Backdoor Roth confusion

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Backdoor Roth confusion

Postby Rexindex » Fri Nov 09, 2012 6:00 pm

I am confused about the Backdoor Roth.

Below are the facts pertaining to our situation and then our questions. We are grateful in advance for the help!

* spouse and I each have some money in individual Roths
* both of us have most of our funds in traditional Ira's
* our agi this year will be $200k
* spouse maxes 401k, I am Ineligible this year

Questions:

Can one or both of us make a $5k traditional Ira contribution, then immediately convert to a Roth?

If we are (or one of us) eligible, is there anything to pay tax on other than the $5k or $10k conversion?

Is there any tax liability on the pre existing traditional ira's?

Does it make sense to do this if we have the funds assuming we have figured out the tax now versus upon retirement question?
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Re: Backdoor Roth confusion

Postby JamesSFO » Fri Nov 09, 2012 6:17 pm

I think the key line is "both of us have most of our funds in traditional IRAs". The tax on the conversion will be apportioned across all of your IRAs.

So the "perfect" backdoor roth where you have no IRA is $5K to IRA then convert $5K and so no taxes are due.

But if you have existing IRA 1 with $100K balance/all of which was previously deducted then you try to roll over $5K additional to Roth, taxes will be on the $5K/$105K or $4.2K of gains rather than 0.

Best

EDIT: I may have my math wrong above but the point stands which is you will pay a proportionate amount of gains in ALL of your IRAs
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Re: Backdoor Roth confusion

Postby YDNAL » Fri Nov 09, 2012 7:16 pm

Rexindex wrote:* both of us have most of our funds in traditional Ira's

If you contribute to a NON-deductible IRA with intention to immediately convert to Roth IRA, this contribution is combined with all IRAs. When you say "most of our funds in Traditional IRAs" it says that the conversion would be treated as if it is significantly coming from Trad IRAs.
Landy
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Re: Backdoor Roth confusion

Postby Rexindex » Fri Nov 09, 2012 7:21 pm

YDNAL wrote:
Rexindex wrote:* both of us have most of our funds in traditional Ira's

If you contribute to a NON-deductible IRA with intention to immediately convert to Roth IRA, this contribution is combined with all IRAs.
When you say "most of our funds in Traditional IRAs" it says that the conversion would be treated as if it is significantly coming from Trad IRAs.



That is correct. I am still a little confused and cant seem to find the answers on a site. So if we have $200k in traditionals accumulated over the years, but this year contribute $5k to a traditional, then convert it to a Roth, I am converting the first $5k of all my traditional IRA's? :?
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Re: Backdoor Roth confusion

Postby Alan S. » Fri Nov 09, 2012 7:34 pm

The conversion taxation is separate for each spouse. If you each have a pre tax TIRA balance of 100k, make a 5k non deductible contribution and convert 5k, the taxable amount will be 4,760.
If you each have 200k, the taxable amount would be 4,880.

The pro rated ratio is calculated on Form 8606, which you also use to report the non deductible contributions and the conversion.
You are not limited to a conversion of 5k, only the contribution is limited. You can convert the amount that benefits you.

You are NOT converting the first 5k in your TIRA. The pro rate rules are often viewed as a "Cream in the coffee" situation. Once you make a 5k non deductible contribution (cream) it is permanently mixed with the coffee (the pre tax balance). Anything removed from the coffee is therefore a mixture of both pro rated per Form 8606.

Finally, note that if you each can roll your pre tax TIRA balance into your 401k plans (when you are eligible) you would leave the 5k of basis behind. You could then convert that 5k tax free and in later years keep making the 5k non deductible contribution and converting it tax free. Effectively, you have made a Roth IRA contribution by doing this.

There is a separate 8606 for each spouse and therefore each spouse will have their own pro rate factor. An 8606 only holds one SSN.
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Re: Backdoor Roth confusion

Postby Rexindex » Fri Nov 09, 2012 7:42 pm

thanks for the explanation!
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Re: Backdoor Roth confusion

Postby DSInvestor » Fri Nov 09, 2012 7:42 pm

Here's a link to IRS Form 8606. Follow lines 1-15 to see how it works.
http://www.irs.gov/pub/irs-pdf/f8606.pdf

I like Alan's cream in the coffee explanation.
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Re: Backdoor Roth confusion

Postby YDNAL » Fri Nov 09, 2012 7:46 pm

Rexindex wrote:
YDNAL wrote:
Rexindex wrote:* both of us have most of our funds in traditional Ira's

If you contribute to a NON-deductible IRA with intention to immediately convert to Roth IRA, this contribution is combined with all IRAs. When you say "most of our funds in Traditional IRAs" it says that the conversion would be treated as if it is significantly coming from Trad IRAs.

That is correct. I am still a little confused and cant seem to find the answers on a site. So if we have $200k in traditionals accumulated over the years, but this year contribute $5k to a traditional, then convert it to a Roth, I am converting the first $5k of all my traditional IRA's? :?

If you have pre-tax Traditional IRAs of $200K and $5K post-tax Non-deductible IRA, you have $205K in "IRAs." So a $5K conversion to a Roth IRA is 97.6% taxable (200/205).
Landy
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Re: Backdoor Roth confusion

Postby DSInvestor » Fri Nov 09, 2012 8:25 pm

Since the IRA basis was not fully consumed by your 5K partial conversion, the remaining basis will carry forward to the next year's 8606 form.

So if you contributed 5K non-deductible (IRA basis) this year and used $122 basis in the conversion, 4888 of remaining basis will carry forward to next year. Make sure that is tracked in form 8606.

IMO, the backdoor into Roth IRA is best when there aren't any pre-tax assets or there is a way to rollover the pretax assets to a 401k plan that form 8606 can't see. This way, you add 5K basis and consume 5K basis on the conversion and pay no conversion tax. You end every year with zero basis so it keeps it simple.

If your Traditional IRAs are purely pre-tax and you can't rollover to a 401k it may be better to contribute 5K to taxable account instead. This keeps your IRAs purely pretax which makes it much easier when you withdraw, convert or when your IRA beneficiaries withdraw. You will know that every dollar withdrawn is taxable. No worries about prorating or tracking basis in the IRAs.
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