Timing Roth IRA Conversions: Avoid pro-rata rule by later opening separate account?

Investing

Dear Joanna,

A quick follow-up to your previous article on Backdoor Roth IRA Conversions:

Would the pro rata rule apply in the case where qualified (pre-tax) contributions were deposited into a traditional IRA account subsequent to a Roth conversion?  By way of an example: post-tax contributions subject to IRS limitations were deposited into a traditional IRA account in May of a calendar year; after which, the entirety of the balance was converted and moved to a separate Roth account, reducing  the traditional IRA account balance to $0.  Later that year in November, funds from a qualified account (e.g., a 401k rollover ) were deposited into that same Traditional IRA such that the entirety of the balance was now sourced solely from pre-tax funds because the Roth conversion had already taken place earlier that year.  Given that the pre- and post-tax funds were at no time co-mingled in the same account, and that the pre-tax funds were deposited after a conversion had already taken place and the account zeroed out, would there be any basis for pro rata solely given the fact that the event happened to have occurred in the same calendar year? Would I have to open a new account or can I put the new money in the same empty Traditional IRA that I rolled over earlier in the year?

Thanks,

Kris

 

Hi Kris,

Great question. The short answer is no, you cannot do this. The pro rata rule applies to the accounts and the amounts you hold at the end of the tax year, not on the day you do the conversion.

For those less familiar with Backdoor Roth IRAs, the pro rata rule states that if you convert any Traditional IRA assets (Traditional IRA, Simple IRA, SEP IRA) to a Roth IRA, that you cannot select to rollover only the non-deductible assets and leave the deductible assets in the Traditional IRA. Instead, you must roll them over prorata. For example, if you have $10k in a non-deductible Traditional IRA and $10k in a deductible SEP IRA you cannot choose to rollover only the $10k of non-deducbitble assets. If you do, the government will treat it as if you converted over $5k of the non-deductible assets and $5k of the deductible assets. I discuss more on the mathematics of the pro rata rule in my previous article.

But this question is less about the math and more about language. When they say you must convert “all” or a portion of “all” of your Traditional IRA assets, does that mean all at the time you did the conversion or all at any point during the tax year? The answer is the latter. All conversions done in a year are considered.

For exact details, see IRS Form 8606 – Nondeductible IRAs. You will need to fill out this form when contributing to or rolling over nondeductible IRA assets.

If you do decide to rollover all of your Traditional funds to Roth in one year and then contribute again to a Traditional in a following year, there is no need to open a “new” account. When you converted all of your Traditional assets you left the account empty. Putting new funds into the empty account is essentially the same as opening a new account. The IRS looks at all of your IRA assets across all companies so distinctions as to where the account was opened and whether or not they created a new account number for you do not matter. So if you have $5k in a non-deductible Traditional IRA at Fidelity and $5k in a non-deductible Traditional IRA at Vanguard and $10k in a deductible IRA at Schwab, the government only views this as $10k non-deductible and $10k deductible in a Traditional IRA. It may be easier to calculate taxes owed if you never co-mingle non-deductible and deductible assets, but it’s not technically necessary to have separate accounts.

Thank you to Russell Herdman for his contributions to this article.

 

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About the Author

Joanna D. Pratt, CFA is an experienced institutional investor.  She holds a bachelor’s degree in economics and certificate in finance from Princeton and an MBA from Stanford.

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