...

I am not sure Fidelity rep is correct that you can undo the Roth conversion (the second step of the Backdoor Roth).
No they won’t accept anything else but 401k funds from previous employer.

I hope Fidelity is wrong.
aristotelian
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Re: Made Roth IRA contribution mistake - Prorata rule issue

Post by aristotelian »

If you recharacterize without doing conversion you would still have to fill out 8606 but there would be no conversion to report, therefore no tax and no pro rata. You would have a $6k nondeductible contribution, however, with the gains eventually being taxed as income.
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Planner01
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Re: Made Roth IRA contribution mistake - Prorata rule issue

Post by Planner01 »

Fidelity wants me to fill out a return of excess form instead of recharacterizing the money.
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samsoes
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Re: Made Roth IRA contribution mistake - Prorata rule issue

Post by samsoes »

Can you hold the pension check and not deposit it until after Jan 1 2022?
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lakpr
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Re: Made Roth IRA contribution mistake - Prorata rule issue

Post by lakpr »

samsoes wrote: Tue Jun 22, 2021 7:55 am Can you hold the pension check and not deposit it until after Jan 1 2022?
I don't think that would work. Once the check is in the OP's hands, he is obligated to report the value of his Traditional IRA to be the figure on the check, whether or not he deposits the check until Jan-1-2022. The pension fund that is distributing the check would report the amount to the IRS, and if it is not balanced by a report from an IRA custodian for equal amount, IRS assumes that the OP would have cashed the check and ask for taxes + penalties.
lakpr
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Re: Made Roth IRA contribution mistake - Prorata rule issue

Post by lakpr »

Planner01 wrote: Tue Jun 22, 2021 7:22 am No they won’t accept anything else but 401k funds from previous employer.
I would like to challenge that. Can you get the exact wording from the Summary Plan Description document for your plan, related to rollovers of outside assets?

Here is the quote from my own plan:
lakpr_401k_plan_SPD wrote: Rollover contributions
In order to allow you consolidate your retirement savings for more effective management, as a participant you may transfer money into the Plan that you may have with or received from other plans and certain IRAs. This is known as a rollover. You are always 100% vested in your rollover contributions and may withdraw the amounts in your rollover account at any time, subject to IRS rules. Contact <<my plan custodian>> at <<phone number>> to speak with a rollover specialist who can assist you with this straightforward process.
That "certain IRAs" allows me to roll the pre-tax assets into the plan even though the source for those pre-tax assets may be non-deductible contributions, as in your case. 401k plans cannot allow, by law, Roth and after-tax assets from IRAs; that's not plan-dependent.

[ Sidebar: notice also that it says I am 100% vested in my "rollover contributions" and can roll it out any time I choose -- but importantly, NOT THE GROWTH THERE ON. So if I rollover $100k and it becomes $120k, I can roll out $100k any time but cannot roll the $20k earnings that were earned within the plan until I leave employment.]
tashnewbie
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Re: Made Roth IRA contribution mistake - Prorata rule issue

Post by tashnewbie »

To my knowledge, you can’t recharacterize a Roth conversion (which is what the second step of the regular backdoor process is and what you appear to have done).

If you can’t deposit the pension check into a 401k or another workplace plan, I think the only way to avoid the pro rata rule is to do a return of the converted amount. You’d owe taxes on the associated earnings, if any, while it was in the TIRA and Roth IRA, plus taxes and an early withdrawal penalty on the taxable portion of the converted amount, if any, if you’re <59.5.
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Planner01
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Re: Made Roth IRA contribution mistake - Prorata rule issue

Post by Planner01 »

tashnewbie wrote: Tue Jun 22, 2021 11:01 am To my knowledge, you can’t recharacterize a Roth conversion (which is what the second step of the regular backdoor process is and what you appear to have done).

If you can’t deposit the pension check into a 401k or another workplace plan, I think the only way to avoid the pro rata rule is to do a return of the converted amount. You’d owe taxes on the associated earnings, if any, while it was in the TIRA and Roth IRA, plus taxes and an early withdrawal penalty on the taxable portion of the converted amount, if any, if you’re <59.5.
An early withdrawal penalty on the money we just contributed a few months ago? Couldn’t we just do an excess contribution withdrawal?
lakpr
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Re: Made Roth IRA contribution mistake - Prorata rule issue

Post by lakpr »

Planner01 wrote: Tue Jun 22, 2021 11:19 am
tashnewbie wrote: Tue Jun 22, 2021 11:01 am To my knowledge, you can’t recharacterize a Roth conversion (which is what the second step of the regular backdoor process is and what you appear to have done).

If you can’t deposit the pension check into a 401k or another workplace plan, I think the only way to avoid the pro rata rule is to do a return of the converted amount. You’d owe taxes on the associated earnings, if any, while it was in the TIRA and Roth IRA, plus taxes and an early withdrawal penalty on the taxable portion of the converted amount, if any, if you’re <59.5.
An early withdrawal penalty on the money we just contributed a few months ago? Couldn’t we just do an excess contribution withdrawal?
Not after the Roth conversion.
tashnewbie
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Re: Made Roth IRA contribution mistake - Prorata rule issue

Post by tashnewbie »

Planner01 wrote: Tue Jun 22, 2021 11:19 am
tashnewbie wrote: Tue Jun 22, 2021 11:01 am To my knowledge, you can’t recharacterize a Roth conversion (which is what the second step of the regular backdoor process is and what you appear to have done).

If you can’t deposit the pension check into a 401k or another workplace plan, I think the only way to avoid the pro rata rule is to do a return of the converted amount. You’d owe taxes on the associated earnings, if any, while it was in the TIRA and Roth IRA, plus taxes and an early withdrawal penalty on the taxable portion of the converted amount, if any, if you’re <59.5.
An early withdrawal penalty on the money we just contributed a few months ago? Couldn’t we just do an excess contribution withdrawal?
Unfortunately, yes. But it is probably a small amount.

Slight edit to my earlier response: I think you’d owe taxes and 10% early withdrawal penalty (if you’re <59.5) on the associated earnings, if any. Plus, you’d owe taxes and a penalty on the taxable portion of the converted amounts (there probably wouldn’t be any taxable portions or they'd be very small amounts, if you converted the TIRA into Roth IRA shortly after you made the TIRA contribution).

See these articles about issues related to Roth IRA withdrawal ordering rules (might be helpful to also look at IRS publication 590-B):

https://www.kitces.com/blog/understandi ... nversions/

https://www.investopedia.com/terms/o/orderingrules.asp
Topic Author
Planner01
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Re: Made Roth IRA contribution mistake - Prorata rule issue

Post by Planner01 »

So our options are to either see if the new 401k would take the rollover IRA or withdraw the money and pay the taxes and penalty, right?
lakpr
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Re: Made Roth IRA contribution mistake - Prorata rule issue

Post by lakpr »

Planner01 wrote: Tue Jun 22, 2021 11:51 am So our options are to either see if the new 401k would take the rollover IRA or withdraw the money and pay the taxes and penalty, right?
You do have the third option -- to pay the pro-rata taxes on the Roth conversion. No penalties due.

Depending on the amount, you can gradually convert the Rollover IRA to Roth IRA up to the top of the current tax bracket you find yourselves in.

Since tax rates are poised to go up in 2026 anyway (that is the current law), Roth conversions now may not be a bad deal.

=====================

A fourth option: find some side-job income. That would enable to you to open a Solo 401k. Open one, and roll this Rollover IRA into the Solo 401k. Quit the side job the year after the rollover to Solo 401k is completed.
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Planner01
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Re: Made Roth IRA contribution mistake - Prorata rule issue

Post by Planner01 »

lakpr wrote: Tue Jun 22, 2021 12:03 pm
Planner01 wrote: Tue Jun 22, 2021 11:51 am So our options are to either see if the new 401k would take the rollover IRA or withdraw the money and pay the taxes and penalty, right?
You do have the third option -- to pay the pro-rata taxes on the Roth conversion. No penalties due.

Depending on the amount, you can gradually convert the Rollover IRA to Roth IRA up to the top of the current tax bracket you find yourselves in.

Since tax rates are poised to go up in 2026 anyway (that is the current law), Roth conversions now may not be a bad deal.

=====================

A fourth option: find some side-job income. That would enable to you to open a Solo 401k. Open one, and roll this Rollover IRA into the Solo 401k. Quit the side job the year after the rollover to Solo 401k is completed.
Sorry for the many questions. Trying to be clear and understand.

The prorata taxes would be on the $6k contribution for 2021, right? If that’s the case, it might be worth it as an easy way to be done with this.
lakpr
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Re: Made Roth IRA contribution mistake - Prorata rule issue

Post by lakpr »

Planner01 wrote: Tue Jun 22, 2021 1:26 pm Sorry for the many questions. Trying to be clear and understand.

The prorata taxes would be on the $6k contribution for 2021, right? If that’s the case, it might be worth it as an easy way to be done with this.
That is correct. Be aware though, that some of the Rollover IRA will be deemed non-deductible following this election.

Say the Rollover IRA value is $100k as of 12/31/2021. That is the date that IRS looks at, to determine the pro-rata taxes.

You made a non-deductible contribution of $6k during the year. Then you converted $6k out of $106k balance during the year,

So the non-deductible portion of the Roth conversion is $6k/$106k = 5.6% on which taxes are not due. 94.4% is taxable conversion or approximately $5660 is added to the taxable income on your 2021 tax return.

$5660 is also the non-deductible contribution left back in the IRA.

If and when you get a chance to roll the Rollover IRA to a 401k plan in the next year, you must roll only $100k - $5.66k = $94.33k. You cannot roll the $5.66k into the 401k plan, technically. Keep that in mind!
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Duckie
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Re: Made Roth IRA contribution mistake - Prorata rule issue

Post by Duckie »

Planner01 wrote: Tue Jun 22, 2021 7:22 am No they won’t accept anything else but 401k funds from previous employer.
But how would they know? Just tell them the Rollover IRA holds retirement assets from your former employer. You don't need to be specific about what kind of assets.
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Planner01
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Re: Made Roth IRA contribution mistake - Prorata rule issue

Post by Planner01 »

lakpr wrote: Tue Jun 22, 2021 8:31 am
Planner01 wrote: Tue Jun 22, 2021 7:22 am No they won’t accept anything else but 401k funds from previous employer.
I would like to challenge that. Can you get the exact wording from the Summary Plan Description document for your plan, related to rollovers of outside assets?

Here is the quote from my own plan:
lakpr_401k_plan_SPD wrote: Rollover contributions
In order to allow you consolidate your retirement savings for more effective management, as a participant you may transfer money into the Plan that you may have with or received from other plans and certain IRAs. This is known as a rollover. You are always 100% vested in your rollover contributions and may withdraw the amounts in your rollover account at any time, subject to IRS rules. Contact <<my plan custodian>> at <<phone number>> to speak with a rollover specialist who can assist you with this straightforward process.
That "certain IRAs" allows me to roll the pre-tax assets into the plan even though the source for those pre-tax assets may be non-deductible contributions, as in your case. 401k plans cannot allow, by law, Roth and after-tax assets from IRAs; that's not plan-dependent.

[ Sidebar: notice also that it says I am 100% vested in my "rollover contributions" and can roll it out any time I choose -- but importantly, NOT THE GROWTH THERE ON. So if I rollover $100k and it becomes $120k, I can roll out $100k any time but cannot roll the $20k earnings that were earned within the plan until I leave employment.]
You were God sent. I called again and they WILL take care the rollover IRA. So that’s what we are going to do as that frees up the way to continue to do the backdoor Roth IRA.
Thank you!!!

Duckie you are right.
lakpr
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Re: Made Roth IRA contribution mistake - Prorata rule issue

Post by lakpr »

Planner01,

VERY glad that the issue is resolved!
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celia
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Re: Made Roth IRA contribution mistake - Prorata rule issue

Post by celia »

If you want to convert part of the rollover IRA money while it is in the IRA, you can do that too.
A dollar in Roth is worth more than a dollar in a taxable account. A dollar in taxable is worth more than a dollar in a tax-deferred account.
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