cream in the coffee rule

Cream in the Coffee Maneuver (How to Liberate After-Tax from an IRA)

How to Roth Convert Basis Stuck in Your IRA

 

Not infrequently, high income folks continue to contribute to an IRA even though they earn too much to take a tax deduction. Since this money cannot be deducted for tax purposes, it is considered after-tax or basis in your IRA.

Also, not infrequently, CPAs don’t know what to do about this situation. They allow clients to continue to make non-deductible contributions which they can’t Roth convert due to the pro-rata rule.

Unfortunately, all growth of after-tax money in your traditional IRA is taxable! If you could convert it to Roth, future growth is tax free!

How can you liberate the after-tax money in your IRA and get it into your Roth? Welcome to the cream in the coffee maneuver, or how to Roth convert basis stuck in your IRA.

 

After-Tax Money (Basis) in your IRA and Form 8606

Do you have after-tax money (also called basis) in your traditional IRA?

First thing to check is your most recent tax return. Do you see form 8606? This is a form that you (should) file every year with the IRS to show how much basis you have in your IRA.

It is common for people to forget to file form 8606, or drop it after a few years. Remember that form 8606 is not “proof” to the IRS that you have basis in your IRA, it is merely a work sheet to keep track of it.

You can go back and reconstruct your basis in your IRA if you have lost form 8606 or you are missing a few years. It is worth your time to do so now. Keep records of the basis you report on 8606 as, again, this form is just a work sheet, not evidence in case of IRS audit.

cream in the coffee

Above, you can see an example of form 8606. The form is cut; I just wanted you to see what the top looks like so you can pull it to review from your most recent tax returns.

Next, pay attention to line 14. Line 14 of form 8606 has the basis for this year and all earlier years. If this line is not correct, fix it or you will pay tax again on money you already paid taxes on. Double taxation is not fun!

 

Double Taxation

What happens if you forget to record your basis in a traditional IRA?

When you take a distribution from an IRA, it is fully taxable at ordinary tax rates unless you use form 8606 to show you are taking a pro-rata tax deduction due to basis.

Don’t let Money you have already paid taxes on be taxed again! Double Taxation!

This is important. If you don’t report that a distribution contains after-tax (basis) via the 8606 on your taxes, you will owe taxes on money that has already been taxed.

Next, remember, in the eyes of the IRS, you only have one IRA.

You may have a SEP and a SIMPLE and a rollover and three different other traditional IRAs. But the IRS doesn’t care about separate accounts. It is all one. This is called the IRS Aggregation Rule; you only have one IRA in the eyes of the IRS. If you have basis in one IRA (or even if you keep one IRA separate just for your after-tax contributions) and try to convert it to a Roth, you are going to bump against the pro-rata rule.

 

The Pro-Rata Rule

The pro-rata rule is used to determine how much of a distribution is taxable when your IRA has both pre-tax and after-tax (basis) dollars. You take the ratio, and then determine the amount that is taxable.

As a simple example, say you have 6k a basis and 6k of pre-tax in your IRA (as you might if you had a non-deductible IRA one year and deducted your IRA before). If you distribute the money (or do a Roth conversion), you will pay taxes on 6/12 or 50% of the money (as long as you use 8606 to show your basis).

If you have a SEP or a rollover IRA with 600k of pre-tax money and 6k of non-deductible contribution, then only 6/606 or about 1% that escapes taxation.

This is the pro-rata or proportion you have in after-tax vs. pre-tax.

The pro-rata rule is what keeps many people from doing a yearly Backdoor Roth IRA. (It does not prevent you from doing the Mega Backdoor 401k to Roth IRA because this is done in a 401k and not an IRA.)

Another way to think about the Pro-Rata Rule:  cream in the coffee.

 

Cream in the Coffee Maneuver

If you have just a bit of basis (cream) in your large IRA (the coffee), it is all mixed together. You can’t take a sip (a distribution or conversion) without getting both!

How can you get the cream out? After all, the basis grows in your IRA but you owe ordinary taxes on the growth. It would be nice to separate the cream from the coffee so you can Roth convert the basis and get tax-free growth. You can, via the cream in the coffee maneuver.

Sometimes called the “cream in the coffee rule” (but it isn’t really a rule), this is a great way to separate the cream from the coffee. This is how to liberate your after-tax basis from your IRA!

How to Do the Cream in the Coffee Maneuver

With the cream in the coffee maneuver, you take advantage of the fact that you can only roll-over pre-tax money into a 401k. By law, 401k plans will only accept roll-ins of pre-tax money!

Say you have a 401k at work, or a solo 401k from 1099 income. Most of the time (read the summary plan document), 401k plans allow roll-ins because they want your money! They only, however, allow pre-tax money to be rolled in, never after-tax or Roth money.

So, if you have 6k of basis and 6k of pre-tax money in your IRA, you could roll in 6k to your 401k and then do a Roth conversion tax-free with the remaining after-tax money!

Or if you have 600k of pre-tax money from a separate rollover, you could roll that money back into a current 401k to get that messy 6k of basis our of your 8606 and out of your life.

As long as you have a zero pre-tax IRA balance on December 31st (the only time the IRS applies the aggregation rule is on December 31st every year), you have done it! You liberated the basis in your IRA via the cream in the coffee maneuver!

 

Some Caveats to Consider Regarding the Cream in the Coffee Maneuver

Remember, you only have one IRA. It doesn’t matter how many different accounts you have as they are all aggregated in the eyes of the IRS. And it doesn’t include your spouse, as the “I” stands for “individual.”

If you have mixed up basis and pre-tax money, you need to keep form 8606 up to date. Go check your tax return right now if you think you have basis in your IRA.

The IRS only looks once (December 31st) every year to check on your total basis in order to calculate your taxes on any IRA distributions. A Roth conversion is a roll-over, so the same pro-rata rules apply.

Roth IRAs are not subject to the aggregation rule and are not pro-rata. They are always after-tax. It is a little trickier with Roth 401k plans, since employer contributions are always pre-tax, but we won’t go there now.

Finally, also remember you can do a once in a life time HSA roll over (a QHFD) to get rid of a small amount of pre-tax money from your IRA as well. Fun fact.

 

Summary: How to Roth Convert Basis Stuck in Your IRA

Using the Cream in the Coffee Maneuver, you can liberate after-tax (basis) from your IRA and then convert to a Roth tax-free. This allows all subsequent growth of your Roth to be tax free! We love Roth money.

This is important to consider if you want to do a yearly backdoor Roth IRA, or if you have been contributing to your IRA over the years and unable to deduct it.

Simply separate the coffee out by rolling the pre-tax money into a 401k, and then Roth convert the cream.

Did your tax guy not tell you about this? Well, he or she is the one who has been (hopefully) filing your 8606 year after year showing the buildup of basis in your IRA in the first place. Likely they have never heard of the cream in the coffee maneuver.

But now you know, and you can get your December 31st pre-tax IRA balance to zero and avoid the pro-rata rule. The cream in the coffee maneuver scores again!

The cream in the coffee maneuver is how you liberate the after-tax money suck in your IRA.

Posted in Taxes.

5 Comments

  1. Great article! What if one doesn’t have a 401K, but rather a 403b? Is it possible to roll over the after-tax basis of traditional IRA contribution into a Roth directly? Or wait until a lower income yearly and convert pre- and after-tax traditional IRA into Roth? Thanks.

    • Most 403b plans will accept roll ins, but check the plan documents. Once you have the pre-tax part of the IRA into an employer plan, you can convert the after-tax basis to Roth. A conversion is a roll over.

      Or you can wait until you are doing Roth conversions, but then you have that 8606 to track you basis while you are doing partial Roth conversions!

      Thanks for reading!

  2. Since I am retired now & do not have access to a 401k, what can I do to separate the 2-3 % after Tax IRA Contribution rather than repeated calculating & completing Form 8606 . ??

    Can I transfer the post tax monies a into a IRA at a different Broker,?

    Is this Kosher with IRS ?

    Thankyou for your opinion & help.

    • You are out of luck. You need an employer plan. Remember all IRAs are just one IRA according to the IRS!

  3. Great summary. We actually found ourselves in this predicament a couple years ago, where we only had after-tax dollars in our IRAs, but my husband then rolled a 401k from his old employer into the plan, thus mucking it all up! It was before we really understood the pro rata rules.

    Unfortunately his 401k plan did not allow roll ins from IRAs (only other 401ks), so we were unable to use this maneuver to remedy the situation. I left mine with my employer so have “black coffee.”

    If I were to add anything to this, I’d recommend people hold off on rolling over old 401k plans to an IRA if they have or will ever have after-tax money in the plan. Either roll it into your new 401k or leave it with the old. Also, I would remind people that you will still pay taxes on any gains when you do a Roth conversion. We converted some money last year. My coffee was all black, but I still I still paid taxes on about 40% of it because of the gains.

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