Non Deductible Traditional IRA vs Roth IRA

[BrianOB]

So I've been reading another vitriolic and extremely long thread here arguing the benefits of Traditional vs Roth IRAs and I'm very confused. Without wanting to start any more fights, I'm hoping that my situation is simple enough and that someone can explain it to me. Here's the summary:

The good news is that my wife just started in a much higher paying job and we rolled her money out of a criminally bad 401K (The Hartford) into a Vanguard account.

The bad news is that my wife still only has access to a crappy 401K plan (Valic) at work. We plan to max this (Traditional) 401K out using the cheapest bond fund available in the anticipation of rolling it over to Vanguard in a few years as well.

The part I may have stuffed up: When she rolled over her 401K into a rollover IRA, I told her to additionally open a Taxable account and another Traditional IRA (TIRA) at Vanguard. We maxed out the latter TIRA account too. I figured we wouldn't qualify for a Roth IRA (RIRA) due to the MAGI limits (>$169K?). Also, we're already in the top bracket so our tax rate probably isn't getting much higher at retirement.

Federal Tax Bracket: 35%, No State Tax
Age: 35/35

Here are my questions:

(1) According to the BH wiki it looks like the Traditional IRA will be non-deductible due to the MAGI limits. The comparison table (for stocks) makes taxable investing look more favourable but we want to use it to hold exclusively Bonds (in which we are underweight). Is this a reasonable strategy?

http://www.bogleheads.org/wiki/Non-dedu ... tional_IRA

(2) I didn't realise that anyone at any income level can convert a Traditional IRA to a Roth account now - should we? We don't plan to touch it before 59.5, plan to be retired by then and we also don't plan to leave anything behind (no heirs). We're also already in the top tax bracket so I don't see our tax bracket rising.

(3) Are these the same thing? If we convert it can we still contribute to it (post-tax) even though we exceed the income tax limits or is it just something you have to do every year? i.e. create a new TIRA, convert it to RIRA.

http://www.bogleheads.org/wiki/Backdoor_Roth_IRA
http://www.bogleheads.org/wiki/Roth_IRA_conversion

(4) If it's an entirely non-deductible Traditional IRA then are the withdrawals tax free, same as the Roth IRA?

https://personal.vanguard.com/us/whatwe ... a/whichira

(5) In short - Is a non-deductible Traditional IRA a sensible thing to own in our position?

Thanks for your time,

[chipmonk]

(3) Are these the same thing? If we convert it can we still contribute to it (post-tax) even though we exceed the income tax limits or is it just something you have to do every year? i.e. create a new TIRA, convert it to RIRA.

http://www.bogleheads.org/wiki/Backdoor_Roth_IRA
http://www.bogleheads.org/wiki/Roth_IRA_conversion

I would say that Backdoor Roth IRA refers to the ongoing practice of funding a Roth IRA via the mechanism of Roth IRA conversion.

To fund a Backdoor Roth IRA, you make non-deductible contributions to the TIRA every year, and then convert them to Roth shortly afterwards (paying tax only on the very small gains incurred between contributing and converting). In this way, it is pretty much equivalent to just contributing to a Roth IRA in the first place.

There are complications if you have other non-Roth IRAs... read the wiki.

[retiredjg]

(1) According to the BH wiki it looks like the Traditional IRA will be non-deductible due to the MAGI limits. The comparison table (for stocks) makes taxable investing look more favourable but we want to use it to hold exclusively Bonds (in which we are underweight). Is this a reasonable strategy?

It is a reasonable strategy and it was regularly suggested here a few years ago. However, there is some current thinking that using muni bonds (tax-exempt bonds) in your taxable account may be a better idea at the present time. Muni bonds are simply paying more than taxable bonds, even before taxes on the taxable bonds. This will not always be true, but it seems like a pretty good bet right now.

Another strategy is to use I Bonds in taxable, but you can only buy a limited amount per year.

(2) I didn't realise that anyone at any income level can convert a Traditional IRA to a Roth account now - should we? We don't plan to touch it before 59.5, plan to be retired by then and we also don't plan to leave anything behind (no heirs). We're also already in the top tax bracket so I don't see our tax bracket rising.

No, you should not convert at your present rate. There is no reason to pay 39.6% federal now when you could pay considerably less later if you do conversions when you are in a lower tax bracket. Or don't do conversions at all and simply pull from your traditional IRA/401k at a lower rate.

(3) Are these the same thing? If we convert it can we still contribute to it (post-tax) even though we exceed the income tax limits or is it just something you have to do every year? i.e. create a new TIRA, convert it to RIRA.

I'm not sure what this question means. Are what the same thing?

(4) If it's an entirely non-deductible Traditional IRA then are the withdrawals tax free, same as the Roth IRA?

Yes, but the only way it would be entirely non-deductible is if there are no earnings. The IRS considers all of a person's traditional IRAs to be one IRA. You don't get to have one that is non-deductible and another that is not. For example, your wife's rollover IRA is (presumably) all deductible. If that is 90% of her tIRA and she has another that is all non-deductible that makes up the other 10%, her ONE IRA is 90% untaxed and 10% taxed.

(5) In short - Is a non-deductible Traditional IRA a sensible thing to own in our position?

Don't know. And the answer might be different for you and for your spouse. You might be a good candidate for back door Roth, but she obviously is not.

If you are nearing retirement and if you foresee a few years when you will be in a low tax bracket (no pension, delaying SS, living mostly on return of already taxed money from a taxable account), that could give you some years to systematically convert tIRA to Roth IRA at a low tax rate.

Knowing more about your specific situation might be helpful. It would be good to have some Roth assets, but I would not be converting to Roth at your tax rate.

[BrianOB]

Thank you both for the replies.

Chipmonk: That helps me a lot. Everywhere I've looked people seem to have a strong pro-Roth-IRA bias, and an anti-non-deductible Trad IRA bias and there are a mountain of articles and comments urging people to convert and I wasn't sure whether the Roth IRA Conversion and Backdoor Roth Conversion were the same mechanism.

So is the Backdoor Roth contribution just an extra administrative step where you contribute to the IRA then a day later move the money to your Roth account, then pay taxes? That kind of seems.... laborious and bureaucratically illogical. Why create an income contribution limit for one type of account then allow people to circumvent it with a few mouse clicks? Why can't we just skip the mouse clicks? (I guess that's rhetorical)

retiredjg: Thanks for the clear answers. As I mentioned above I was spooked a bit by the Pro-Roth sentiment I ran into and I was worried I stuffed something up (I still might have). We're 35 and we want to semi-retire at 45. No pension, and no expectation of SS.

When you say the IRS treats all your traditional IRAs as one fund does that mean that her Rollover 401k Fund will need to be added to her ND TIRA contributions then divided again into deductible & non-deductible portions? Even though the monies there were entirely contributed pre-tax? They aren't treated as separate accounts with different properties?

Thanks again for your time.

[travellight]

I am no expert on this and spent many months trying to learn about it here.

This is my understanding:

A Roth conversion (A) and a back door ROTH (B) are two different things. A makes no sense for you being in the top tax bracket. B does make sense, imo. B involves several steps and is more complex. You have to isolate the basis in your current tIRA. You do this by calculating all your contributions and taking the gains (money made from your contributions) and transfer them to a 401K, thereby isolating only the basis in your tIRA. You can then transfer that to a ROTH IRA and not pay any taxes on the transfer because it is all already taxed money. That is the back door ROTH as I understand it. It is a huge benefit because you grow your money tax free and withdraw it tax free. It is my hope to be in the top tax bracket in my retirement for the rest of my life so a ROTH is a great benefit.

Hope this helps.

[retiredjg]

There is a pro-Roth sentiment and some of it is based on misinformation and misunderstanding. You are wise to question it. But this does not mean that having some money in Roth by or in retirement is a bad idea. Having some Roth is a good idea, but when and how you get it depends on what you have to pay for it. Paying 35% is not a good choice if you have another choice.

Here's an example to answer your question.

Joe's IRA #1 is $2,000 all deductible contributions (not yet taxed)

Joe's IRA #2 is $1,000 all non-deductible contributions (already taxed)

The IRS sees this as one $3,000 IRA, 1/3rd of which has been taxed. If you take out $1000 (or convert $1000 to Roth) you will pay tax on two-thirds ($667) and not pay tax on one third ($333). It does not matter which account that $1000 comes out of - the tax would be the same.

Since your wife has a rollover IRA, the money in the rollover IRA would be pro-rated (as above) with any other traditional IRA, SIMPLE IRA, or SEP IRA that she might have. So she is not a good candidate for back door contributions to Roth IRA. Similarly, conversion of Roth IRA is a bad idea for her while you are in the 35% tax bracket.

When/if you semi-retire without pension or SS, you may fall into a very low tax bracket - that's the time for her to do some conversions. Do some each year (up to the top of the 15% tax bracket is a common suggestion) so that when she reaches RMD age, there won't be a huge amount she has to take out each year.

About conversion and back door.... A conversion of traditional IRA is just that - changing money from one to the other by paying taxes at your current tax rate. The back door is 2 steps: contribute to tIRA, convert to Roth IRA. So the back door contains a conversion but is not exactly the same as a conversion. And it does not work well if there are other IRAs "in the way" (that have to be pro-rated).

Your wife could become a good candidate for back door contributions to Roth IRA if she can move all her deductible rollover IRA and other tIRA money into a 401k or 403b plan. But if she has a SIMPLE or SEP IRA....it's a no-go unless you can fine a place to put them as well. However, since her current 401k sucks, you probably don't want to do this. It is probably not worth it.

At this point, I have no idea if you are a good candidate for back door contributions to Roth IRA. What kind of accounts are in your name?

[BrianOB]

Travellight, Retiredjg thank you for your time.

I think it seems more clear to me now that it's not as simple as RIRA = Better. It looks like the timing of your Roth contributions is important.

I do not have any IRA accounts in my name and no 401K.

[livesoft]

I do not believe a non-deductible IRA is worth it for you even if you only put bond funds in the IRA. For it to be worth it, you need to convert it to Roth IRA at a lower tax rate, but that is not going to happen due to the rollover IRA.

If you need more bond assets than you can fit in your tax-advantaged accounts, then a tax-exempt muni bond fund is for you. I think you would be better off in a tax-exempt muni bond fund in a taxable account than you would putting that money in a non-deductible IRA.

FWIW, my spouse had a 401(k) at Hartford (blech!) and was able to roll it over to an IRA. We will not be doing any conversions to Roth IRA until we are in a low tax bracket. We will be in a low tax bracket when we retire early and before drawing SS benefits. During those years we will live off the money in our taxable accounts (remember those muni tax-exempt bond funds I mentioned above plus tax-efficient equity funds) while doing Roth conversions piecemeal on the side. The money withdrawn from our taxable accounts should be virtually tax-free.

[retiredjg]

I do not have any IRA accounts in my name and no 401K.

This means you (individually) can make contributions to Roth IRA.

For this purpose of IRA/Roth IRA, you and your wife are separate. What applies to her might not apply to you.

In the 35% tax bracket, neither of you can contribute directly to Roth IRA (you make too much money). She is not a good candidate for "back door" contributions to Roth IRA because of that rollover IRA. You, on the other hand, are a good candidate for the back door contributions to Roth IRA because you don't have any IRAs (traditional IRA, SIMPLE IRA, or SEP IRA) in your name.

http://thefinancebuff.com/the-backdoor- ... ow-to.html

[BrianOB]

I do not believe a non-deductible IRA is worth it for you even if you only put bond funds in the IRA. For it to be worth it, you need to convert it to Roth IRA at a lower tax rate, but that is not going to happen due to the rollover IRA.

If you need more bond assets than you can fit in your tax-advantaged accounts, then a tax-exempt muni bond fund is for you. I think you would be better off in a tax-exempt muni bond fund in a taxable account than you would putting that money in a non-deductible IRA.

FWIW, my spouse had a 401(k) at Hartford (blech!) and was able to roll it over to an IRA. We will not be doing any conversions to Roth IRA until we are in a low tax bracket. We will be in a low tax bracket when we retire early and before drawing SS benefits. During those years we will live off the money in our taxable accounts (remember those muni tax-exempt bond funds I mentioned above plus tax-efficient equity funds) while doing Roth conversions piecemeal on the side. The money withdrawn from our taxable accounts should be virtually tax-free.

Hi livesoft, thank you for the reply. So you would prefer to direct future funds towards our taxable account. Is it acceptable to hang onto the NDIRA until we are at an age/income where the Roth conversion makes sense? i.e. the account already exists. Is there cost to keeping it there?

I have some other questions about her new 401K but I might make a new post for it.

[Alan S.]

If you already have a basis in your TIRA as documented on Form 8606, there are only 3 ways to eliminate it:
1) With RMDs and other distributions over your entire remaining lifetime that drains the accounts while you are still alive
2) Converting the entire balance and paying taxes pro rate to eliminate your basis before you otherwise would under 1) above
3) Rolling your pre tax amount over to an accepting employer plan leaving behind only the 8606 recorded basis, which you then convert tax free.

3) is the only action you can take to eliminate the basis quickly and without current taxes. If you are not in a position to do this, you are stuck with the basis for quite awhile, and just live with it. If you don't make new contributions that add to basis or take distributions, there is no added work or reporting in any of those years or added costs, except possibly low balance IRA administration fees.

[HonoluluGator]

If you already have a basis in your TIRA as documented on Form 8606, there are only 3 ways to eliminate it:
1) With RMDs and other distributions over your entire remaining lifetime that drains the accounts while you are still alive
2) Converting the entire balance and paying taxes pro rate to eliminate your basis before you otherwise would under 1) above
3) Rolling your pre tax amount over to an accepting employer plan leaving behind only the 8606 recorded basis, which you then convert tax free.

3) is the only action you can take to eliminate the basis quickly and without current taxes. If you are not in a position to do this, you are stuck with the basis for quite awhile, and just live with it. If you don't make new contributions that add to basis or take distributions, there is no added work or reporting in any of those years or added costs, except possibly low balance IRA administration fees.

#3 is an attractive option for me (mix of pre-tax dollars and post-tax dollars in tIRA, as well as Roth IRA.) But how do you determine which money in your tIRA is the pre-tax and which is the post-tax dollars? Can you just transfer all money except the 8606 recorded basis, regardless of investments/returns, or do you need to figure out which money is invested where, what the returns are, etc?

[retiredjg]

The post tax money is the number on Form 8606. It does not refer to any particular shares. The pre-tax money is everything else. Again, it does not refer to any particular shares.

If you do it all in the same calendar year, the order does not matter. You can convert the basis (the number on the 8606) to Roth and then send the rest to your 401k/403b (if they will accept it). This is cleaner than the reverse order because you convert the basis to the exact penny. However, if something delays sending the other money to the 401k/403b and that money is in tIRA on December 31, it gets prorated in with the Roth conversion.

Or you can do your original thought - leave the money in tIRA until you can convert at a lower tax rate. Doing this, however, would prevent that person from doing back door contributions to Roth IRA each year.

[johnnysk]

@livesoft »
"FWIW, my spouse had a 401(k) at Hartford (blech!) and was able to roll it over to an IRA. We will not be doing any conversions to Roth IRA until we are in a low tax bracket. We will be in a low tax bracket when we retire early and before drawing SS benefits. During those years we will live off the money in our taxable accounts (remember those muni tax-exempt bond funds I mentioned above plus tax-efficient equity funds) while doing Roth conversions piecemeal on the side. The money withdrawn from our taxable accounts should be virtually tax-free."

Please excuse my ignorance, but what exactly do you mean by tax efficient equity funds?

[retiredjg]

He means stock mutual funds that are tax-efficient (don't cause you to pay extra taxes). Broad based index funds such as a total international index or a total stock market index are the ones most favored around here. Sometimes people use tax-managed mutual funds as well.

Things to avoid in your taxable account would be actively managed stock mutual funds. That's because of the buying and selling that goes on as the fund is "managed" for best return. This buying and selling can cause you to pay taxes on capital gains (result of buying and selling) even though you have not sold any of the fund yourself.

Another thing to avoid are funds (stock or bond) that pay a lot of dividends - the dividends are taxed each year, even if you reinvest them.