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.
