IRA Pro Rata Math/Basis

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cruzbay
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IRA Pro Rata Math/Basis

Post by cruzbay »

Thank you in advance for your help on this! Three questions:
1) I have two IRAs, one was originally a Rollover IRA but then I added non-deductible contributions making it a tIRA. The non-deductible contributions total 83K out of a 293,960 balance. In addition, I have a SEP IRA with a balance of 261,212. Total is $555,172
83K basis is roughly 15% of the total
472,172 is roughly 85% of the total.
So if I want to convert to Roth and I did it now for the sake of this question, I will pay tax on 85% of every dollar. Yes?

2) Would you add more non-deductible contributions just for the purpose of getting it into Roth in the coming years?

3) Also, what if my CPA overstated the basis on the first 8606 that was filed (2005)? The error would then be carried forward to current 8606. The 83K listed above is the true basis. The amount of the rollover was correctly listed on the 1040 for the year it occurred (2003). Two years later, when the first non-deductible contribution was made was when the error occurred.
shess
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Re: IRA Pro Rata Math/Basis

Post by shess »

cruzbay wrote: Wed Jan 13, 2021 1:20 pm Thank you in advance for your help on this! Three questions:
1) I have two IRAs, one was originally a Rollover IRA but then I added non-deductible contributions making it a tIRA.
It was always a tIRA in all the ways that matter. There is not really such a thing as a "Rollover IRA" or "Conduit IRA". There is a provision where if you take a rollover to an IRA, you can later roll it to a 401k, as long as you don't mix any contributions into that account, which is where the concept of "Rollover IRA" came from. These days many 401k plans allow rolling in tIRA in general, so it's becoming less and less material.
cruzbay wrote: Wed Jan 13, 2021 1:20 pm The non-deductible contributions total 83K out of a 293,960 balance. In addition, I have a SEP IRA with a balance of 261,212. Total is $555,172
83K basis is roughly 15% of the total
472,172 is roughly 85% of the total.
So if I want to convert to Roth and I did it now for the sake of this question, I will pay tax on 85% of every dollar. Yes?
I'd put it as 85% of the dollars will be 100% taxed, and 15% of the dollars will not be taxed again. I know that works out the same, it just feels clearer to me when you start stacking tax rates and phaseouts and stuff on top of it.
cruzbay wrote: Wed Jan 13, 2021 1:20 pm 2) Would you add more non-deductible contributions just for the purpose of getting it into Roth in the coming years?
Personally, with those numbers, no, I'd probably not do any conversions at all, because that's a LOT of funds to convert. Maybe you'll retire early and can use a Roth conversion ladder or something to get some conversions done, and benefit from that basis.

That said, the amount you can additionally contribute is trivial relative to the size of the accounts, so you can also make an argument along the lines of "whatever".

Note that if your employer 401k (or other) plan allows you to rollover tIRA funds, you can clean things up by rolling in the non-basis portion and then converting the leftover basis to Roth. I once did this to get access to backdoor Roth, and also to remove an account (which was satisfying). But in my case the 401k had the big numbers and the tIRA was relatively small, and the 401k had the same fund choices I'd have used in my tIRA (better, in fact, due to institutional shares).
cruzbay wrote: Wed Jan 13, 2021 1:20 pm 3) Also, what if my CPA overstated the basis on the first 8606 that was filed (2005)? The error would then be carried forward to current 8606. The 83K listed above is the true basis. The amount of the rollover was correctly listed on the 1040 for the year it occurred (2003). Two years later, when the first non-deductible contribution was made was when the error occurred.
Not sure what you're asking. Can you just substitute whatever arbitrary number you want 15 years later? Not really. You probably have to amend all the years from the error to the present.
lakpr
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Re: IRA Pro Rata Math/Basis

Post by lakpr »

1: You understand it correctly. Yes, every dollar you convert to Roth is assumed to be 15 cents non-deductible contribution and 85 cents pre-tax contribution, and IRS expects you to pay taxes on the 85 cents part.

2. Yes I would, if there is any hope of landing a job with a 401k where the pre-tax IRA assets can be moved over. Are you self-employed? The presence of SEP-IRA hints that you may be. If you are, and if the business is still alive, open an Individual 401k plan with E*Trade. Specifically E*Trade and not Vanguard, because the intent here is to roll the SEP-IRA and the Rollover IRA and the pre-tax growth on the non-deductible contributions, all into the Individual 401k plan. Once you have done that, and leave only the basis behind, you convert the $83k balance in full to Roth with no further taxes.

With that plan in mind, I would be loathe to deprive myself of the potential Roth space. So yes I would contribute to the non-deductible IRA before the IRA contribution deadline expires.

If there is no hope of ever rolling the pre-tax balances into a 401k plan, then I would start converting piece by piece up to the top of the current tax bracket.

3. I do believe that you can re-file the Form 8606 for all the previous years. The important consideration here is that the error neither increased nor decreased your tax liability all these years. That is quite critical, since if the amendment on the Form 8606 results in a change in tax liability, you must file form 1040-X for the year in question.

Technically the IRS can fine you for filing the Form-8606 very late, but I have not heard of IRS actually imposing such penalties.

If you do follow the option of filing the Form 8606 for all previous years, make sure you send them with return receipt requested; IRS is not known to acknowledge receipt of the forms. Your RRR is your proof, hang on to it.

[ Disclaimer: I am not really sure of my answer for 3 myself either, so please double check with other experts on the forum ]
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cruzbay
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Re: IRA Pro Rata Math/Basis

Post by cruzbay »

Thank you both for your input. I do have an S Corp for which I am the only employee. The S Corp has been making the SEP IRA contributions. I will see if I can open an individual 401K as you suggested and roll the pre-tax dollars there after which the basis would be moved as one transaction to a Roth. I know to leave a zero balance at the end of the year. If this is an acceptable plan given that I am S-Corp, I will go ahead and make the non-deductible contributions (2020 and 2021) and convert them to Roth shortly thereafter and once the pre-tax is moved out. Then, I have 12 years after retirement but before 70 to convert the pre-tax dollars to Roth watching out for IRMAA at 63.

If I am at Schwab, is there a reason to open the new 401K at E*trade? I would prefer to stay with one brokerage if possible.

Looks as though I better start completing new 8606 forms! Knowing that the basis is correct will help me sleep at night even though it will cost me at conversion time. I will take your advice and get the mailing receipt to document their receipt of the mailed forms.
lakpr
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Re: IRA Pro Rata Math/Basis

Post by lakpr »

cruzbay wrote: Wed Jan 13, 2021 4:24 pm If I am at Schwab, is there a reason to open the new 401K at E*trade? I would prefer to stay with one brokerage if possible.
The important criterion would be -- if you adopt the plan at Schwab, would you be allowed to roll the Traditional IRA and SEP-IRA assets into the plan?
A secondary criterion would be -- does the plan permit conversions of pre-tax assets to Roth within the plan (could be useful in the future when you are either winding down the business or perhaps you have had a bad business year and use the low income for the year as an opportunity to convert to Roth)

I am NOT familiar with the Schwab Individual 401k plan off-the-shelf. But E*Trade plans do fulfill both the criteria. Vanguard's plans fail the first criterion, and Fidelity's the second.

cruzbay wrote: Wed Jan 13, 2021 4:24 pm Looks as though I better start completing new 8606 forms! Knowing that the basis is correct will help me sleep at night even though it will cost me at conversion time. I will take your advice and get the mailing receipt to document their receipt of the mailed forms.
I will caution you once more -- that the tax liability should NOT CHANGE, after you change the Form 8606 for the applicable year. { If the entire amount is non-deductible and you have NOT done any Roth conversion since then till now, you are golden .... but make sure about the no-change-in-tax-liability }
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cruzbay
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Re: IRA Pro Rata Math/Basis

Post by cruzbay »

Thanks for the further clarification, lakpr! There is no change in tax liability until I start to convert the funds. I will file the corrected 8606 forms from 2005 forward in order to list the accurate basis (the non-deductible contributions made.)

Regarding the proposed Schwab account: Ah, now I understand. Will make sure that Schwab meets all the criteria you listed. If not, I will benefit from your research and go to E*Trade!
shess
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Re: IRA Pro Rata Math/Basis

Post by shess »

lakpr wrote: Wed Jan 13, 2021 4:31 pm
cruzbay wrote: Wed Jan 13, 2021 4:24 pm If I am at Schwab, is there a reason to open the new 401K at E*trade? I would prefer to stay with one brokerage if possible.
The important criterion would be -- if you adopt the plan at Schwab, would you be allowed to roll the Traditional IRA and SEP-IRA assets into the plan?
Yeah, this is the key point - not all Solo 401k plans allow rolling in tIRA assets. I mean, check with Schwab if you can do so, but if they don't, or you can't figure it out, I'd consider going with the e-trade plan (which people have successfully done this with), roll everything into there, and then amend the plan to move it to Schwab. You only have to do this once, after all.

Just note that moving the plan to Schwab is not as simple as opening a plan with Schwab and rolling it over. Search the forums for threads on this.
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cruzbay
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Re: IRA Pro Rata Math/Basis

Post by cruzbay »

Great advice given here. Thanks so much!
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celia
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Re: IRA Pro Rata Math/Basis

Post by celia »

I strongly doubt the CPA’s reporting is wrong. In 2005, you probably made a non-deductible contribution for 2004 (before April 15) as well as for 2005. Even if wrong, I would just continue as-is. Technically, you can longer amend your 2005 Form 8606 anyways, since it is part of your 2005 tax return.

The percent of any Roth conversion that is taxed will change each year as the pre-tax amount grows (as of 12/31/2021) if converting today and the basis changes as you convert or add more non-deductible contributions.

Since the pro rata rule will continue to apply (even to your heirs) until all your IRAs are empty, it is best if you can simplify this by rolling the pre-tax amount to a new 401k.
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