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| Image by @dino via Flickr |
If you have an IRA that includes contributions that are both pre-tax and post-tax (deductible and non-deductible) as well as growth, you may have an option available to you that will allow for a tax-free Roth conversion.
As you know, a Roth conversion can be done with IRAs that have mixed contributions, but when this is done, you will owe tax on a portion of the rollover – the pro-rata portion that includes the pre-tax money. Even if your pre-tax money is in a totally separate traditional IRA, the conversion of your post-tax money will be partly taxed due to the cream-in-the-coffee rule, which requires that all IRAs be considered as one with regard to distributions (including Roth conversions).
For example, let’s say you have an IRA (or several IRAs combined) that is comprised of $5,000 in deductible contributions, $4,000 in non-deductible contributions, and $1,000 of growth of the contributed funds. If you convert $1,000 to a Roth IRA, you will be taxed on 60% of the $1,000 conversion, and 40% of the conversion will be non-taxable. This is because there is a total of $4,000 (40%) in the account that was non-deductible contributions, which can be converted tax-free. The deductible contributions and the growth in the account are taxable distributions, and so converting them to Roth will result in including that $600 in your income as taxable.
However, if you happen to have a 401(k) plan (or other Qualified Retirement Plan) that you’re participating in, you may have the option available to roll over your pre-tax money from the IRA into the QRP.
Taking our example from before – if you rollover into your 401(k) plan the $6,000 representing the deductible contributions and growth, your IRA will be left with only the $4,000 of non-deductible contributions. This amount can then be converted to a Roth IRA tax-free.
Many QRPs have the option available to allow for roll-in of IRA money. What’s cool about this is that roll-ins are only allowed when the money is pre-tax, as in deductible contributions or growth of the account. This means that you can separate the cream from the coffee – that is, separate the pre-tax money from the post-tax money, by rolling the pre-tax money into your QRP. Then, what’s left is your post-tax money, which you can freely convert to a Roth IRA without incurring tax.
