An Example of a 401k Rollover Followed by a ROTH Conversion

In the posts, 401k Rollovers, Where Should My Money Go? and The Deductible Traditional IRA, Non Deductible Traditional IRA and the ROTH IRA, we covered 401k classifications and rollovers, which can be used as a reference for this example.

To briefly discuss a ROTH conversion (see www.bogleheades.org), as an example, suppose you worked at a company and contributed $10,000 in tax-deferred traditional personal contributions (elective deferral) and $20,000 in after-tax traditional personal contributions into your 401k. If the 401k plan had no limitation against this (check with your employer), this could speed up your retirement contributions (see 401k Rollovers, Where Should My Money Go? for more on contribution limits).

Now, suppose the account grew to $50,000 due to the earnings from both pots of money. If you left employment with the company, you could rollover your 401k into a traditional IRA, and file IRS Form 8606, to track $20,000 as a non-deductible basis for your traditional IRA.

You would have $50,000 in a Traditional IRA, of which $20,000 would be considered a non-deductible contribution.

Let's say the account then grew to $100,000. Still, $20,000 is considered non-deductible, which is 20% of the account. If you then decided to convert $10,000 from your Traditional IRA into a ROTH IRA, you would essentially be converting $2,000 of non-deductible money (which is 20%), since the IRS requires you to convert in proportion to the non-deductible contributions over all your Traditional IRA money (even if you have multiple accounts).

That year, you would file IRS Form 8606, to reduce your non-deductible basis from $20,000 to $18,000. You would also pay taxes on $8,000, as if you received this $8,000 as income.

See retireplan.about.com for more on tracking your non-deductible basis.

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This post was reposted from http://finlit.biz/retirement-2/an-example-of-a-401k-rollover-followed-by-a-roth-conversion/, originally written on December 11th, 2013.