Q. Having just read your article "Converting your 401(k) to a Roth,” I am concerned about my ability to contribute $6,500 to my nondeductible Traditional IRA and then immediately convert to my Roth with no tax consequences as I have done for several years. My income does not allow me to contribute directly to my Roth. Here is my question: Since I am more than 59 1/2. I wish to rollover $250k from my 401(k) to my traditional IRA. Does the pro-rata rule mean I will be taxed on my $6,500 even though it is already post-tax money? If so, does that $250k balance in my Traditional IRA doom me to the same efforts year after year after year? Thanks. — D.S.
A. I have two concerns here. First, I hope you have not had any other IRAs than what you described. If you have other non-Roth IRA accounts, a SIMPLE IRA, or a SEP-IRA, you have been underreporting the taxable income on your conversions and have underpaid your taxes. To understand why, one must understand the pro-rata rule.
There is no need to be concerned about taxing the $6,500 twice. Because the $6,500 has already been taxed, no taxes will be due on that again. However, the pro rata rule can prevent you from simply converting just the $6,500. When the pro rata rule applies, it will determine how much of the $6,500 can be used to reduce the taxable portion of a conversion and how much of the $6,500 remains for use to offset taxable distributions in the future.
To calculate how much of a conversion would be tax-free, step one is to determine the total of after tax contributions to all your IRA accounts, including SIMPLE IRAs, SEP IRAs, and traditional IRAs. You do not count amounts converted to a Roth. You should have been filing a Form 8606 to track these contributions.
In step two, you total the balances of all your IRA accounts, including SIMPLE IRAs, SEP IRAs, and traditional IRAs as of Dec. 31 of the year in which you make your conversion. Again, you do not count Roth IRAs. This is the source of my concern about underpayment of taxes.
Step three is to figure the ratio of the total of the after-tax contributions to the total balances of the IRAs is the percentage or pro rata amount of the conversion that is not taxed. Therefore, if you have owned the IRAs listed, those balances needed to be included in the calculation even if all the after-tax contributions only went into one IRA account.
Likewise, even without any other non-Roth IRAs, rolling the 401(k) to an IRA would have a profound effect. If you do not own any other non-Roth IRAs, contribute $6,500 on an after-tax basis to a traditional IRA, convert the $6,500 to a Roth, and rollover the $250,000 401(k) in the same tax year, the tax-free amount of the conversion is only $164.72 ($6,500/($6,500+$250,000). In future years, the remaining $6,335.28 becomes part of the calculation in step one above.
My second concern relates to the technique of making nondeductible contributions to a traditional IRA and immediately converting to a Roth. This so-called "backdoor Roth" has gained some popularity since the tax code changed allowing anyone, regardless of income, to convert money in a traditional IRA to a Roth IRA. I believe your approach to be unnecessarily aggressive.
There is no income limit for allowing nondeductible contributions to an IRA. Further, there is no income limit for allowing Roth conversions. So what's the issue? There is a little thing in the tax law called the "step transaction doctrine" which when invoked, treats a series of independent steps as a single action for tax purposes.
There are a few ways the IRS looks at a series of transactions but the one that could apply here is the "end result test.” Here the steps are viewed as predetermined steps toward an overall outcome that is not permitted. As you stated, you could not just contribute $6,500 into a Roth IRA, yet that is the end result from what you describe. While, I have yet to see any cases where the IRS invoked the step transaction doctrine, I think you may have some vulnerability.
There is some debate in the adviser community as to how a backdoor Roth could be implemented less aggressively. One common solution I hear is to put some time between the nondeductible contribution and the conversion. The suggestions range from a few days to months to waiting to convert until the tax year following the tax year of the contribution. Another common suggestion is to wait for the contribution to earn some interest so something is taxable upon the conversion. Congress lifted the income limitations that prevented high income taxpayers from converting because they wanted to generate revenue from the conversions. Your aggressive implementation isn't resulting in any taxes for Uncle Sam. Proceed with caution.
Also see: Backdoor Roth IRA conversion: Tax-free?
Q. I cannot receive Social Security (even though I have paid into it and am fully vested) due to my retiring with a state pension. My question is: can I claim any of my ex-wife's Social Security? I am 60 my ex is 56 and receives half my state pension. — F.D.
A. Generally, you can receive benefits on your ex-wife's record, even if she has remarried, if all of the following apply:
- Your marriage lasted 10 years or longer,
- You are unmarried,
- You are age 62 or older,
- Your ex-spouse is entitled to Social Security retirement or disability benefits (if she hasn't applied, but is qualified, you need to be divorced more than two years)
- The benefit you are entitled to receive based on your own work is less than the benefit you would receive based on your ex-spouse's work.
However, since you aren't getting Social Security payment now due to your pension, it is likely that if you met all the above criteria, any benefits from your ex-spouse's record would similarly be subject to offset.
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