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If you own a traditional IRA that has nondeductible and deductible contributions as well as earnings and you also have an employer sponsored tax deferred account like a 401(k) or Thrift Savings Plan (TSP) that will accept an IRA rollover, then here’s a way to do a tax-free Roth conversion. I learned about this maneuver from a comment to my comment on a prior HD article. It’s pretty slick although a little complicated, so I thought it deserved to be its own HD article. A benefit is, it will reduce the amount in your traditional IRA and therefore reduce your RMD and increase the amount in your Roth that can be withdrawn or passed on to your beneficiaries’ tax free. This will be even more beneficial if future tax rates increase.
If you file form 8606 ‘Nondeductible IRAs’ with form 1040, then you have a record of your total basis (nondeductible contributions) in your traditional IRA. Your total basis should be large enough to make this maneuver worth your effort.
So, what you do is subtract your total basis from the total amount in your traditional IRA and rollover that amount into your employer sponsored tax deferred account. Make sure your sponsor will accept an IRA rollover. The remaining funds in the IRA can now be converted to a Roth and since the contributions were made with previously taxed funds this conversion is tax free. A note of caution, make sure the funds that are rolled over are in your tax deferred account before you initiate the Roth conversion. So, what does this entail? First, you should sell all the securities in your IRA and place the funds in your IRA cash account. That way the amount in your IRA is stable and therefore you know the exact amount that gets rolled over and converted. Also, only cash can be rolled over into your taxed deferred account. For the Roth conversion any amount over your total basis will be taxed. Another consideration – the rollover and conversion process can take a few weeks so expect to be ‘out of the market’ during this time. You initiate the process by contacting your tax deferred account custodian. Once the rollover is completed the cash can be reallocated into securities. Now for the Roth conversion. Since all remaining funds in your IRA are in cash you know the exact amount to be converted. If you earn interest on your total basis while waiting for the rollover to complete, then only that interest will be taxed as calculated on form 8606.
So, how do you report these transactions to the IRS? I’m not a tax accountant, but I try to be thorough in understanding IRS instructions & publications. It’s pretty straight forward for DIY tax filers. Both the rollover and conversion are considered IRA distributions. The conversion is captured on form 8606 and the total distribution amount is recorded on form 1040 ‘line 4a IRA distribution’ and if applicable ‘line 4b Taxable amount’. See the instructions for form 1040 ‘Lines 4a and 4b IRA Distributions’. One more important point. Keep your account statements that show these transactions, the amounts and when they were made and make sure your Roth conversion occurred after your IRA funds were rolled into your tax deferred account. If desired, you can roll funds in your tax deferred account back into a traditional IRA. The IRS does not require a wait time before you can roll funds back into a traditional IRA. I completed this process this past June.
Is this only permissible if you haven’t taken any withdrawals from the T-IRA that has 8606 funds mixed in?
I don’t see why withdrawals would disqualify this maneuver. However, your basis would be less than your total non-deductible contributions since withdrawals are taken pro-rata.
I believe you need to wait for the next year before rolling funds back to the traditional IRA, as form 8606 asks for the year-end value of the traditional IRA. If the money doesn’t stay “hidden” in the 401(k) then you’ll pay tax as if you never rolled it there.
Yes, for this to fully work, the year-end balance in all of your traditional IRAs should be $0.00 at the end of the year in which you do the Roth conversion. That is, you move all money out of the IRA into either the employer sponsored tax-deferred plan or to the Roth before the end of the year. If you also want to roll money from the employer sponsored plan back into a traditional IRA, you need to wait until after the year in which you do the Roth conversion.
But once you complete this, all future earnings on the money you converted to the Roth will be tax free, instead of taxed upon withdrawal from the traditional IRA, as they would have been if you did not do the conversion.
Jonathan, you & Randy make a very good point and that is exactly what I plan to do, roll funds back into a traditional IRA next year. That makes the transaction process clearer and gives the IRS less reason to poke around in your tax return. The reason to roll back into an IRA is for more investment options. But the IRS doesn’t require you to wait until the next calendar year. So, if rolling back into an IRA the same year you will need to provide the IRS supplemental information describing what you did, and if you e-file your tax return you can fax or mail this information separately to the IRS. This would likely delay receipt of a refund.