Backdoor Roth confusion

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ifish100
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Backdoor Roth confusion

Post by ifish100 » Fri Sep 04, 2015 8:28 pm

I received some confusing advice today, I would like to see if some fellow Bogleheads could help, as I am sure some other people have done this before.

My income level is beyond being able to contribute each year to a Roth IRA. As such I was going to try to set up a backdoor Roth strategy. After reading several articles in Forbes, speaking with some people at Vanguard and Fidelity, I thought I had a plan. However after a conversation with an advisor at Vanguard today I think my plan was incorrect.

My initial plan. I have about $162K in a Traditional IRA. Of this $162K, 31% is contributions that were non-deductible, i.e. I did not get a tax deduction when I put the money in. The balance (69%) is deductible contributions and growth. My plan was to move the 31% into a Roth IRA I have, and put the 69% into a Roll-in in my 401K plan at work. I checked with the plan administrator and they said a roll in was allowable in my work 401K plan. The 69% I would owe taxes on when I start withdrawing money from my 401K in retirement, years from now. It seemed like a great plan... no taxes today, shelter the 31% in the Roth and it's future earnings from taxes, the 69% would just be added into my taxable 401K plan at work. Once this is liquidated then I could employ the back door Roth strategy of putting money into the Traditional IRA and doing a conversion the next day to Roth for every year going forward.

Then I called Vanguard and the advisor there told me I could not do it like that. He said I could not split off the 31% and 69%, instead I would have to take all of it, and pay the taxes now on the 69%. That sounds like a traditional Roth conversion to me. I thought I could roll the 69% into the 401K at work and not have to pay taxes on it now, but he said that was not right. I thought I could execute the plan and not have any tax burden to pay today.

It sounded like my best strategy based on his advice today, is just leave it alone, then when I retire, make a real lean year of income and convert the whole thing at once to Roth, I could likely avoid paying much in taxes on it.

The advisor did mention that going forward I could simply set up a second Traditional IRA, contribute to that account, then put it into a Roth conversion the day after I put it into the Traditional. Thereby I could in essence put into a Roth every year. If that is possible to do I do not understand why that advice is not given to every high income earner, because the only choice is a Traditional IRA and the high income earner cannot deduct any of it anyway.

I am either real glad I talked to the advisor today (or I would have made quite the little tax goof, like owing 38% of that 69% in taxes for 2015), or I am suspicious if he is right based on the other 3 or 4 people I have talked to about my initial plan. I am not sure which is correct. I am also puzzled that one can simply open a second Traditional IRA while that first Tradional one is sitting there, I thought it had to be liquidated first, then the backdoor Roth could be implemented.

Thanks for your input.

Alan S.
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Re: Backdoor Roth confusion

Post by Alan S. » Fri Sep 04, 2015 8:38 pm

The advisor is incorrect. There is a "special rule" exception to the pro rate rules when you are rolling IRA funds into a qualified plan. Since the qualified plan CANNOT accept your after tax IRA dollars (basis), the special rule states that funds rolled into your qualified plan are composed FIRST of the pre tax IRA dollars. The advisor apparently is not aware of this rule.

You were therefore correct in the first place. As long as you roll the pre tax balance of all your owned IRA accounts into your qualified plan before the end of the year you are doing the back door Roth, the back door Roth conversion will be tax free providing you do it before any earnings are generated on your after tax contribution.

Further, the advisor is incorrect on his second point as well. You cannot isolate your IRA basis to a single IRA account. All your owned TIRA accounts are considered to be one combined account.

LateStarter1975
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Re: Backdoor Roth confusion

Post by LateStarter1975 » Fri Sep 04, 2015 9:19 pm

Alan S. wrote:The advisor is incorrect. There is a "special rule" exception to the pro rate rules when you are rolling IRA funds into a qualified plan. Since the qualified plan CANNOT accept your after tax IRA dollars (basis), the special rule states that funds rolled into your qualified plan are composed FIRST of the pre tax IRA dollars. The advisor apparently is not aware of this rule.

You were therefore correct in the first place. As long as you roll the pre tax balance of all your owned IRA accounts into your qualified plan before the end of the year you are doing the back door Roth, the back door Roth conversion will be tax free providing you do it before any earnings are generated on your after tax contribution.

Further, the advisor is incorrect on his second point as well. You cannot isolate your IRA basis to a single IRA account. All your owned TIRA accounts are considered to be one combined account.
This is my understanding too. The advisor was incorrect
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tfb
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Re: Backdoor Roth confusion

Post by tfb » Sat Sep 05, 2015 2:56 pm

ifish100 wrote:Then I called Vanguard and the advisor there told me I could not do it like that.
Is he really an advisor or just a customer service rep? Don't ask for tax advice from a customer service rep.
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ThisTimeItsDifferent
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Re: Backdoor Roth confusion

Post by ThisTimeItsDifferent » Sat Sep 05, 2015 3:37 pm

Please escalate this with Vanguard to correct the "adviser's" error so s/he does not repeat it.

Although I am a huge, huge fan of Vanguard, one of their advisers made an error with me that cost me money.

When I converted a non-deductible TIRA to a Roth, I specifically asked for a separate Roth account so I could isolate its basis in the event of a recharacterization, and I told them why and they said it would be a separate account.
They only created a sub-account which was not isolated.

When I subsequently recharacterized, I saw a transfer from a pre-existing Roth to a TIRA, and for 2 years of calls and emails when I told them there should be no pro-rata rule since they were separate accounts, they kept just saying "the math is really difficult," never saying that it was not a separate account until someone finally bothered to check.

Alan S.
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Re: Backdoor Roth confusion

Post by Alan S. » Sat Sep 05, 2015 6:44 pm

ThisTimeItsDifferent wrote:Please escalate this with Vanguard to correct the "adviser's" error so s/he does not repeat it.

Although I am a huge, huge fan of Vanguard, one of their advisers made an error with me that cost me money.

When I converted a non-deductible TIRA to a Roth, I specifically asked for a separate Roth account so I could isolate its basis in the event of a recharacterization, and I told them why and they said it would be a separate account.
They only created a sub-account which was not isolated.

When I subsequently recharacterized, I saw a transfer from a pre-existing Roth to a TIRA, and for 2 years of calls and emails when I told them there should be no pro-rata rule since they were separate accounts, they kept just saying "the math is really difficult," never saying that it was not a separate account until someone finally bothered to check.
I recall reports of this problem 3 or 4 years ago, where VG would use two different Roth accounts in order to calculate the earnings on a conversion, and this situation was related to the old VG account platform where a Roth mutual fund had to be held in a different account than CDs, ETFs or stocks which were held in a VG Brokerage Roth. That earnings calculation could work either for you or against you depending on which Roth had the highest earnings. This would not happen now to those who have the single brokerage account that can hold all investments.

In your case, if your conversion was non taxable, it would take a unique situation to warrant a recharacterization. Since you owed no taxes on the conversion, why did you recharacterize?

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ifish100
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Re: Backdoor Roth confusion

Post by ifish100 » Mon Sep 07, 2015 8:25 am

Thank you to those who responded, that agrees with what other people had told me (it seems to be about 8 sources now saying it is one way, and the 1 advisor with the incorrect information):
1) In order to do the backdoor Roth I would need to liquidate that old Traditional IRA that I had.
2) I could liquidate it now without tax consequences by paring off the portion that is non-deductible contributions and sending that to a Roth, and the deductible+ growth would be rolled into my 401K plan at work into the pretax money, and I would pay taxes on it just like all my other 401K money in there when I take it out in retirement (I only have pretax contributions in the 401K at work).

3) Going forward in order to do the backdoor Roth I would first need to complete #1 and then I could contribute to a Traditional IRA, then convert it in year to a Roth.

I will contact my regular advisor at Vanguard and confirm with him that 1,2, and 3 are the proper steps and there should not be any current tax consequence.

Thanks

retiredjg
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Re: Backdoor Roth confusion

Post by retiredjg » Mon Sep 07, 2015 8:59 am

Remember that it is critical that the part going into 401k must happen by the end of the year. If that does not happen, the non-deductible contributions that you converted to Roth IRA earlier in the year will be prorated with the remaining tIRA.

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Re: Backdoor Roth confusion

Post by tfb » Mon Sep 07, 2015 12:21 pm

ifish100 wrote:2) I could liquidate it now without tax consequences by paring off the portion that is non-deductible contributions and sending that to a Roth, and the deductible+ growth would be rolled into my 401K plan at work
If you flip the sequence here people you talk to will understand it better, i.e. deductible + growth to 401k first, convert the remainder to Roth afterwards. It's also the logical/right way to do it.
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retiredjg
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Re: Backdoor Roth confusion

Post by retiredjg » Mon Sep 07, 2015 12:29 pm

tfb wrote:
ifish100 wrote:2) I could liquidate it now without tax consequences by paring off the portion that is non-deductible contributions and sending that to a Roth, and the deductible+ growth would be rolled into my 401K plan at work
If you flip the sequence here people you talk to will understand it better, i.e. deductible + growth to 401k first, convert the remainder to Roth afterwards. It's also the logical/right way to do it.
I agree this makes more sense sometimes.

If you do it this way, I'd suggest you exchange the already taxed part to money market so that it will not change value while you are waiting to do the Roth conversion. This just makes the paperwork easier and ensures you don't pay tax on any earnings or have some basis left over.

When I did it, I did not exchange into money market. I didn't want to risk having less to convert than was already taxed, so I held out a few hundred dollars of the not-taxed money in addition to the already taxed money. When the rollover of the rest of the money was completed, I just had to watch the market to be sure I had at least enough to convert to cover all the basis. It worked out OK and I ended up paying tax on about $200, but if a market crash had happened while I was waiting, it would have been pretty inconvenient.

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Re: Backdoor Roth confusion

Post by tfb » Mon Sep 07, 2015 12:43 pm

retiredjg wrote:When I did it, I did not exchange into money market. I didn't want to risk having less to convert than was already taxed, so I held out a few hundred dollars of the not-taxed money in addition to the already taxed money. When the rollover of the rest of the money was completed, I just had to watch the market to be sure I had at least enough to convert to cover all the basis. It worked out OK and I ended up paying tax on about $200, but if a market crash had happened while I was waiting, it would have been pretty inconvenient.
You just keep waiting until it comes back up to your basis. You are not paying tax on the backfill anyway, as if the money is already in Roth. There is no deadline for converting.
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retiredjg
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Re: Backdoor Roth confusion

Post by retiredjg » Mon Sep 07, 2015 1:51 pm

tfb wrote:
retiredjg wrote:When I did it, I did not exchange into money market. I didn't want to risk having less to convert than was already taxed, so I held out a few hundred dollars of the not-taxed money in addition to the already taxed money. When the rollover of the rest of the money was completed, I just had to watch the market to be sure I had at least enough to convert to cover all the basis. It worked out OK and I ended up paying tax on about $200, but if a market crash had happened while I was waiting, it would have been pretty inconvenient.
You just keep waiting until it comes back up to your basis. You are not paying tax on the backfill anyway, as if the money is already in Roth. There is no deadline for converting.
Agreed and that is what I would have done if necessary. But I realized later it, after reading about it here, would have been easier and more convenient to just have the exact basis in money market - no waiting and no tax, no aiming at a moving target.

ThisTimeItsDifferent
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Re: Backdoor Roth confusion

Post by ThisTimeItsDifferent » Mon Sep 07, 2015 9:55 pm

Alan S. wrote:
ThisTimeItsDifferent wrote:Please escalate this with Vanguard to correct the "adviser's" error so s/he does not repeat it.
In your case, if your conversion was non taxable, it would take a unique situation to warrant a recharacterization. Since you owed no taxes on the conversion, why did you recharacterize?
Actually, my comment was incomplete. My first conversion was partly deductible and partly non-deductible. After I recharacterized due to market losses, my 401k subsequently started allowing roll-ins of deductible non-conduit TIRA's so I did that to isolate its basis and subsequently (re)converted the non-deductible TIRA amount that remained to a Roth.

Alan S.
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Re: Backdoor Roth confusion

Post by Alan S. » Mon Sep 07, 2015 10:13 pm

OK, that explains it. You had a combination of 3 factors that made recharacterization worthwhile.

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