401k Rollover to ROTH and tax implications with ROTH backdoor

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SAinUSA
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401k Rollover to ROTH and tax implications with ROTH backdoor

Post by SAinUSA » Wed Jun 29, 2016 12:32 pm

Hello all!!

I'm a bit confused so looking for some help. I did a 401k Rollover from Fidelity into Vanguard, it's currently in the Rollover IRA Brokerage.

Total fund is from Fidelity is:
Contributions Employee Deferral    
Inception To Date $16,458     
Total Account Balance $23,389

I would like to convert to Roth IRA and am having trouble calculating my tax implications (I'm currently $250k year tax bracket)

I would also like to do a backdoor Roth, contributing $5,500 as I have done the last 2 years

I have no other retirement accounts

Please help me understand the tax complications!!

Thank you! :D

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unclescrooge
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Re: 401k Rollover to ROTH and tax implications with ROTH backdoor

Post by unclescrooge » Wed Jun 29, 2016 12:35 pm

My understanding is that your entire IRA balance will be taxable.

If I were you I would roll over the IRA into a 401k before doing the back door ROTH.

SAinUSA
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Re: 401k Rollover to ROTH and tax implications with ROTH backdoor

Post by SAinUSA » Wed Jun 29, 2016 1:02 pm

Thanks

So I would basically owe tax on my pre-tax contributions which would be $8000?

niceguy7376
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Re: 401k Rollover to ROTH and tax implications with ROTH backdoor

Post by niceguy7376 » Wed Jun 29, 2016 1:21 pm

Your contributions were 16458 and growth was (23389 - 16458 = 6931).

As for rolling over trad IRA to roth IRA, you pay tax on the whole amount of 23389.

retiredjg
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Re: 401k Rollover to ROTH and tax implications with ROTH backdoor

Post by retiredjg » Wed Jun 29, 2016 3:49 pm

Unless your original 401k was Roth 401k, then all $23,389 is taxable if you convert it to Roth IRA. If your original 401k was Roth 401k, they should have rolled the Roth part into Roth IRA, not traditional IRA.

Having this money in tIRA completely wrecks your ability to use the back door to contribute to Roth IRA. You can do it, but you won't want to because the money in the tIRA will be pro-rated with your IRA contribution/conversion.

Hard to even guess what your tax bracket is without knowing if you are single or married filing jointly. Looks like maybe 28% if married and 33% if single. Not the best brackets to be in to do Roth conversions.

Do you have a new 401k/403b/457b that will accept the rollover?

SAinUSA
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Re: 401k Rollover to ROTH and tax implications with ROTH backdoor

Post by SAinUSA » Wed Jun 29, 2016 4:32 pm

Thanks, seems I just did something really stupid... :oops:

Im single, so 33%. I did 401k rollover straight

Here are my current fund values:

Traditional IRA $0.00
Rollover IRA Brokerage $23,691
Roth IRA $14,684

Don't have a current 401k option as working in a startup

:oops: :oops: :oops:

retiredjg
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Re: 401k Rollover to ROTH and tax implications with ROTH backdoor

Post by retiredjg » Wed Jun 29, 2016 4:41 pm

SAinUSA wrote: I did 401k rollover straight
What does that mean?

Do you think you'll have a high income for the next few years at this startup? If not, it could be a good time to convert the tIRA to Roth IRA.

SAinUSA
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Re: 401k Rollover to ROTH and tax implications with ROTH backdoor

Post by SAinUSA » Wed Jun 29, 2016 5:00 pm

Yeah I will have high income for awhile

I did a 401k rollover to a IRA

retiredjg
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Re: 401k Rollover to ROTH and tax implications with ROTH backdoor

Post by retiredjg » Wed Jun 29, 2016 5:09 pm

So why do you think you did something really stupid?

SAinUSA
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Re: 401k Rollover to ROTH and tax implications with ROTH backdoor

Post by SAinUSA » Wed Jun 29, 2016 5:14 pm

I should have just left it in the 401k, as I will get taxed on the roth conversion and hinders my ability to do backdoor roth

retiredjg
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Re: 401k Rollover to ROTH and tax implications with ROTH backdoor

Post by retiredjg » Wed Jun 29, 2016 5:34 pm

Well, yes. Probably. Sort of.

Making these lemons into lemonaid….while you don't have a 401k, you can contribute to tIRA and deduct the contribution (assuming there is no pension involved at this startup which I doubt). That's $5,500 less in taxable income each year.

Then when you do have your next 401k type plan, it is likely you can roll all of it (rollover IRA and new contributions) into the new 401k and start the back door process again.

In the meantime, you can save what you want in a "taxable account" - something that is not a 401k, 403b, IRA, or whatever. Not having a plan at work does not mean you should not be saving for retirement. There are several very tax-efficient funds you can use in a taxable account to save for retirement.

SAinUSA
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Re: 401k Rollover to ROTH and tax implications with ROTH backdoor

Post by SAinUSA » Wed Jun 29, 2016 10:56 pm

Thanks for the comments, everybody. :happy

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celia
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Re: 401k Rollover to ROTH and tax implications with ROTH backdoor

Post by celia » Thu Jun 30, 2016 2:38 am

SAinUSA wrote:I should have just left it in the 401k, as I will get taxed on the roth conversion and hinders my ability to do backdoor roth
Not necessarily. I think you are probably worrying about this post:
retiredjg wrote:Unless your original 401k was Roth 401k, then all $23,389 is taxable if you convert it to Roth IRA. If your original 401k was Roth 401k, they should have rolled the Roth part into Roth IRA, not traditional IRA. (If you didn't have a Roth 401k, ignore this.)

Having this money in tIRA completely wrecks your ability to use the back door to contribute to Roth IRA. You can do it, but you won't want to because the money in the tIRA will be pro-rated with your IRA contribution/conversion. (This doesn't apply if you will be converting the entire tIRA and the entire Back Door contribution this year. If the tIRA is usually empty and just a conduit until the conversion is done, this doesn't apply.) See below where the taxes are calculated.

Hard to even guess what your tax bracket is without knowing if you are single or married filing jointly. Looks like maybe 28% if married and 33% if single. Not the best brackets to be in to do Roth conversions. (but possibly the lowest you may ever be while working in the field you are in)

Do you have a new 401k/403b/457b that will accept the rollover? (ignore)
How Federal Income Taxes are Calculated (State taxes, if applicable, are similar but with a different chart.)

Let's say your wages are 250K and you have no other income and you don't own a house (ie., can't itemize mortgage interest and property taxes, so you will be taking the Standard Deduction).

Look at the 2016 Tables 1 and 2 here for Single taxpayers:
http://taxfoundation.org/article/2016-tax-brackets

Your 250K total income will be taxed in different sections or pieces:
The Standard Deduction plus one Exemption (person) on your tax return means the first $6,300 + $4,050 will be tax-free.
(If you have more than $6,300 in itemized deductions--such as mortgage interest and property taxes which are usually what makes itemizing worth it for those who itemize, you can subtract your total deductions instead of $6,300. If you have other dependents (say, a child), you can also subtract $4,050 for each additional person.)
So you will have Taxable Income (line 43 on the 1040) of $250,000 - 6,300 - 4,050 = $239,650.

In Table 1, we see that the first $9,275 is taxed at 10%, which equals $927.50.
The amounts between $9,276 and $37,650 are taxed at 15%, which equals (37650 - 9275) * .15 = $4,256.25.
The amounts between $37,651 and $91,150 are taxed at 25%, which equals (91150 - 37650) * .25 = $13,375.00.
The amounts between $91,151 and $190,150 are taxed at 28%, which equals (190150 - 91150) * .28 = $27,720.00
The remainder of your $239,650 will be taxed at 33%, which equals (239650 - 190150) * .33 = $16,335.00
If we total the tax on these 5 pieces, we get a total federal Income Tax of $62,613.75, if my math is correct, which should be close to what you owed last year, assuming your income was also $250,000. (The Standard Deduction and Exemption increase each year.)

Note that each section of income was taxed at a higher rate than the previous section. This is called a "Graduated (or Progressive) Income Tax".

Now that you have an overview of how taxes are calculated and before we add in the Roth conversions, I'd like you to notice how the tax rates jump up from 10% to 15% to 25% to 28% to %33 (and beyond--although going into the highest tax brackets have different rules that apply to these taxpayers). Mathematically, these rates are not spaced evenly. Going from 10 to 15% is an increase of 5%, while going from 15 to 25% is 10%. There isn't as much difference between 25 and 28%, but going from 28 to 33% is a 5% jump again.

Taxes on YOUR Conversions
You already know that when you do Back Door Roth contributions, you make a non-deductible contribution to a traditional IRA, then soon after convert it to Roth. You don't have to pay taxes on this conversion since you paid taxes on the money as part of your wages and never deducted the contribution from your income (since you were ineligible due to high income).

If you convert $23,691 that was rolled over from your 401K, the value on the day of conversion is added to your taxable income. That will currently fall squarely in the 33% tax bracket for you. Since you subtracted the contributions from your income in the years they were made, a conversion will make the contributions (and the growth) fully taxable. (If you had had a Roth 401K, you didn't subtract the contributions from your income in the years they were made, so those contributions (and the growth) can go to a Roth tax-free.)

You can probably readily see that that additional money would keep you in the same tax bracket (33%) this year. Often, when the conversion pushes the taxpayer into the next tax bracket, she decides to convert just enough to stay in the lower bracket and then continues with more conversions in later years.

The decision as to if you should convert this year or not should be based on what YOU think will happen in future years to your tax bracket. If your income will stay the same or go up until retirement, go ahead and convert now. If you will "retire early" (because you are financially independent by age 55, for example), it could make sense to wait until then, when your tax bracket is lower. Also keep in mind, that in the next 30 years or so, the tax brackets can go up or down depending on what Congress wants to do. Or you could move to a lower (or no) income tax state some day.

Going back to the uneven tax rate jumps (discussed in italics above), you could even decide that the current tax rates aren't that important to you compared to the opportunity to have many years of tax-free growth in an IRA. [One interesting scenario is if the market went into a 30% decline, for example, the smaller value of that account could then be converted for less in taxes. I think of it as when "stocks are on sale", it means that "conversion taxes are on sale too".]

When "retiredjg" said:
Having this money in tIRA completely wrecks your ability to use the back door to contribute to Roth IRA. You can do it, but you won't want to because the money in the tIRA will be pro-rated with your IRA contribution/conversion.
he/she meant that since the IRS considers all the assets in your tIRAs as co-mingled (even if held at different custodians), the combination of $23,691 (that is tax-deferred) and $5,500 (that was non-deductible) both being in traditional IRAs at the same time will make tax calculations more complex. For each dollar that is converted, 23,691 / (23,691 + 5500) (or 81%) of it will be taxed. So if you do a Back Door Roth contribution of $5,500, you will have to pay taxes on $4463 of it. HOWEVER, when you convert the rest of the tIRA, you will only have to pay taxes on 81% of the value of the conversion. If you do both conversions this year, it will be a "wash" and you will end up paying the same taxes based on the value of the tIRA on the day of conversion.

On a side note, you have your choice of whether you want taxes withheld from the converted amount or pay them using taxable assets. I suggest that whenever you convert, pay from taxable for three reasons:
1) If you decide to recharacterize (un-do the conversion), the dollars withheld and sent to the IRS cannot go back into the tIRA.
2) If part of the conversion is sent to the IRS, you will forever lose that tax-deferred space.
2) If you are under 59.5, not only will taxes be due on those "taxes" sent to the IRS, but you may have a 10% for early withdrawal of those dollars.
A dollar in Roth is worth more than a dollar in a taxable account. A dollar in taxable is worth more than a dollar in a tax-deferred account.

SAinUSA
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Re: 401k Rollover to ROTH and tax implications with ROTH backdoor

Post by SAinUSA » Thu Jun 30, 2016 11:38 am

Wow, thank you so much for such a detailed response, Celia!

Really appreciated it!

retiredjg
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Re: 401k Rollover to ROTH and tax implications with ROTH backdoor

Post by retiredjg » Thu Jun 30, 2016 4:07 pm

If you plan to stay in the US, tax-deferral is a good thing.

Deferring what would be 33% in federal taxes until a time when you can pay at a lower rate (such as a period of no work or during retirement when your tax bracket is usually lower) is usually a smart idea because you end up with more money.

I would encourage you NOT to convert the rollover to Roth now at 33% and NOT to put money into Roth IRA either. For the time being.

Instead, put money into tIRA (lowering your taxable income by $5,500 each year and your federal taxes by probably $1,815 each year). Do that until you have another 401k.

When you get your next 401k, you can (probably) roll all that money in it - continuing the tax-deferral - and start over on doing the back door contributions to Roth IRA as you did before.

What I think you'd have to watch for is getting "covered" by a pension plan/401k during the middle of the year. In such a year, I believe you are considered "covered" all year even if you only are covered part of it. For that year, at your high income, you would not be able to deduct contributions to tIRA.

I agree with all that celia said except "If your income will stay the same or go up until retirement, go ahead and convert now." If you were in a low tax bracket now (15% or maybe even 25%) that might apply. But since you are already in the 33% bracket, you need to compare to whether you will ever in your lifetime (not just "until retirement") be in a bracket lower than 33%. If so (which seems pretty likely for most folks), don't convert to Roth now. Convert when your bracket goes down.

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