Sec. 408(d)(1) ordinarily requires a pro rata allocation between taxable and nontaxable amounts (using the Sec. 72 annuity rules) when reporting distributions received from an individual retirement plan (an individual retirement account or annuity (IRA)). The practical effect is that a taxpayer must recover any nontaxable amount (basis) ratably as distributions are received, by tracking basis on Form 8606, Nondeductible IRAs. The tax liability on such a distribution can sometimes lead a taxpayer to improperly conclude his or her best option is to recover the nontaxable portion ratably as distributions are received, without considering a Roth conversion.

Taxpayers looking for tax benefits and flexibility should consider Sec. 408(d)(3)(A)(ii), which provides an important but sometimes overlooked exception to the pro rata rule. It applies to certain distributions rolled over to an eligible retirement plan (that is not an IRA). For this exception to apply, “the maximum amount which may be paid into such plan may not exceed the portion of the amount received which is includible in gross income (determined without regard to this paragraph).” Put another way, if a taxpayer rolls over a distribution from his or her IRA to an eligible retirement plan (e.g., a Sec. 401(k) plan) for his or her own benefit, and the amount rolled over equals only the sum of deductible contributions and earnings on all contributions (whether earned on deductible or nondeductible portions) but not any nondeductible contributions, the entire amount rolled over will not be taxed at the time of rollover. Instead, that amount will be taxed as it is distributed from the Sec. 401(k) or other eligible plan under rules applicable to the particular plan. The taxpayer’s remaining IRA balance after the rollover should equal its basis, so the taxpayer could immediately withdraw that remaining balance tax free or convert it to a Roth IRA tax free.

Eligible retirement plans that can receive (but are not required to accept) rollovers from IRAs include qualified trusts (including Sec. 401(k) plans), Sec. 403(a) annuity plans, Sec. 403(b) annuity contracts, and Sec. 457(b) plans (that meet certain requirements). Taxpayers with nontaxable amounts sitting in an old employer’s eligible retirement plan might consider first rolling over the old plan to an IRA, then transferring the taxable amounts from the IRA to the new employer’s eligible retirement plan.

A taxpayer might not have an eligible retirement plan to which taxable amounts can be rolled. In that case, self-employed persons, corporations, or partnerships could set up Sec. 401(k) plans, thereby creating an eligible retirement plan to receive rollover payments.

Example. Cheryl, a high-wage earner, age 48, is an active participant in an employer retirement plan. Her modified adjusted gross income is too high to enable her to deduct a traditional IRA contribution or contribute directly to a Roth IRA. She has a $50,000 balance in a traditional IRA, of which $27,000 represents nondeductible contributions; a $20,000 balance in a SEP-IRA, none of which represents nondeductible contributions; a $10,000 balance in a SIMPLE IRA, none of which represents nondeductible contributions (assume she has been a participant for more than two years); and a $100,000 balance in a Sec. 401(k) plan at her current employer, of which $1,000 represents nondeductible contributions. Assume the Sec. 401(k) plan of an old employer, which permitted after-tax contributions by employees, was previously rolled over to her traditional IRA, thus creating the $27,000 basis. Assume her current Sec. 401(k) plan permits after-tax contributions by employees and will accept rollovers from her traditional IRA, SEP-IRA, and SIMPLE IRA, and Cheryl is willing to accept the investment prospects offered by the plan. She is already making the maximum current-year Sec. 401(k) contribution and would like to benefit from a Roth IRA, if possible.

In light of this, Cheryl should consider what practitioners refer to as a “backdoor” Roth IRA contribution. First, Cheryl would make a $5,000 nondeductible contribution to her traditional IRA. The amount, equal to the maximum annual Roth IRA contribution she would not otherwise be eligible to make because of her income level, also creates additional basis. Second, she would roll over (within 60 days, unless a hardship exception applied) to her current Sec. 401(k) plan everything in her IRAs except an amount equal to her $32,000 basis in the accounts. The distribution would qualify because it would not be a required minimum distribution. Sec. 408(d)(3)(G), which states a distribution from a SIMPLE IRA during the first two years of participation can be rolled over only to another SIMPLE IRA, would not apply.

Under the rules of Sec. 408(d)(3)(H), the rollover in step two above could consist of any combination totaling $53,000 (for example, $53,000 of her $55,000 traditional IRA balance), leaving basis of $32,000 in her IRAs (in this example, $2,000 in her traditional IRA, $20,000 in her SEP-IRA, and $10,000 in her SIMPLE IRA). None of the $53,000 in rollovers would be taxable at the time of the rollovers. Third, she would convert the $32,000 remaining in her IRAs to a Roth IRA. Note that the $99,000 future taxable amount in the Sec. 401(k) plan immediately before the conversion would not factor into the pro rata calculation because the Sec. 401(k) plan is not an IRA. After everything was done, Cheryl would be set up so that in future years she could make annual nondeductible contributions to her traditional IRA followed by annual conversions to her Roth IRA, with few, if any, tax consequences.

Kim T. Mollberg, CPA, CGMA, CMA, MBT, is an assistant professor of accounting at Minnesota State University Moorhead, Moorhead, MN.

Edited and posted by Harold Goedde CPA, CMA, Ph.D. (taxation and accounting)