20-Apr-22
Isolating Basis in an IRA
Take-Away: The pro-rata rule, which provides for the taxation of part of a distribution from a traditional IRA which contains both pre-tax and after-tax contributions, can be circumvented in only three ways, when the goal is to isolate basis (after-tax contributions) in the traditional IRA, which can then be converted to a Roth IRA.
Background: We have covered in the past the pro-rata rule with regard to IRAs, or informally referred to as the ‘cream-in-the-coffee rule.’ Once pre-tax contributions and after-tax contributions to a traditional IRA are mixed, it is impossible, generally speaking, to separate them. As such, if a distribution is made from the traditional IRA after both types of contributions have been made to it, part of the distribution will be tax-free (the post-tax contribution) while the balance will be taxable (the pre-tax contribution portion.) Accordingly, it is difficult to isolate the post-tax portion of any distribution from a traditional IRA so that it can be rolled over into a Roth IRA. Recall too, that all of the owner’s IRAs are treated as a single IRA when it comes to applying the pro-rata rule. That being said, there are a three exceptions to isolate the after-tax contribution to a traditional IRA, to facilitate a Roth IRA conversion of that after-tax portion, but two only deal with limited amounts.
Exception #1 -QCDs: A qualified charitable distribution, or QCD, is available to a traditional IRA owner who is age 70 ½. A QCD is limited to $100,000 per person per year. It applies only to direct distributions to a charity (other than a private foundation, a donor advised fund, or charitable gift annuity.) A QCD applies only to taxable amounts held in the traditional IRA, which makes a QCD an exception to the pro-rata rule. By leveraging annual QCDs, a traditional IRA owner could conceivably reduce the taxable dollar held in his/her traditional IRA, thus possibly reducing the balance down to only after-tax contributions. This would seem to be applicable primarily to an individual with a small amount in their traditional IRA, and perhaps a small amount of after-tax contributions to that traditional IRA.
Exception #2 – QHFDs: An IRA owner is allowed to make a one-time tax-free transfer from a traditional IRA to a qualified health savings funding distribution, or QHFD. That transfer to the QHFD is not subject to the 10% early distribution penalty. Thus, a transfer of pre-tax funds from the traditional IRA to the QHSA can also be used to isolate after-tax contributions remaining in the IRA. Unfortunately, as noted, this is a one-time opportunity, and the amount of pre-tax contributions that can be moved to the QHSA is capped at the QHSA contribution amount for the tax year, e.g. $8,200 for an IRA owner who is age 55. Again, using a QHFD to isolate after-tax contributions in a traditional IRA is of limited utility, but might apply to a small traditional IRA balance.
Exception #3 – Reverse Rollover to Qualified Plan: The third exception to the pro-rata rule used to isolate basis in a traditional IRA is sometimes called the reverse rollover to an employer’s qualified plan, like a 401(k) plan. Only pre-tax funds held in the traditional IRA can be rolled from an IRA to an employer-sponsored qualified plan. However, unlike the other two exceptions, there is no limit to how much an be rolled over to the employer’s qualified plan; arguably the entire pre-tax portion of the owner’s traditional IRA could be transferred through a reverse rollover to the qualified plan account all at one time. A rollover of all of the owner’s pre-tax contributions to his/her traditional IRA can be made to a qualified plan, but only if the qualified plan documentation expressly accepts reverse rollovers from an IRA. A qualified plan does not have to accept such transfers. If the plan accepts such transfers, that would leave behind in the traditional IRA only after-tax contributions, which would then be subject to a tax-free Roth IRA conversion.
- Caution: The former pre-tax IRA dollars held in the qualified plan after the reverse rollover, could then be returned to the traditional IRA the following year. However, if this is pursued, it is important that the participant (IRA owner) NOT roll the pre-tax plan dollars back into the traditional IRA until at least the next year, or they will be included in the previous Roth IRA conversion pro-rata
Conclusion: Yes, it is possible to isolate basis in a traditional IRA for purposes of converting that basis to a Roth IRA. But as indicated, the opportunities are extremely limited, and probably the best, the reverse rollover to a qualified plan is only available if there is a qualified plan in which the IRA owner is also a participant, and only if that qualified plan formally accepts the transfer of traditional IRA account balances.