Backdoor Roth vs Megabackdoor Roth Tax Implications

Freetax8
Freetax8 Member Posts: 5 Newcomer
in Filing my taxes

From what I am reading…

-For a backdoor Roth - The situation is that I have an existing traditional IRA from previous 401k contributions which are all pretax. If I create a new account to house annual after-tax contributions that are to be converted to ROTH via backdoor conversions, does the pro rata rule applies in this case?

-For a mega backdoor ROTH - The situation is that my employer allows for after tax contributions. I will still have traditional IRA at another institution with previous 401k contributions that were all pretax. If I start to employer's plan for after tax contributions to my 401k and convert those to ROTH, does the pro rata law apply to convert those after tax contributions to ROTH?

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  • MatthewD
    MatthewD FreeTaxUSA Admin, FreeTaxUSA Agent Posts: 1,002 image
    Hi Freetax8,

    Scenario #1: Yes, the pro-rata rule applies. The IRS aggregates all your traditional, SEP, and SIMPLE IRA accounts—regardless of whether they are in new or old accounts—to determine the tax liability of a Roth conversion. Creating a separate account for after-tax contributions does not isolate them from the pre-tax funds.

    Scenario #2: No, the pro-rata rule does not apply to your outside traditional IRA when converting after-tax 401(k) contributions to a Roth account via a Mega Backdoor Roth. The pro-rata rule, which aggregates all traditional IRAs, only applies to backdoor Roth IRA conversions, not to in-plan conversions or rollovers from a 401(k).
  • Freetax8
    Freetax8 Member Posts: 5 Newcomer
    edited June 4

    Thanks MatthewD! And to follow up on this from scenario #2…if I leave the company and am forced to move the funds an IRA, I just need to have them put it into two separate accounts; pretax contributions into a traditional IRA and post tax contributions into a ROTH IRA? And the pro rata will still not apply as long as the pre tax and post tax amounts are kept separate?

  • MatthewD
    MatthewD FreeTaxUSA Admin, FreeTaxUSA Agent Posts: 1,002 image
    Hello,

    Yes, you have the right idea. Under IRS Notice 2014-54(https://www.irs.gov/pub/irs-drop/n-14-54.pdf), you can split your 401(k) distribution into two separate rollovers: pretax funds go directly into a Traditional IRA, and post-tax contributions (along with their earnings) go directly into a Roth IRA. The pro-rata rule will not apply to this separation, as it only affects conversions and mixed traditional IRA balances, not employer-plan rollovers.

    Even if you move them into two different IRA accounts, the Pro Rata rule may still apply to distributions from your IRA accounts, but only if you convert a post-tax account into a Roth.
  • Freetax8
    Freetax8 Member Posts: 5 Newcomer

    So Helpful Matthew D! Thank you so much for all your helpful info.

    Can you clarify on what you wrote above:

    "Even if you move them into two different IRA accounts, the Pro Rata rule may still apply to distributions from your IRA accounts, but only if you convert a post-tax account into a Roth."

    If I'm reading into this correctly…moral of the story being convert the Post Tax contributions immediately into ROTH?

    In my case, when I do leave/retire from my current company, I'll be left with the following:

    1. Existing traditional IRAs (from previous companies)
    2. a new Pretax IRA (from the current company that I just left)
    3. a new Post Tax ROTH IRA (all automatically converted from my current company that I just left)

    I think your comment is specific to IF I had a Post Tax 401k that did not get converted to ROTH? If I left the company and never converted any of the Post Tax 401k, it would become a Post Tax IRA and the pro rata would apply to this if I converted any of those funds to a ROTH IRA?

  • MatthewD
    MatthewD FreeTaxUSA Admin, FreeTaxUSA Agent Posts: 1,002 image
    Hello Freetax8,

    I am happy to clarify.

    The "pro rata rule" most commonly applies when you make a withdrawal or a Roth conversion from a traditional, SEP, or SIMPLE IRA and your account(s) contain a mix of both pre-tax and after-tax (non-deductible) contributions.

    Under IRS rules, you cannot select which specific dollars you are withdrawing or converting. The IRS looks at the balance of all your non-Roth IRAs. Any distribution must consist of a proportional, pro-rata mix of your total pre-tax and after-tax money.

    Based on the scenario you are sharing, it is likely when you start taking retirement withdrawals, the pro rata rule will likely apply to any IRA withdrawals, since you have a mix of both. We do the calculations for you. What you have to do is list the balance of the IRA account (pre-tax) and Roth after tax contributions (or Roth basis) of each IRA at the end of each year so the proportion, pro rata mix can be correctly allocated to what is taxable and what is not.

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