Jack and Coke Main

Basis in your IRA? Try Separating the Jack from the Coke

With the potential end of the Backdoor Roth IRA barely 3 months away, what can steely-eyed killers do to gain angles before the final merge?

Recall from last week’s article, that if the Backdoor Roth door is boarded up, then taxpayers will no longer be allowed to convert after-tax dollars to Roth dollars.  This article will look at a couple of cases that might affect military families and lay out some mission planning for the last three months of 2021.

Don’t let the (Back) Door Hit You on the Way Out

If you’re going to be over the MAGI limit of $140K (S) / $208K (MFJ) for 2021, and you haven’t already executed your planned Backdoor Roth IRA maneuver yet… say reason for delay?  While many families wait until tax time, when their prior year earnings are clarified, to make IRA contributions.  This is not the year for that.

Though we don’t know the final parameters of any (potential) new tax law, it’s highly unlikely that the Backdoor will stay open after midnight on December 31st 2021.  Actually, you may want to think of December 1st 2021 as a better target.

Custodians (e.g., Vanguard, Schwab, Fidelity, etc.) can get overwhelmed with financial transactions at year-end.  It’s not uncommon for them to set deadlines to be able to process the hordes of complex transaction requests they receive in order to meet Uncle Sam’s 31 December deadline.

If you need a primer on how to do a Backdoor Roth IRA, this article should help.

Avoiding the Pro-Rata Rule

One of the major snags of Roth Conversions is that, if a taxpayer has any pre-tax earnings or contributions in an IRA, then any conversion is considered a pro-rata amount of pre- and post-tax dollars.  The Jack is inextricably mixed with the Coke.

For example, if you have a Traditional IRA with $12,000 in it consisting of $6,000 of after-tax contributions and $6,000 of earnings, then when you convert $6,000 to your Roth IRA, Aunt IRS will view that as 50% pre- and 50% post-tax.  You can’t just convert the $6,000 of after-tax contributions.  You’ll pay income tax on the $3,000 of pre-tax dollars at that time.  Once you put pre- and post-tax dollars in the same account you’ve mixed the Jack and the Coke.  You can’t take a sip of just Jack or Just Coke—every sip gets you some of both.

This pro-rata rule can be complex because it aggregates across ALL pre-tax IRAs.  If a taxpayer has a Traditional IRA and a SIMPLE IRA, the IRS views that as a single IRA.  A SEP IRA gets the same treatment.  Note, that this is for the taxpayer only.  For example:

Spouse 1 has a Traditional IRA, a SIMPLE IRA, and a 401(k).

Spouse 2 has a Traditional IRA, a Roth IRA, and a TSP.

If spouse 2 wants to convert money from the traditional IRA to the Roth IRA, the IRS only looks at Spouse 2’s accounts to aggregate pre-tax IRAs.  The TSP doesn’t count in this IRA equation and Spouse 1’s accounts only factor into Spouse 1’s aggregation.

TSP to the Rescue

One of the great things about the TSP (and many employer 401(k) plans) is than it accepts rollovers from other accounts.  The TSP will not accept after-tax dollars from an IRA, or 401(k), but it will accept pre-tax dollars.

Here’s why this matters:

Let’s say you started to do a Backdoor Roth IRA earlier this year.  You contributed $6,000 to a Traditional IRA, but because you were above the limit to deduct those dollars, it was a Non-deductible Traditional IRA (NDT-IRA).  You meant to Roth convert immediately but you got busy.  The account grew and now you have $10,000 in this NDT-IRA.

The TSP will accept the $4,000 of earnings and until the ball drops on 2021, you can roll the original $6,000 of basis (after-tax dollars) into your Roth IRA.

This is how you separate the Jack from the Coke—you move pre-tax dollars into the TSP (or 401(k) as appropriate) and then convert the basis to your Roth.   Now the after-tax dollars stay “Roth” and the pre-tax dollars could be available for a future Roth conversion, tax-situation permitting.

If you or your spouse has a 401(k) with after-tax dollars, you may be able to Roth convert those dollars either inside the plan or outside the plan, but this is highly dependent on what the plan allows.  Call your plan administrator quickly if you think you might be able to do this… and be prepared to hear some holding music because they’re likely swamped!

If you or your spouse has an orphaned 401(k) from a previous employer or perhaps a Solo 401(k) that’s no longer in use (and probably should be closed anyway) and that has a mix of pre- and post-tax dollars, it may still be possible to separate the Jack from the Coke, but you may have to close the account to do so.

This is because many plan administrators only allow separation of pre- and post-tax dollars on final account closure.  Let’s look at how this might work:

Assume you have a 401(k) with $50,000 consisting of $25,000 of pre-tax and $25,000 of post-tax dollars in it.  While the account is open, the administrator only allows pro-rata movement of dollars.  Upon closure however, the administrator will separate the dollars.  You can move $25K to your Roth IRA and $25K to any other pre-tax account like a Traditional IRA, the TSP, or another 401(k).


One fringe case to keep an eye out for as you scramble for one last Backdoor Roth is vesting.

If you or your spouse works for a small company that offers a SIMPLE IRA, there is a 2-year vesting period from the first contribution.  During this 2-year period, any rollover suffers a 25% tax penalty.  If you’re considering clearing out a SIMPLE IRA in order to allow one last Backdoor Roth conversion (remember that all pre-tax IRAs aggregate in the eyes of the IRS), keep in mind that paying 25% on the SIMPLE dollars is definitely leaving the IRA a tip!

You’ll want to get out the abacus and make sure that paying 25% to move those dollars is a better move than waiting out the 2-year period and managing whatever options the (ever-changing) tax law provides at that time.

Cleared to Rejoin

The end of the Backdoor Roth IRA may be near, but you still have time to act.  Failure to act may be leaving hefty tip to the IRS, but acting could require some serious account gymnastics.  As always, consult your financial or tax advisor to make sure that any contribution or conversion strategy makes sense for you both in this tax year and over your lifetime.  If so, you may have one last opportunity to “separate the Jack from the Coke” and cause tax-bill shrinkage!

Fight’s On!

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