Contributed by: CoryF, FreeTaxUSA Agent, Tax Pro
Wait a second, I have taxable income on my conversion to a Roth IRA. I thought if I put in enough nondeductible IRA contributions there would be no taxable income, but I am still seeing taxable income on my Roth IRA conversion. What is happening here?
Congratulations, you have successfully started the process to create a backdoor Roth IRA conversion despite your higher income limiting normal Roth IRA contributions. You may or may not have heard of the pro rata rule that can make some of your conversion taxable, even if you contributed non-deductible money to the IRA. This article will help you understand how you may still have taxable income despite your contributions being after-tax.
The pro rata rule only applies when you have an IRA with both pre-tax and after-tax contributions. The money in this type of IRA mixes and cannot be distinguished during a Roth IRA conversion. There are a couple of ways past contributions are treated as pre-tax.
- When rolling over an existing retirement account from a past employer, like a 401(k) or 403(b). These contributions gave you a tax benefit, directly, on your W-2 wages each year of contributions. Most of the time, you are required to rollover the contributions due to a change in employment.
- You could have pre-tax contributions if you previously received an income deduction on your tax return because of contributing to current year IRA. For example, you contribute to an IRA with money from your bank account which creates an income deduction on your tax return.
- You find out that you can contribute to your existing IRA or another account with a financial institution with after-tax dollars. These contributions create a situation where the pro rata rule can make a portion of a conversion to Roth IRA taxable, even if you convert the contribution immediately to Roth IRA
The pro rata rule is defined as taking a percentage of contributions of pre- and after-tax (nondeductible) contributions and applying the rule to a conversion amount, or percentage of, the Roth IRA, making a portion of pre-tax contributions taxable on your income tax return.
Here’s an example.
You have an existing IRA with a $100,000 value at the end of the year. This value consists of $80,000 pre-tax contributions and $20,000 after-tax contributions. The $20,000 in after-tax contributions is the portion for which you have basis in your IRA. Basis regarding IRAs means the portion of your IRA value coming from contributed money that has already been taxed. This creates an 80/20 split or 80% pre-tax. You decide to convert $6,000 to a Roth IRA (thinking it is all well and good you have over $6000 in nondeductible contributions). Here, the pro rata rule applies 80% directly to the conversion amount and 80% of $6,000 equals $4,800. This becomes the amount of taxable income you show on your income tax return due to the pro rata rule. The other $1,200 will show as non-taxable on your Form 8606, page 2, line 18.
FreeTaxUSA software is equipped to complete this calculation and apply the rule correctly. Here are the screens where you will manually enter information.
Follow this menu path: Income > Retirement Income (1099-R):
- Start with the retirement distribution that is being converted to a Roth:
- The screens to enter this 1099-R include a screen to identify this distribution is being converted to a Roth. The next screen to enter will be to indicate that you have nondeductible contributions:
- The most important screen is the basis screen. This screen will make the calculation accurate. In the above example, the total value is equal to $100,000 ($6,000 conversion + $94000 IRA total balance at the end of the year). The value of the IRA question requires the total account balances for all traditional SEP, SIMPLE, and regular IRA accounts. The total basis field of $20,000 is the prior year nondeductible contributions made to the IRA. This entry is essential for the calculation of the pro rata rule below:
- This creates the Form 8606 showing this calculation:
Your traditional (pre-tax) account value will be $95,200 ($100,000 – $4,800 taxed) and your nondeductible basis in the IRA will be $18,800 moving forward.
