Converting rollover IRA to Roth over more than one tax year

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Topic Author
germain
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Converting rollover IRA to Roth over more than one tax year

Post by germain »

I am wondering what the tax implications are for a multiyear conversion strategy described as follows.

403b from old job: $50,000, none of which are Roth dollars

In old 403b the fund options are limited and the expense ratios are high. I do not want to roll the old 403b into current 403b for the same reason, limited options with high expenses.

Current Plan: transfer old 403b to a new Rollover IRA at Vanguard then convert to Roth over 2 years

2024:
-rollover old 403b to IRA
-convert half to Roth
-pay estimated taxes to IRS upon conversion

2025:
-convert the remainder to Roth
-pay estimated taxes to IRS upon conversion

other relevant info:
-no existing traditional IRA
-existing Roth IRA
-still working and < 59.5

I have read about forum members who run into trouble with cost basis/prorating complications on form 8606 when they don't convert all traditional IRA dollars to Roth at once but I'm not sure if that comes into play here since this is a rollover IRA that only has pre-tax dollars. Am I thinking about this correctly?

Also, will I still be allowed to make a Roth IRA contribution for the 2024 and 2025 tax years (as long as my MAGI stays under the appropriate limit)?

Thanks
terran
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Re: Converting rollover IRA to Roth over more than one tax year

Post by terran »

Do you or will you have non-deductible traditional IRA contributions that you want to convert as well (I.e. do you plan to make backdoor Roth contributions)? That's the only reason you'd have prorating complications, and it's not the end of the world, just a slightly more complicated form 8606 with much of the conversion being taxable.

If your MAGI is low enough for direct Roth contributions then there's no reason you can't make them. The conversion will increase you AGI/MAGI.

Why do you want to convert to Roth? You could just leave this in the rollover IRA.
Silk McCue
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Re: Converting rollover IRA to Roth over more than one tax year

Post by Silk McCue »

The issue of pro rata does not come into play in this scenario. These are straight Roth conversions that you are describing. Performing the conversions has no impact on contributions. We did this over a few years before retiring 3 years ago at ages 60/62.

Cheers
ehh
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Re: Converting rollover IRA to Roth over more than one tax year

Post by ehh »

It is, of course, all about tax rates now vs anticipated tax rates in retirement. What is your current marginal tax rate? Will your plan put you into the next tax bracket and if so by how much? Do you think tax rates will increase in 2026?

Can you pay the taxes with non tax advantaged money? If not, conversion is less advantageous.
germain wrote: Mon Apr 01, 2024 7:28 pm I have read about forum members who run into trouble with cost basis/prorating complications on form 8606 when they don't convert all traditional IRA dollars to Roth at once but I'm not sure if that comes into play here since this is a rollover IRA that only has pre-tax dollars. Am I thinking about this correctly?
I could be wrong, but I don't recall problems when doing traditional IRA to Roth conversions after age 59.5. I had a small amount of post tax dollars in the traditional IRA but that was handled easily on form 8606.
germain wrote: Mon Apr 01, 2024 7:28 pm Also, will I still be allowed to make a Roth IRA contribution for the 2024 and 2025 tax years (as long as my MAGI stays under the appropriate limit)?
If you have earned income, yes.
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David Jay
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Re: Converting rollover IRA to Roth over more than one tax year

Post by David Jay »

No problems with what you want to do. You are allowed to perform as many Roth conversions as you choose as often as you choose.
germain wrote: Mon Apr 01, 2024 7:28 pm I have read about forum members who run into trouble with cost basis/prorating complications on form 8606 when they don't convert all traditional IRA dollars to Roth at once but I'm not sure if that comes into play here since this is a rollover IRA that only has pre-tax dollars. Am I thinking about this correctly?
Yes. The pro-rata and 8606 issues relate to those who have a mix of pre-tax and after-tax in their tIRA
germain wrote: Mon Apr 01, 2024 7:28 pmAlso, will I still be allowed to make a Roth IRA contribution for the 2024 and 2025 tax years (as long as my MAGI stays under the appropriate limit)?
Yes. Conversions have no impact on contributions
It's not an engineering problem - Hersh Shefrin | To get the "risk premium", you really do have to take the risk - nisiprius
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David Jay
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Re: Converting rollover IRA to Roth over more than one tax year

Post by David Jay »

My one question would be: Why do the conversions while still working (and presumably are in a higher tax bracket) rather than wait until retired (and presumably are in a lower tax bracket)?

Waiting until after retirement appears to be the most common BH approach to Roth conversions.
It's not an engineering problem - Hersh Shefrin | To get the "risk premium", you really do have to take the risk - nisiprius
ehh
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Re: Converting rollover IRA to Roth over more than one tax year

Post by ehh »

David Jay wrote: Mon Apr 01, 2024 7:49 pm My one question would be: Why do the conversions while still working (and presumably are in a higher tax bracket) rather than wait until retired (and presumably are in a lower tax bracket)?

Waiting until after retirement appears to be the most common BH approach to Roth conversions.
+1

Taking anticipated ACA subsidies (before age 65), IRMAA (after age 65) and social security claiming strategy into consideration. Lots of moving pieces.
Topic Author
germain
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Re: Converting rollover IRA to Roth over more than one tax year

Post by germain »

Thanks for the replies. Some answers:

Will I have non-deductible traditional IRA contributions that I want to convert as well?
No

Why now? I'd like to do this before the tax bracket change in 2026 and I project that it will be at worst a tax-neutral move, but hopefully a tax-advantageous move.

One of the comments above was this
"The pro-rata and 8606 issues relate to those who have a mix of pre-tax and after-tax in their tIRA"

This highlights a point of my confusion. I know that my rollover IRA will have only pre-tax dollars but how does the IRS know that my rollover IRA only has pre-tax dollars? How do I document that when filing taxes?
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celia
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Re: Converting rollover IRA to Roth over more than one tax year

Post by celia »

David Jay wrote: Mon Apr 01, 2024 7:49 pm My one question would be: Why do the conversions while still working (and presumably are in a higher tax bracket) rather than wait until retired (and presumably are in a lower tax bracket)?

Waiting until after retirement appears to be the most common BH approach to Roth conversions.
This could make sense for several reasons (and is what we did). Situations when it makes sense are:

* You saved "too much" in tax-deferred and projections show your tax bracket will go up when RMDs start.

* You file MFJ now but one spouse is likely to die within a few years and the tax rate for Singles would push the survivor into a higher tax bracket.

* You will be subject to IRMAA rates when Medicare starts unless you convert now. It could only be a higher tax bracket now for a few years compared to IRMAA later on for the rest of your life.

* Tax brackets are scheduled to increase in 2026 compared to now.

* You expect to inherit a large tax-deferred account and will have to pay taxes on the withdrawals for up to 10 years.
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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celia
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Re: Converting rollover IRA to Roth over more than one tax year

Post by celia »

germain wrote: Mon Apr 01, 2024 8:07 pm This highlights a point of my confusion. I know that my rollover IRA will have only pre-tax dollars but how does the IRS know that my rollover IRA only has pre-tax dollars? How do I document that when filing taxes?
It is assumed that the money in non-Roth IRAs are tax-deferred (ie, pre-tax). If any of it isn't, the taxpayer needs to file Form 8606. Most people don't need to file that.

Without having any post-tax dollars in your IRAs, just file your taxes as you usually do since it doesn't impact you.
LotsaGray
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Re: Converting rollover IRA to Roth over more than one tax year

Post by LotsaGray »

celia wrote: Mon Apr 01, 2024 8:28 pm
germain wrote: Mon Apr 01, 2024 8:07 pm This highlights a point of my confusion. I know that my rollover IRA will have only pre-tax dollars but how does the IRS know that my rollover IRA only has pre-tax dollars? How do I document that when filing taxes?
It is assumed that the money in non-Roth IRAs are tax-deferred (ie, pre-tax). If any of it isn't, the taxpayer needs to file Form 8606. Most people don't need to file that.

Without having any post-tax dollars in your IRAs, just file your taxes as you usually do since it doesn't impact you.
No assuming necessary. The 401K custodian has those records
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germain
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Re: Converting rollover IRA to Roth over more than one tax year

Post by germain »

Yes, the original 401k/403b custodian has those records, but the new custodian of the rollover IRA does not have those records. So Celia's answer addresses the question. Thank you.

It does make sense that the assumption is that the dollars in the rollover/traditional IRA are pre-tax dollars since this assumption favors the government. I suppose the onus then falls on the taxpayer to prove otherwise when the dollars are not all pre-tax.
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celia
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Re: Converting rollover IRA to Roth over more than one tax year

Post by celia »

germain wrote: Tue Apr 02, 2024 11:03 am It does make sense that the assumption is that the dollars in the rollover/traditional IRA are pre-tax dollars since this assumption favors the government. I suppose the onus then falls on the taxpayer to prove otherwise when the dollars are not all pre-tax.
If there are any post-tax dollars coming over, they are usually separated out and put in a Roth IRA instead. You wouldn't want a mix of pre- and post-tax dollars in your traditional/rollover IRA anyway since the pro rata rule would apply every time you withdrew from the IRA.
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germain
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Re: Converting rollover IRA to Roth over more than one tax year

Post by germain »

celia wrote: Wed Apr 03, 2024 12:06 am If there are any post-tax dollars coming over, they are usually separated out and put in a Roth IRA instead. You wouldn't want a mix of pre- and post-tax dollars in your traditional/rollover IRA anyway since the pro rata rule would apply every time you withdrew from the IRA.
Right, that makes sense when we're just talking about one rollover from all pre-tax dollars, as is my situation. Then, as long as I have no existing other traditional IRA consisting of post-tax dollars, the IRS knows that they need to collect tax on every dollar withdrawn/converted from the rollover IRA.

But how about the more complicated hypothetical situation where somebody might have a rollover IRA (consisting of pre-tax dollars) and an additional traditional IRA (consisting of post-tax annual contributions). My understanding is that the sum total of these holdings is what is used by the IRS for all calculations whenever there is a withdrawal or conversion of dollars from either IRA. So under this situation how does the IRS know that they need to collect tax on every dollar withdrawn/converted from the rollover IRA but that they don't need to collect tax on every dollar withdrawn/converted from the traditional IRA? It doesn't seem like the custodian of the IRAs report this, do they?
LotsaGray
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Re: Converting rollover IRA to Roth over more than one tax year

Post by LotsaGray »

germain wrote: Wed Apr 03, 2024 3:28 pm
celia wrote: Wed Apr 03, 2024 12:06 am If there are any post-tax dollars coming over, they are usually separated out and put in a Roth IRA instead. You wouldn't want a mix of pre- and post-tax dollars in your traditional/rollover IRA anyway since the pro rata rule would apply every time you withdrew from the IRA.
Right, that makes sense when we're just talking about one rollover from all pre-tax dollars, as is my situation. Then, as long as I have no existing other traditional IRA consisting of post-tax dollars, the IRS knows that they need to collect tax on every dollar withdrawn/converted from the rollover IRA.

But how about the more complicated hypothetical situation where somebody might have a rollover IRA (consisting of pre-tax dollars) and an additional traditional IRA (consisting of post-tax annual contributions). My understanding is that the sum total of these holdings is what is used by the IRS for all calculations whenever there is a withdrawal or conversion of dollars from either IRA. So under this situation how does the IRS know that they need to collect tax on every dollar withdrawn/converted from the rollover IRA but that they don't need to collect tax on every dollar withdrawn/converted from the traditional IRA? It doesn't seem like the custodian of the IRAs report this, do they?
You use the information from the first custodian to fill out a 8606.

The information is not secret. 401K custodian will provide you this documentation. I always knew to the penny my after tax amount in my 401K. If you choose to mix pre and post tax dollars in you tIRA you file an 8606.

Only need to assume all pretax if you choose not to document the mix. You have all the information and documentation to calculate proration.
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celia
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Re: Converting rollover IRA to Roth over more than one tax year

Post by celia »

germain wrote: Wed Apr 03, 2024 3:28 pm But how about the more complicated hypothetical situation where somebody might have a rollover IRA (consisting of pre-tax dollars) and an additional traditional IRA (consisting of post-tax annual contributions).
The second IRA also owns pre-tax dollars once there is any growth at all in the account because all growth in an IRA is always pre-tax.
My understanding is that the sum total of these holdings is what is used by the IRS for all calculations whenever there is a withdrawal or conversion of dollars from either IRA. So under this situation how does the IRS know that they need to collect tax on every dollar withdrawn/converted from the rollover IRA but that they don't need to collect tax on every dollar withdrawn/converted from the traditional IRA? It doesn't seem like the custodian of the IRAs report this, do they?
The IRS sees ALL of your non-Roth and non-Inherited IRAs as one big co-mingled IRA, even if some of the money is held in separate accounts or at multiple custodians. All withdrawals or conversions from these accounts will be subject to the same pro rata calcs. Form 8606 tracks the basis (post-tax money) on Form 8606. The "remaining" basis is an accounting number, and it is not associated with any particular account. You could have one large IRA or twenty small ones. If both situations have the same basis, there really isn't any difference between them. Withdrawing $x from either case will give the same tax results.
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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germain
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Re: Converting rollover IRA to Roth over more than one tax year

Post by germain »

celia wrote: Thu Apr 04, 2024 12:31 am The second IRA also owns pre-tax dollars once there is any growth at all in the account because all growth in an IRA is always pre-tax.
Right!
celia wrote: Thu Apr 04, 2024 12:31 am The IRS sees ALL of your non-Roth and non-Inherited IRAs as one big co-mingled IRA, even if some of the money is held in separate accounts or at multiple custodians. All withdrawals or conversions from these accounts will be subject to the same pro rata calcs. Form 8606 tracks the basis (post-tax money) on Form 8606. The "remaining" basis is an accounting number, and it is not associated with any particular account. You could have one large IRA or twenty small ones. If both situations have the same basis, there really isn't any difference between them. Withdrawing $x from either case will give the same tax results.
Ah, so the 8606 is tracking the percentage of the sum total of the IRA accounts on which the IRS is still due their cut of tax. This makes a lot of sense now. Thanks.
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celia
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Re: Converting rollover IRA to Roth over more than one tax year

Post by celia »

germain wrote: Thu Apr 04, 2024 6:15 pm Ah, so the 8606 is tracking the percentage of the sum total of the IRA accounts on which the IRS is still due their cut of tax. This makes a lot of sense now. Thanks.
Yes, but let me be more precise.

Form 8606 calculates the percentage of the tax-deferred IRA accounts for that one tax year that is tax-free. Even if you didn't touch any IRAs after that, the percentage keeps changing as the account(s) grow or lose value.

The "basis" is a fixed dollar amount. It can only increase when you add more non-deductible dollars. It can only decrease when you withdraw (for RMDs, conversions, tax withholding from the withdrawal). When you do a QCD to charity, that is assumed to be entirely tax-deferred dollars (or like a loss of value in the account(s) ).

Since the basis is a dollar amount, you can compare it to all the dollars that were in the tax-deferred IRAs THAT YEAR, to get a percentage. That is what the pro rata rule is!
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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germain
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Re: Converting rollover IRA to Roth over more than one tax year

Post by germain »

That makes a lot of sense. As long as a taxpayer keeps good records of changes to the basis then the percentage calculation shouldn't be too difficult. Thanks for teaching me.
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