I’m 47, and my traditional IRA is worth roughly $130,000. About $100,000 of that IRA is after-tax contributions and filed and recorded on that basis on the 8606 tax form each year. If I convert that account to my Roth IRA, do I only pay tax on the $30,000?
How does that get handled? Assuming I don’t withdraw from the Roth account before I’m 59 1/2 years old, are the entire withdrawals — contributions and earnings — tax-free?
I recently left my job, and want to convert my significant traditional 401(k) into my traditional IRA, but at that point, the after-tax basis of the account will only be about 10% and therefore I believe I would be subject to a lot more taxes on any conversion.
Can I do both of these transactions in a single tax year and receive the benefit? For example, first convert the current traditional IRA account to a Roth, and then roll over my traditional 401(k) to the traditional IRA and have conversion still only taxed at the $30,000? Or does this have to happen in a second tax year?
Related: We’re in our 70s, have $1.3 million in IRAs and $1.15 million in cash. But we have ‘no clue’ what to do with the money.
It is fantastic that you keep track of the different types of taxed (and non-taxed) contributions you make to your IRA, as well as the fact that you have everything recorded on Form 8606. Financial planners have mentioned how important it is to keep the records of those contributions organized, so you’re ahead of the game.
“Knowing the basis in advance of a Roth conversion is helpful,” said Brandon Opre, a certified financial planner and founder of TrustTree Financial. “Otherwise, we’re going back through decades of records trying to add up the client’s basis.” (Your basis reflects the after-tax balance in your account.)
Having a mixture of after- and pre-tax contributions in your traditional accounts will put you face-to-face with the pro-rata rule, which states any money taken out of that account (be it converted or distributed) will include a percentage of tax-free and taxable dollars in relation to how the account is divided. As a result, after-tax contributions should move directly to a Roth IRA.
Whether or not you should move the remaining amount of pre-tax money is up to you, and your accountant if you have one. You could be faced with a bigger tax liability depending on where you are in your tax bracket. The goal is to avoid pushing yourself into a higher bracket, which will dictate whether or not you should make the full conversion of the rest of that $30,000.
A two-year plan
But you have a couple of moving parts — you’re talking about moving money between IRAs as well as a 401(k) plan. It should take two tax years to accomplish your goals, said Maureen Demers, a certified financial planner and owner of Demers Financial Planning, since you will first need to do the Roth conversion by Dec. 31 before rolling over the 401(k).
You should keep your 401(k) separate from the IRA with after-tax contributions to avoid a taxable event for each conversion, said Erika Safran, founder and principal at Safran Wealth Advisors. But “back-door Roth conversions” for the IRA with after-tax dollars would be “ideal,” she said. (Back-door Roth accounts are, simply put, made of converted dollars that were once after-tax contributions in a traditional account.)
If your 401(k) plan had any after-tax contributions that were moved to a traditional IRA instead of a Roth, you would run into the pro-rata rule (similar to what you’ll face with the after-tax contributions made to the traditional IRA, which is far less tax advantageous). So, just as you are so wonderfully organized with your IRA, review your standing within that account.
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