Should I make backdoor Roth IRA contributions?

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hudson4351
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Should I make backdoor Roth IRA contributions?

Post by hudson4351 » Sat Nov 14, 2015 10:14 pm

Last tax year I contributed $5500 to a Roth IRA but when I filed my taxes learned that I was only eligible to contribute $2500. I had Vanguard recharacterize $3000 of my contribution as a nondeductible contribution to my existing Rollover IRA.

Should I start making backdoor Roth IRA contributions? My rollover IRA has ~$32k of deductible contributions in it, meaning I would owe nearly $9k in taxes if I converted the entire thing to a Roth (28% bracket). I could cover that, but is it worth it? It seems the deductible contributions I have in there from a 401k rollover are really acting as a roadblock to backdoor Roth contributions due to the proration restriction.

I don't have any planned periods of a lower tax bracket coming up. Statistically I am likely to roll over more 401ks into that account over my working lifetime, and likely with much higher balances. Given that, backdoor Roth IRA contributions seem impossible at this point unless I'm willing to swallow 4-5 figure tax bills.

Am I missing something? Is it worth it to just pay the taxes up front?

DSInvestor
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Re: Should I make backdoor Roth IRA contributions?

Post by DSInvestor » Sat Nov 14, 2015 10:22 pm

You can avoid the prorata problem if you can isolate your IRA basis by doing a rollover of all IRA assets in excess of your IRA basis into your 401k.

1. Verify that your employer plan will accept inbound rollovers and low cost investment options.
2. Convert to Roth an amount equal to your IRA basis.
3. Rollover all remaining assets into your 401k before Dec 31 of the year that you did a conversion. This will give you a zero balance in your IRAs as of Dec 31 which is the key to avoid prorata rule.
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Re: Should I make backdoor Roth IRA contributions?

Post by Kevin M » Sat Nov 14, 2015 11:01 pm

hudson4351 wrote:Statistically I am likely to roll over more 401ks into that account over my working lifetime, and likely with much higher balances. Given that, backdoor Roth IRA contributions seem impossible at this point unless I'm willing to swallow 4-5 figure tax bills.

Am I missing something?
Yes, you are. Why would you roll over more 401(k)s into the IRA rather than roll the IRA into a 401k? You have discovered one of the main issues with rolling a 401k into an IRA, so why compound it rather than fix it (if possible)?

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hudson4351
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Re: Should I make backdoor Roth IRA contributions?

Post by hudson4351 » Sat Nov 14, 2015 11:48 pm

Good catch, I forgot about the possibility of rolling an IRA into a 401k. I will check with my employer next week and see if that is possible. Having said that, the decision to roll an IRA into a 401k (or an old 401k into a new one) doesn't seem very straightforward to me. What if the 401k has bad investment options and/or high fees? Would those be offset by the ability to contribute to a backdoor Roth IRA? My 401k is at Fidelity, offers Vanguard funds, and currently has no quarterly fees, but it has had quarterly fees in the past and the plan administrator could suddenly decide to pull the Vanguard options. If I roll an IRA into it and later decide the options are better at Vanguard, I'm guessing I can't roll it back out until I leave that employer, correct?

How bad would it be in the long run to just pay the taxes up front? I've personally favored non-Roth accounts for the reasons outlined in this article:

http://thefinancebuff.com/case-against-roth-401k.html

but the truth is no one knows what the tax code will be in 30-40 years, therefore making an absolute statement is impossible.

DSInvestor
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Re: Should I make backdoor Roth IRA contributions?

Post by DSInvestor » Sat Nov 14, 2015 11:50 pm

Sometimes 401k plans will only accept rollovers from Rollover IRAs. Hopefully your TIRA contribution into your Rollover IRA did not convert your IRA into a contributory IRA. To be safe, we normally recommend that Traditional IRA contributions go into a separate TIRA account from the Rollover IRA.
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Re: Should I make backdoor Roth IRA contributions?

Post by danaht » Sun Nov 15, 2015 9:12 am

If your employer does not allow rollovers into a 401k:

1) You could start looking into opening an individual 401k (it's free (except for closing costs) just like an IRA for most brokerages. note - You can only contribute money to an individual 401k if you have a side business - however you should still be able to rollover funds to one without contributing. I believe Charles Schwab's individual 401k accepts rollovers from an IRA. Be aware that if you have $250,000 (or more) in an individual 401k - that will cause you to file another form annually with the IRS. You might want to talk with an accountant before doing this - because individual 401ks can be tricky and I am not sure if this is entirely legal if you never contribute to it from a side business.

or if you don't want to open an individual 401k:

2) You could slowly convert your IRA each year to a Roth IRA (that way you minimize the tax hit) Perhaps convert $10,000 each year for 3 years. This would be in lieu of a Roth contribution. Also, when the market drops (like August) - this is an ideal time to call your broker and do the in-kind transfers for conversion.

I have an individual 401k and I also have a IRA with 100% deferred (before) taxes money. I am not at the point where I want to roll-over the IRA - because I am still below the Roth IRA income limits. Rolling over the IRA will cause the $250,000 form reporting requirement - which I don't want to deal with at this time. In addition - I like keeping my investments split between several brokers. (having all my money in one 401k plan would be devastating if that broker went bankrupt (only $500,000 would be insured - and good luck collecting). I am starting to convert the IRA to a Roth - but this will take 50 years at the conversion pace that I have set.

hudson4351
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Re: Should I make backdoor Roth IRA contributions?

Post by hudson4351 » Sun Nov 15, 2015 12:19 pm

danaht wrote: 2) You could slowly convert your IRA each year to a Roth IRA (that way you minimize the tax hit) Perhaps convert $10,000 each year for 3 years. This would be in lieu of a Roth contribution. Also, when the market drops (like August) - this is an ideal time to call your broker and do the in-kind transfers for conversion.
Just to make sure I understand this, the total amount of tax paid would be the same if the conversion was spread out across a few years, correct? In each year the deductible portion of the IRA that was being converted would be subject to income taxes at my marginal rate.
Last edited by hudson4351 on Sun Nov 15, 2015 1:01 pm, edited 1 time in total.

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Re: Should I make backdoor Roth IRA contributions?

Post by JW-Retired » Sun Nov 15, 2015 12:41 pm

hudson4351 wrote:
Just to make sure I understand this, the total amount of tax paid would be the same if the conversion was spread out across a few years, correct? In each year the nondeductible portion of the IRA that was being converted would be subject to income taxes at my marginal rate.
Probably a typo.... but it's the deductible portion that would be taxed. Any non-deductible contributions in there would not be.

You could keep on making non-deductible contributions and converting what you can afford each year. Eventually the remaining deductible contributions should be diluted enough that you could convert the balance. Be sure you understand IRS form 8606 before you do anything. This form tracks the non-deductible contribution basis year to year.
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hudson4351
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Re: Should I make backdoor Roth IRA contributions?

Post by hudson4351 » Sun Nov 15, 2015 1:03 pm

JW-Retired wrote:
hudson4351 wrote:
Just to make sure I understand this, the total amount of tax paid would be the same if the conversion was spread out across a few years, correct? In each year the nondeductible portion of the IRA that was being converted would be subject to income taxes at my marginal rate.
Probably a typo.... but it's the deductible portion that would be taxed. Any non-deductible contributions in there would not be.

You could keep on making non-deductible contributions and converting what you can afford each year. Eventually the remaining deductible contributions should be diluted enough that you could convert the balance. Be sure you understand IRS form 8606 before you do anything. This form tracks the non-deductible contribution basis year to year.
JW
You are correct, I meant to say the deductible portion would be taxed. I fixed my post above.

In general, is it better to pay the tax up front or when the money is withdrawn during retirement? My analysis is based on the link I posted above at the finance buff's website, which seems to favor traditional accounts.

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Re: Should I make backdoor Roth IRA contributions?

Post by DSInvestor » Sun Nov 15, 2015 1:27 pm

hudson4351 wrote:In general, is it better to pay the tax up front or when the money is withdrawn during retirement? My analysis is based on the link I posted above at the finance buff's website, which seems to favor traditional accounts.
It all depends on your tax situation. In my tax situation where I was high income while working, retiring with no pension but assets in taxable, it made no sense at all to make any Roth 401k contributions as I can withdraw or convert to Roth in retirement for zero tax for many years while taking advantage of preferential tax treatment of QDI/LTCG in the taxable account. Roth 401k contributions require that you give up a tax deduction because you're redirecting money away from Traditional 401k. Roth IRA is different because you're not necessarily giving up a tax deduction. If you're covered by an employer plan and have high income, you're not eligible for the Traditional IRA tax deduction. If you can't take the TIRA deduction, it makes sense to convert those non-deductible TIRA assets tax free to Roth IRA. The after tax money can be invested in Taxable, in TIRA or in Roth IRA. Of those three options, Roth IRA is the best. Unfortunately, you have a mix of pre-tax and after-tax money in your TIRA/Rollover IRA. I suggest looking into isolating your IRA basis by rolling all the pre-tax IRA assets into your current 401k if a) it accepts rollovers from IRA and b) has low cost investment options.

If you will retire with a generous defined benefit pension or expect a big stream of income in retirement that will consume all of your lowest tax brackets, this will drive your TIRA/401k withdrawals to fall in higher brackets resulting in higher average tax on those withdrawals. In this case, if your withdrawals may be taxed at a higher rate than your current marginal rate, Roth 401k may make sense.

If you reside in a high income tax state like California and may move to a low or no income tax state or state that does not tax retirement withdrawals, you'd need to factor in the upfront state tax cost to use Roth 401k or taxable amount of Roth conversion.
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Re: Should I make backdoor Roth IRA contributions?

Post by Kevin M » Sun Nov 15, 2015 3:31 pm

hudson4351 wrote:What if the 401k has bad investment options and/or high fees? Would those be offset by the ability to contribute to a backdoor Roth IRA?
Clearly expensive 401k choices offset to some extent the benefits of adding $5,500 of tax-free space each year. I'd think in terms of the incremental annual cost due to higher fund ERs vs. having an additional $5,500 grow tax free. Keep in mind that $5,500 tax free is worth more than $5,500 tax-deferred, so you might want to think in terms of your share vs. government share of 401k; your share grows tax free.

So at 25% constant tax rate, your share of $5,500 in the 401k is $4,125, so you can think of it as $4,125 growing tax free, and not have to mess around with tax computations.

Assume some growth rate, and subtract the incremental fund expense in calculating growth of $4,125 in 401k vs. $5,500 in Roth. Say you assume growth at 6%, with ER of best fund in 401k 1% more, so reduces growth to 5%. Let's use 30 years as investment horizon.

5,000 * (1.06)^30 = 28,717
4,125 * (1.05)^30 = 17,828

So it seems that the Roth space is significantly more valuable even if best fund in 401k is 1% more expensive.

I'm not sure this is the correct way to model it, but it's what comes to mind. Others can poke holes in it and present a better model if they can.

Also keep in mind that when you change jobs, you can leave assets in the old 401k if it's better, or move them to the new 401k if it's better.
My 401k is at Fidelity, offers Vanguard funds, and currently has no quarterly fees, but it has had quarterly fees in the past and the plan administrator could suddenly decide to pull the Vanguard options.

But how significant were the quarterly fees, or would they be if put back in place? My daughter pays a quarterly fee, and also has Vanguard funds, but even with quarterly fee (which is only a few bucks), she comes out way ahead of her sister who only has expensive (ER > 1% for least expensive fund) actively managed funds.

And then maybe your next job will have a better plan you can roll old 401k into.
If I roll an IRA into it and later decide the options are better at Vanguard, I'm guessing I can't roll it back out until I leave that employer, correct?
Probably. Some plans offer in-service withdrawals, but this probably isn't very relevant until you are age 59 1/2 or older: In-Service Withdrawal: The Law and The Plan Rules.

The options probably will be better in a Vanguard IRA for most people, although some are lucky enough to have institutional shares in their 401k plans, so even lower cost than Admiral shares at Vanguard. But again, you're closing off the tax-free Roth backdoor by holding on to the tIRA with deductible contributions, so you have to estimate the opportunity cost of not growing Roth space by $5,500/year vs. the higher cost of the 401k funds.
How bad would it be in the long run to just pay the taxes up front? I've personally favored non-Roth accounts for the reasons outlined in this article:
You can model it along the lines of what I did above.

I don't see what this has to do with Roth vs. traditional 401k though. The t401k probably will give you plenty of distributions to fill up your 0%-15% tax brackets in retirement, so putting some into the Roth each year enables you to withdraw more in the 0% tax bracket.

I don't think tfb is saying not to use backdoor Roth if you can't get the deduction on a tIRA contribution. He's just saying to put enough into tax-deferred accounts to be able to fill up the lower tax brackets when you start taking distributions, since you get a bonus based on the differential between tax rates during contributions and distributions.

Are you maxing your 401k contributions each year? If not, perhaps do that before worrying about the IRA. Not only does it get you a higher current tax deduction, but contributing more to 401k will lower income, and make it more likely that you can put more into tIRA if you want.

Also remember that you may be able to convert traditional to Roth in future low-income years, e.g., between retirement and starting RMDs and SS.
but the truth is no one knows what the tax code will be in 30-40 years, therefore making an absolute statement is impossible.
Which is a good argument to put something into Roth accounts. People refer to it as tax diversification.

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hudson4351
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Re: Should I make backdoor Roth IRA contributions?

Post by hudson4351 » Mon Nov 16, 2015 9:30 am

DSInvestor wrote:
hudson4351 wrote:In general, is it better to pay the tax up front or when the money is withdrawn during retirement? My analysis is based on the link I posted above at the finance buff's website, which seems to favor traditional accounts.
It all depends on your tax situation. In my tax situation where I was high income while working, retiring with no pension but assets in taxable, it made no sense at all to make any Roth 401k contributions as I can withdraw or convert to Roth in retirement for zero tax for many years while taking advantage of preferential tax treatment of QDI/LTCG in the taxable account.
I hadn't considered this option before. Basically you have enough in taxable to live off of in retirement, but since it doesn't count as income your tax bracket is low, which allows you to convert your traditional 401k into a Roth IRA at a low tax rate. Is that correct? I assume you still have to take RMDs from the 401k during the years you convert part of it to a Roth IRA, correct?
DSInvestor wrote: The after tax money can be invested in Taxable, in TIRA or in Roth IRA. Of those three options, Roth IRA is the best. Unfortunately, you have a mix of pre-tax and after-tax money in your TIRA/Rollover IRA. I suggest looking into isolating your IRA basis by rolling all the pre-tax IRA assets into your current 401k if a) it accepts rollovers from IRA and b) has low cost investment options.
I just checked my employer's 401k plan document and it does appear to allow for rollovers from a TIRA to a 401k. I will need to get more information regarding the exact procedure, but it looks like this is an option I should pursue.

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Re: Should I make backdoor Roth IRA contributions?

Post by DSInvestor » Mon Nov 16, 2015 11:52 am

hudson4351 wrote: I hadn't considered this option before. Basically you have enough in taxable to live off of in retirement, but since it doesn't count as income your tax bracket is low, which allows you to convert your traditional 401k into a Roth IRA at a low tax rate. Is that correct? I assume you still have to take RMDs from the 401k during the years you convert part of it to a Roth IRA, correct?
Let's say I need 50K in retirement. If I have 500K in tax efficient index funds throwing off 10K/yr in QDI. In this case I have 10K to spend just from the QDI. QDI is included in income (AGI) but is taxed at 0% if it falls in 15% bracket of below. I need another 40K to meet expenses, so I sell assets in taxable to raise cash. If I sell 40K with 30K cost basis, my capital gain is 10K. If that is LTCG, the tax rate is 0% if it falls in 15% bracket or lower. Total AGI right now is 20K.

I'm married filing jointly where std deduction is 12,600 and each exemption is 4000. This essentially gives me room for $20,600 of ordinary income at 0% Fed tax rate. I'm have no state income tax in my state.

I convert 20,600 and have 10K QDI, 10K LTCG. AGI = 40,600. Taxable Income = 40,600 - 20,600 = 20,000.
The income is stacked so that ordinary income falls at the bottom. QDI/LTCG is on top of ordinary income and because it falls in 15% bracket or lower receives 0% tax rate.

Fed Tax = ZERO

In this example, I converted an amount equal to my 0% tax bracket but I can convert more. The conversion amount that falls into the 10% tax bracket will be taxed at 10%. So if I converted an extra 10K (30,600 total), I'd pay 1K in fed tax. The effective tax on that conversion is 1000/30,600 or 3%. I received a tax break worth 33-40% while I was working and residing in a state with income tax.

If you itemize deductions, you can have a larger 0% tax bracket.

If you are subject to RMD, you'd have to take your RMD first, then any assets remaining can be converted to Roth.
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Re: Should I make backdoor Roth IRA contributions?

Post by JW-Retired » Mon Nov 16, 2015 12:56 pm

hudson4351 wrote:
Basically you have enough in taxable to live off of in retirement, but since it doesn't count as income your tax bracket is low, which allows you to convert your traditional 401k into a Roth IRA at a low tax rate. Is that correct? I assume you still have to take RMDs from the 401k during the years you convert part of it to a Roth IRA, correct?
Not totally correct as you are wording it. Converting part of an IRA or a 401k to a Roth IRA would not force you to take RMDs if you were under age 70.5, which is the starting age for RMDs. And there is one exception even to that...... if you are still working for the company holding the 401k (or other qualified plan), you are not required to take age 70.5 or later RMDs until you leave that employer.

You do have to take any RMDs you must take before you can do Roth conversions. You can't convert your RMD.
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danaht
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Re: Should I make backdoor Roth IRA contributions?

Post by danaht » Sat Nov 21, 2015 8:32 pm

Also keep in mind - we don't know what the tax rates will be like 10 years from now. I believe that millennials and generation x should plan for a much higher (Europe like) tax structure when they retire. So don't count on being able to withdraw your traditional IRAs at 0-15% - unless you are a baby boomer. This is why it makes sense to convert and contribute as much as reasonably possible to a Roth IRA while income taxes are low! I also would not convert everything to a Roth (unless you can do it all at a 0-15% tax rate) because anything is possible. The other side of tax possibilities are introduction of federal sales taxes, and or VAT taxes. Any federal sales tax / VAT tax would favor the deferred traditional IRAs/401Ks over the Roths.

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Re: Should I make backdoor Roth IRA contributions?

Post by hudson4351 » Sun Nov 22, 2015 1:05 am

Just as an update, I verified that my employer's 401k plan (and Fidelity) allows you to rollover a tax-deductible IRA (rollover in my case). At first Vanguard told me that this would not be possible because I have both rollover tax-deductible contributions and non-deductible contributions in the same account, but they looked into it some more and said it actually is possible with the right paperwork.

Now I need to receive the rollover form from Fidelity, review the 8606 and see how that relates to this, and then review the IRA transfer form from Vanguard.

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Re: Should I make backdoor Roth IRA contributions?

Post by hudson4351 » Wed Feb 24, 2016 1:00 pm

I'm bumping this thread because I had a follow up question.

I reviewed the "IRA Distribution Form" that Vanguard sent me and spoke to Vanguard again, and now Vanguard is again saying they have no way to separate out my deductible IRA contributions from my non-deductible IRA contributions that are in the same account. That is, I apparently can't request to withdraw all of my deductible contributions even though my employer's 401k plan does allow transfers from an IRA.

Is there any possible way for me to separate my deductible IRA contributions from the non-deductible IRA contributions in the same account? There is actually only one non-deductible contribution: the Roth IRA recharacterization I made last year due to being over the income limit for a full contribution.

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Re: Should I make backdoor Roth IRA contributions?

Post by crit » Wed Feb 24, 2016 4:18 pm

It should be possible to open a separate tIRA and do a like-kind/trustee transfer of the non-deductible amount and its gains, leaving only the rolled-over amount?

We're in the same boat as you -- my spouse has a rollover IRA, mediocre offerings in present 401k, and we're hitting the Roth income limit. He works in an industry that has high turnover, so we'll expect to be rolling over 401ks again and again. My initial thought was -- why would we take the trouble to roll his IRA into his 401k when a) it sucks and b) he won't have it that long? Despite the paperwork burden, though, I think it's worth it to open the backdoor.

Or, he'll have a few months without income, which miiiiight get us down to 15% where we could convert (but now that I'm writing this, I realize we'd have no headroom even if we made it to 15%). Ok, kill that thought.

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