Does a rollover IRA impact your basis for converting a traditional to Roth?

Question

In the United States, does having a rollover IRA impact your basis for converting a traditional to Roth? I ask because I have a 401(k) with a former employer than I could rollover to an IRA and get some free money as incentive from the custodian for the transfer, however, I'm concerned that this would impact my ability to contribute each year to a traditional IRA as a non-deductible contribution with 100% basis and then turn around and convert to Roth and avoid the income limitation on contributing to a Roth and pay no taxes on the conversion. When you convert to Roth, the portion of all your IRAs that are converted as well as your total basis of non-deductible contributions are considered and the ratio of total IRA balances converted determines how much of your deductible non-basis is applied as income. Without the rollover, my deductible basis is 100%.

My question is whether the traditional IRA is segregated for this basis calculation or would I lose or water down this benefit if I converted by 401(k) with deductible contributions to a rollover IRA?

Answer 1

There is no segregation of amounts that you have in Rollover (Traditional) IRAs when it comes to figuring out how much of your basis is being converted from your Traditional IRA into a Roth IRA. So, yes, you will lose the benefit of being able to make nondeductible contributions to your Traditional IRA each year and rolling them over into a Roth IRA without tax consequences. Since your 401k amount may be substantially more than the $5K basis you create each year, converting the 401k amount into a Traditional IRA will mean that most of the money converted to the Roth IRA is pre-tax money, and so you end up paying tax on most of the converted amount.