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A $300,000 pre-tax rollover IRA caused nearly all of a $7,500 backdoor Roth conversion to be taxable due to IRS pro-rata rules.
IRS Code Section 408(d)(2) aggregates all traditional, SEP, and SIMPLE IRAs on December 31, meaning a November rollover can retroactively ruin a January conversion.
Rolling pre-tax IRA balances into a 401(k), 403(b), or 457(b) before December 31 removes them from the pro-rata calculation, making backdoor conversions nearly tax-free.
The backdoor Roth is a two-step move for high earners who exceed direct Roth income limits: contribute to a traditional IRA on a non-deductible basis, then convert it to a Roth. The intuition is that money already taxed cannot be taxed again on conversion. For a saver with a clean IRA slate, that holds. For a saver carrying a large pre-tax rollover IRA from an old employer plan, it fails, and the failure is expensive.
A high earner contributes $7,500 on a non-deductible basis to a new traditional IRA and converts it a week later, expecting a tax-free conversion. She also holds a $300,000 rollover IRA from a prior 401(k), all pre-tax. On her return, almost the entire $7,500 conversion shows up as taxable income. The tax code does not let taxpayers choose which dollars to convert.
One Pool, Measured on the Last Day of the Year
The governing provision is Internal Revenue Code Section 408(d)(2), which requires that all of a taxpayer's traditional, SEP, and SIMPLE IRAs be aggregated and treated as a single account for purposes of determining the taxable portion of any distribution or conversion. Any conversion carries the same proportion of pre-tax and after-tax money as the combined pool.
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A single year's non-deductible contribution of $7,500 alongside a $300,000 pre-tax balance represents a small fraction of the total, so nearly all of the converted amount is treated as pre-tax and taxed at ordinary rates. The pool is measured as of December 31 of the tax year, not the day of conversion. A rollover arriving in November can retroactively spoil a backdoor conversion completed in January.
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