Convert Traditional IRA to Roth IRA?

[tainted-meat]

Hello and thank you for your help.

I have a few things going on here so I will describe them the best I can. I have contributed $5000 to a deductible Traditional IRA for years 2011 and 2012 for a total of $10,000 in contributions. The total value of the Traditional IRA is now $11,564.98. I also have an after-tax 401k that I am planning to roll over to a tIRA then convert to an rIRA as well in order to take advantage of tax-free growth. I'm 26y/o

Here is the After-Tax 401k Breakout
Non-Taxable Amount $3,935.41
Taxable Amount $1,350.88

I will gross $70,000 this year but my AGI will be much lower as I have maxed my 401k ($17,000) and HSA ($3,100) contributions. I am filing single but will be married next year. She will make a little over $60,000 next year and we will file MFJ.

My thoughts are to convert the the Traditional IRA amount of $11,564.98 to a Roth IRA. Then, roll the total after-tax (taxable and non-taxable) amounts and convert that to a Roth IRA as well.

Living in Kentucky, I believe I am eligible for the Backdoor Both as well where I can deduct the state tax on the conversion.

Is 25% too high of a tax bracket to convert?

[Bob's not my name]

Living in Kentucky, I believe I am eligible for the Backdoor Both as well where I can deduct the state tax on the conversion.

This isn't precisely correct. You don't get a state tax deduction on the conversion. Your state does not count the conversion as taxable income.

I'm not sure it's really worth converting in the 25% federal bracket, even if there's no state tax. But the total amount is less than $17,000, of which $13,000 will be taxed by the federal government, for a total tax of around $3,200. So the average total tax rate on the entire conversion is under 20%.

Here's a complication: won't the conversion increase your AGI such that your 2012 traditional IRA contribution is no longer deductible against federal and KY taxes? The federal tax would be a wash, but you would lose the Backdoor Both state tax savings.

[tainted-meat]

Hi Bob. Thanks for the reply!

If I am understanding what you're saying correctly, if the TIRA is non-deductible and I try a Backdoor Both, that I will no longer be able to deduct the state tax.
Is the State Tax deductible only if the contributions to the TIRA are deductible for Federal Tax purposes? If so, I definitely do not want to convert. Thank you for your insight on this.

I've read a ton of your posts on this subject and really appreciate the research and insight you have provided!

[Bob's not my name]

I'm not a KY taxpayer, so check your KY tax return on this, but my review of the KY instructions indicates KY, like most states, starts with Federal AGI and makes adjustments. If your TIRA contribution is not deductible under Federal rules, it will not reduce your Federal AGI, so it likewise will not reduce your KY taxable income.

The Backdoor Both is made possible by (1) using a TIRA contribution to reduce your Federal AGI and hence your KY taxable income and (2) immediately converting the TIRA to a Roth, which is a wash for Federal purposes but you get to subtract the conversion from your KY income per the Instructions for Line 11, Schedule M:

The 2012 exclusion amount is 100 percent of taxable retirement benefits or $41,110, whichever is less. All pension and retirement income paid under a written retirement plan (qualified or unqualified) is eligible for exclusion. This includes … income received from converting a regular IRA to a Roth IRA.

This may seem a little confusing, so maybe this summary helps. NOTE: this summary assumes you have only pre-tax TIRAs, not the case for you.

Eligible for deductible TIRA:
Contribute $5,000 to TIRA --> reduce your Federal AGI and your KY taxable income by $5,000
Convert TIRA to Roth --> increase your Federal AGI by $5,000 but NOT your KY taxable income -- it remains $5,000 lower, saving you $300 in state taxes

Ineligible for deductible TIRA:
Contribute $5,000 to TIRA --> no change to Federal AGI or KY taxable income
Convert TIRA to Roth --> no change to Federal AGI or KY taxable income

You may still be able to convert a portion (about half, I think) of your TIRA total without putting your MAGI over $58,000 and impacting the Backdoor Both. For example, if your MAGI were going to be $53,000 with no conversions, and if (for simplicity) your combined TIRAs were 50% pre-tax and 50% post-tax, then converting $10,000 of TIRA to Roth would increase your MAGI to $58,000, still under the TIRA deduction phaseout.

So, let's modify the above for this illustrative situation with mixed TIRAs:

Eligible for deductible TIRA:
Contribute $5,000 to TIRA --> reduce your Federal AGI and your KY taxable income by $5,000
Convert $10,000 of 50/50 TIRA to Roth --> increase your Federal AGI by $5,000 but NOT your KY taxable income -- it remains $5,000 lower, saving you $300 in state taxes

Check me on all of this, since I'm just some guy on the internet.

[tainted-meat]

Hi Bob.

Thanks for the detailed reply and I understand what you are saying now. I really appreciate it! I am going to leave it in a TIRA as the tax hit may be large on a portion of the conversion (25% + 6%). Thank you again!

[sscritic]

I have contributed $5000 to a deductible Traditional IRA for years 2011 and 2012 for a total of $10,000 in contributions.

How do you know? You haven't filed your 2012 taxes yet. It's not the IRA that is deductible, it's the contribution. And even if the contribution is deductible, you don't have to deduct it.

This is the most you can deduct. Add the amounts on lines 12a and 12b and enter the total on Form 1040, line 32. Or, if you want, you can deduct a smaller amount and treat the rest as a nondeductible contribution (see Form 8606) . . . . . . . . . .

IRA Deduction Worksheet—Line 32, 1040 instructions.

[tainted-meat]

I have contributed $5000 to a deductible Traditional IRA for years 2011 and 2012 for a total of $10,000 in contributions.

How do you know? You haven't filed your 2012 taxes yet. It's not the IRA that is deductible, it's the contribution. And even if the contribution is deductible, you don't have to deduct it.

This is the most you can deduct. Add the amounts on lines 12a and 12b and enter the total on Form 1040, line 32. Or, if you want, you can deduct a smaller amount and treat the rest as a nondeductible contribution (see Form 8606) . . . . . . . . . .

IRA Deduction Worksheet—Line 32, 1040 instructions.

Thanks for the reply! The contributipon shuld be deductible if I subtract (17,000 401k and the 3100 HSA) contribution. Correct? Would there be a reason to not deduct a TIRA?

[Bob's not my name]

Yes, it looks like your MAGI will be around $50,000, which is safely under the $58,000 phaseout threshold.

[tainted-meat]

Thanks Bob

[retiredjg]

I also have an after-tax 401k that I am planning to roll over to a tIRA then convert to an rIRA as well in order to take advantage of tax-free growth.

It is not necessary to roll the after-tax 401k money into a tIRA and the convert to Roth IRA. If you do that, it brings the $11K+ money into the calculations (the tIRA would have to be pro-rated with your 401k after tax money).

Instead, you can have the after-tax 401k money rolled directly into Roth IRA. This avoids having to pro-rate your $11k IRA in with the pre-tax 401k money. You will still pay the taxes on the $1,350 earnings. But after that, if you do your rollovers more often, maybe there will be less earnings to pay tax on.

Is 25% too high of a tax bracket to convert?

I would tend to avoid conversions in the 25% bracket myself. I don't think anybody knows if this will be a good idea or a bad idea (tax law changes and all), but it seems to me there is at least a possibility to pay less than 25% at some other time.

[tainted-meat]

Thanks Retiredjg. I am going to have it cut me a check when we get into the New Year and roll it over. Unfortunately, the 401k plan won't do a direct rollover


Cheers!

[retiredjg]

Thanks Retiredjg. I am going to have it cut me a check when we get into the New Year and roll it over. Unfortunately, the 401k plan won't do a direct rollover

Seems to me that you still don't have to go through tIRA. Just send the money from the check (and the "make up" for the taxes withheld) directly to Roth IRA.

If you go through tIRA, it becomes a conversion and conversion rules apply. If you send the money directly to Roth IRA, it's not a conversion. Unless I'm confused.

[tainted-meat]

Hi retiredjg. You are correct, I'll roll it into a Roth as soon as the check gets here.

[Default User BR]

Thanks Retiredjg. I am going to have it cut me a check when we get into the New Year and roll it over. Unfortunately, the 401k plan won't do a direct rollover

Are you sure? Direct rollovers can be done with a check sent to you. What happens is that the check is made out to the receiving institution with a for-benefit-of designation with your name. It's very unusual for a qualified plan not to offer direct rollovers even if (like MyMegaCorp) they insist on sending the check to the account holder.


Brian

[tainted-meat]

Thats a good idea Brian. I'll call them to see if they will do that. I work for a large company as well so I don't see why they wouldn't do it. Thanks for the suggestion!

[retiredjg]

That would solve the problem of needing to make up the part withheld for taxes - they don't have to do that if they send a check made out to the next custodian instead of making the check out to you.