Isolating IRA Basis For More Tax Efficient Roth IRA Conversions
Wondering if anyone has employed this strategy for separating pre and post tax IRA contributions so you can do a “clean tax-free conversion” of only AFTER-TAX contributions, and if so, how did it go?
My employer DOES allow non-plan roll-in contributions so I can make this work, but my spouse left her job so no longer has a 401K or anything with an employer, so how could we do this for her IRA which also has after-tax money in it?
Example –Ben is an IRA owner who is also a participant in a 401(k) plan that allows rollovers into the plan. His total IRA balance is $350,000, of which $40,000 are after-tax contributions. Ben is currently in the 24% ordinary income tax bracket, and he expects to be in the 12% income tax bracket in retirement. As such, an IRA-to-Roth IRA conversion would generally be inadvisable at this time.
Ben, however, can take advantage of his 401(k)’s provision allowing rollovers into the plan, and the exception to the Pro Rata Rule that IRA-to-plan rollovers enjoy. More specifically, Ben can rollover the entire account balance less after-tax contributions, for a total of $350,000 – $40,000 = $310,000, from his Traditional IRA, which represents the total of pre-tax funds accumulated in the account. Although such a distribution would normally be treated as consisting of a ratable amount of pre-tax and post-tax dollars, since the rollover destination is Ben’s 401(k), and after-tax dollars are not allowed to be rolled into such accounts, the entire $310,000 amount will be treated as consisting of pre-tax dollars!
And with $310,000 of pre-tax funds ‘siphoned’ out of the Ben’s IRA, the $40,000 left will consist entirely of after-tax dollars, which can then be converted to a $40,000 Roth IRA, which is a tax-free conversion since all of the remaining IRA dollars are entirely after-tax!
Permalink Submitted by Alan - IRA critic on Thu, 2021-08-19 15:41
Yes, this strategy works and is frequently applied to isolate IRA basis and set up future annual back door Roth conversions as well. Of course, the 401k options and expenses should be acceptable in relation to what they would cost in a TIRA. In addition, one spouse is often not able to undertake this strategy for one reason or another, and there is no substitute solution for that spouse’s IRA basis.
Permalink Submitted by Blue_Sky on Thu, 2021-08-19 15:54
I have some residual (money market) cash in TIRA. Is it better to include that in the rollover to the 401K, or keep it in the IRA? Is it then considered part of the after tax amount?
Permalink Submitted by Jess Stiedemann on Thu, 2021-08-26 08:42
If I were you, I’d rather keep it in the IRA. Jess Stiedemann,Consulting manager,http://www.worktime.com/
Permalink Submitted by Alan - IRA critic on Thu, 2021-08-19 16:08
With many 401k plans you will have to sell the holdings and roll over all cash anyway. It is also preferable to have cash to convert to the Roth so it will not change value during the time the 401k takes to accept the rollover and then to do your conversion. It is safer not to convert first just in case something goes wrong and the 401k does not accept the rollover. Then you would be stuck with a taxable conversion.
You might also ask the 401k plan if you have any restrictions when the rollover IRA balance can be rolled back out of the plan. Most plans will let you roll it back out when you wish even while still working. You may not need to do future back door Roths, and in that case this would be a one time strategy just to get the 40,000 into your Roth tax free. You could then roll the amount you rolled into the 401k back out after the end of the conversion year. But some plans may restrict your roll out options.
If your IRA basis is 40,000, then regardless of holdings, up to 40,000 worth of your remaining TIRA balance is after tax. Your basis floats over the entire IRA regardless of holdings.
Permalink Submitted by Blue_Sky on Thu, 2021-08-19 16:20
They do sell out of the holdings before rolling out, so I suppose folding in the cash to what goes over makes no difference.
The conversion will take place with the IRA custodian (Vanguard where it is now), not with the 401K custodian (Fidelity).
The $40,000 was an example and not reflective of my numbers
From what I’ve read, the recommendation is to wait until the next calendar year (2022) to roll the pre-tax funds back to the IRA
Permalink Submitted by Alan - IRA critic on Wed, 2021-08-25 19:33
If the TIRA pre tax amount is rolled to the 401k, rolling it back out does have to wait until the following year, or the entire purpose of isolating the IRA basis will be lost. And if rolled back to the IRA next year, it means that any future back door Roths will be impaired. If future back doors are not needed and if the 401k allows it, the pre tax amount from the rollover can be rolled back in 2022.