Normally with a high income, you are disallowed from contributing directly to a Roth IRA or receiving a deduction if you contribute to a traditional IRA. Regardless of income level though, you are allowed to make a nondeductible contribution to a traditional IRA.
If you distribute from an IRA while you have a nondeductible basis, you are required to calculate which part of the distribution is traditional (pre-tax) and which part is nondeductible (post-tax) by prorating your distribution as though all of your IRAs are mixed together. The analogy is: Like you can’t take a sip of your coffee without getting part coffee and part cream so too you can’t withdraw from your IRA assets without getting part traditional and part nondeductible.
Only the nondeductible portion escapes taxation.
You report and track your IRA’s nondeductible basis on Form 8606. Only the amount initially contributed without a deduction is ever considered nondeductible. All IRA growth is counted as traditional IRA assets. For this reason, you get the fullest benefit of a backdoor Roth when you have no other traditional IRA assets.
In a previously written article, “Q&A: Can I Do Backdoor Roth and an IRA Rollover In the Same Year?” I make clear that, “If you were to do a $6,000 nondeductible contribution and total Roth conversion through your empty IRA (called a backdoor Roth) in May 2019 and then complete an IRA Rollover of $1M in December 2019, you would have a portion of your backdoor Roth that is taxable.” In this way, you cannot do a clean backdoor Roth and a rollover of your qualified plan into an IRA in the same year.
However, what if you are moving the funds the other way? What if you want to roll your IRA funds into a qualified retirement plan? Can you empty your IRA by rolling the funds into a 401(k) plan and then do a clean backdoor Roth through the account?
That’s the question I recently received from a reader. They write:
Thanks for your article published on Apr 15, 2019 on backdoor Roth and IRA rollover. It is very helpful to get a grasp of the IRS form 8606. I have a similar but a little different scenario compared to what you have written. The case is as the following:
Assume I have only one traditional IRA. At the beginning of 2019, I have pre-tax in that IRA of $20,000 and no nondeductible basis.
Imagine I reverse rollover this $20,000 to an employer retirement 401(k) plan in September. Now, the traditional IRA has a balance of $0. In October, imagine I contribute $6,000 nondeductible into this $0 balance traditional IRA, and immediately did a backdoor Roth conversion. On Dec 31, 2019, this traditional IRA account has a zero balance. Will this backdoor Roth conversion be subject to cream and coffee rule?
This is such a great question!
The tax year 2018 Form 8606 uses the sum of the following three lines as the traditional IRA balance:
- “The value of all your traditional, SEP, and SIMPLE IRAs as of December 31, 2018, plus any outstanding rollovers” on line 6
- “Your distributions from traditional, SEP, and SIMPLE IRAs in 2018. Do not include rollovers (other than repayments of qualified 2017 disaster distributions (see 2018 Form 8915B)), qualified charitable distributions, a one-time distribution to fund an HSA, conversions to a Roth IRA, certain returned contributions, or recharacterizations of traditional IRA contributions ” on line 7
- “The net amount you converted from traditional, SEP, and SIMPLE IRAs to Roth IRAs in 2018” on line 8
In this way, your traditional IRA balance for the tax year is a reconstituted IRA value as of December 31st of that year.
However, you can see explicitly that Line 7 excludes rollovers from the calculation. The form’s instructions clarify this further, saying:
Don’t include any of the following on line 7:
- Distributions you rolled over to another traditional, SEP, or SIMPLE IRA (whether or not the distribution is an outstanding rollover included on line 6).
- Distributions you rolled over to a qualified retirement plan.
The first of these two bullet points is unhelpful to protecting the backdoor Roth. Rolling funds into a traditional, SEP, or SIMPLE IRA or taking your IRA to cash in a risky outstanding rollover contribution would still be included in “the value of all your traditional, SEP, and SIMPLE IRAs as of December 31, 2018, plus any outstanding rollovers” on line 6. Thus, excluding it from Line 7 is necessary to make it not double counted but unhelpful in protecting your backdoor Roth.
However, the second of these two bullet points is telling you to exclude “distributions you rolled over to a qualified retirement plan.” As qualified retirement plan balances are not included in backdoor Roth calculations, this removes those assets from the basis calculation entirely, freeing up room for your backdoor Roth to run through the accounts cleanly.
As a result, rolling your funds into a qualified retirement plan would indeed protect your backdoor Roth.
Following the reader’s example, the math would work out like this:
- Line 6 Total IRA December 31st Values: $0
- Line 7 Total Distributions, Not Including Rollovers: $0 (There was a $20,000 rollover distribution, but we have excluded it per instructions.)
- Line 8 Total Roth Conversions: $6,000
Thus, the Line 9 reconstituted IRA value divisor is $6,000 and the Line 5 basis numerator is also $6,000, making the percentage nondeductible and thus 100% nontaxable for a clean backdoor Roth.
In the reader’s example, they did a backdoor Roth through an empty IRA, having rolled the funds into their 401(k) in September and then making the backdoor Roth contribution in October. Interestingly, the math is the same if these two distributions happen in reverse. The IRS does not care about which month of the tax year the contributions or distributions occur. Any ordering of nondeductible contribution, conversion, and rollover — assuming the values are the same — would result in the same math on Form 8606.
It is worth noting though that if you perform the contribution before you perform the reverse rollover, you could make your IRA assets ineligible from being rolled into your employer’s qualified retirement plan.
It used to be that only an IRA Rollover could be rolled into a qualified retirement plan, such as 401(k) or 403(b). Later, the IRS loosened their rules and now allow any traditional IRA to be rolled into a qualified retirement plan (see the IRS Rollover chart here ). However, many employer retirement plan documents still have specific language that only allows their employer plans to accept money from a previous employer plan. With that language, the employer might not accept your contributory or commingled IRA assets even if the IRS wouldn’t have a problem with the transfer. For this reason, it is best practice to keep your IRA Rollover and IRA Contributory funds separate.
If you ever contribute to an IRA Rollover for any reason such as nondeductible IRA funding, Roth conversion, or consolidating two IRAs together, the Rollover IRA becomes a normal traditional IRA and you may lose the option of rolling it into an employer plan in the future.
If your employer has an updated plan document and does permit roll-ins of traditional contributory IRA assets, then you may be able to do a reverse rollover regardless of if you’ve already flowed a backdoor Roth through the account. However, if you rollover some or all of your nondeductible basis, you could find yourself in a new problem.
Imagine that you rollover the entire value of an IRA worth $32,000 that had a nondeductible basis of $12,000 into your 401(k) plan.
In this example, the Form 8606 math would work out like this:
- Line 6 Total IRA December 31st Values: $0
- Line 7 Total Distributions, Not Including Rollovers: $0 (There was a $32,000 rollover distribution, but we have excluded it per instructions.)
- Line 8 Total Roth Conversions: $0
These sum on Line 9 to $0.
Meanwhile, your Line 5 nondeductible basis as of Dec 31st is $12,000.
Line 10 is then “Divide Line 5 by Line 9” or $12,000 / $0. However, you cannot divide by zero, because there is no resulting number from attempting to do so. All answers (100%, 0%, and every number in between) would be incorrect on Line 10 as math cannot compute a number when you attempt to divide by zero.
Turning to the Form 8606 instructions for help on lines 9 or 10 is sadly disappointing. No instructions exist for these two lines. As far as I know, the IRS has no answer as to what you should do in response to this predicament.
On many websites throughout the Internet, you can find people who say things like “IRA basis cannot be rolled into a 401(k) plan.” Although I cannot find IRS nor U.S. Code confirmation of this principle, the way Form 8606 works is certainly a large deterrent to ever making this mistake.
As a result, the answer is do not roll your nondeductible basis into your qualified retirement plan such as a 401(k) or 403(b). If you do, be sure to roll back out the exact value of your nondeductible basis (or more) before December 31 so as to have a Line 9 sum that is higher than your Line 5 basis.
One method of correcting this mistake would be to roll the funds out of your 401(k) plan, into a Traditional IRA, and then convert it into a Roth IRA. In our example, if you rolled back out $12,000 from your pre-tax 401(k) to traditional IRA and then in a Roth conversion to your Roth IRA, then your Line 8 Total Roth Conversions of Form 8606 would be $12,000, making Line 9 and Line 5 equal and Line 10 the perfect 100% of a clean backdoor Roth.
401(k)-to-IRA and IRA-to-401(k) rollovers can be very complicated to get right. Be bold in asking for assistance. It can save you a lot of time, headache, and money if you do it right on the first try.
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