Backdoor Roth vs. Recharacterization

[dandan14]

Looking into 2018, we'll likely be very close to the Roth income limits.
Is there any reason to prefer one of these options over the other?
1. Contribute to a Roth. Recharacterize if needed.
2. Contribute to a non-deductible and backdoor convert soon after.

[FiveK]

#1 gives you immediate penalty free access to the contribution if recharacterization is not needed. It is more work if recharacterization is needed.

#2 provides certainty: when you are done, no need to check anything further. It imposes a five year wait on penalty-free withdrawal of the conversion amount (see Two 5-Year Rules For Roth IRA Contributions & Conversions).

[dandan14]

Thanks -- that's pretty much what I was thinking as well. I temporarily forgot about the 5 year rule -- because that is so unlikely to come into play here. But you're right -- that does add a little bit of a con to the conversion.

[Epsilon Delta]

#1 also has a downside if your investments surge in the mean time and you have to pay taxes on a number of months gain. More of an issue if your talking a 2018 contribution in January 2018 where it's perhaps 15 months of gains.

[retiredjg]

It imposes a five year wait on penalty-free withdrawal of the conversion amount

I didn't read Kitces' link, but I doubt he says that.

There is a 5 year tax clock on anything that was taxable when the conversion happened, but most people using the back door have little to nothing that is taxed due to the conversion.

[TravelforFun]

1) Recharacterization is no longer allowed per new tax laws. You just have one shot.

TravelforFun

[retiredjg]

I think that recharacterization of a contribution is still allowed. What you can't do now is recharacterize a Roth conversion .

[dandan14]

1) Recharacterization is no longer allowed per new tax laws. You just have one shot.

TravelforFun

Hmm...my understanding is that recharacterizations are still allowed. For instance, you contribute to a Roth and, whoops, you made to much money.
What you can no longer do is convert 3 buckets to a Roth, and undo the 2 that appreciated least. (i.e. the horse race method)

[FiveK]

It imposes a five year wait on penalty-free withdrawal of the conversion amount

I didn't read Kitces' link, but I doubt he says that.

Hmm. I could say that he does, but if the first post isn't believed....

Here's a quote:

...the second 5-year rule applies not to (new) Roth contributions, but to Roth conversions from traditional pre-tax retirement accounts, and determines whether Roth conversion principal will be penalty-free.

[retiredjg]

It imposes a five year wait on penalty-free withdrawal of the conversion amount

I didn't read Kitces' link, but I doubt he says that.

Hmm. I could say that he does, but if the first post isn't believed....

Here's a quote:

...the second 5-year rule applies not to (new) Roth contributions, but to Roth conversions from traditional pre-tax retirement accounts, and determines whether Roth conversion principal will be penalty-free.

The original poster is talking about converting post-tax (non-deductible) money.

[FiveK]

The original poster is talking about converting post-tax (non-deductible) money.

Excellent point, and Kitces does use the wording "pre-tax" so that could be construed to mean "non-pre-tax" amounts aren't covered under the 5 year conversion rule.

There have been other mentions about a backdoor Roth having this particular downside, e.g., 5-Year Roth IRA Rules - The Biglaw Investor:

The 5-Year Conversion Rule...covers all “backdoor” Roth IRA contributions (which are really non-deductible contributions made to a Traditional IRA which are then converted to a Roth IRA). Roth conversions are subject to a separate 5-year rule. Under this rule, you cannot withdraw Roth IRA conversions until five taxable years have passed.
...
In practical terms, it’s ineffective to use backdoor Roth IRA contributions as an emergency fund since you have to wait five years before you can withdraw the funds.

But, hey, we can't believe everything we see on the internet, so let's see if we can parse some IRS language.
From 26 CFR 1.408A-6 - Distributions, I'm assuming
- no direct Roth contributions have ever been made
- there was only one backdoor IRA ever done
- this is not a "qualified" Roth distribution
- this is the first distribution from this Roth
- no 72(t) exceptions
in order to simplify the answer. Apologies if it has been oversimplified - no malicious intent involved.

Q-4. How is a distribution from a Roth IRA taxed if it is not a qualified distribution?
A-4. A distribution ... is includible in the owner's gross income to the extent that the amount of the distribution ... exceeds the owner's contributions to all his or her Roth IRAs.

Q-5. Will the additional tax under 72(t) apply to the amount of a distribution that is not a qualified distribution?
A-5. ...
(b) The 10-percent additional tax under section 72(t) also applies to a nonqualified distribution, even if it is not then includible in gross income, to the extent it is allocable to a conversion contribution, if the distribution is made within the 5-taxable-year period beginning with the first day of the individual's taxable year in which the conversion contribution was made. ...
For purposes of applying the tax, only the amount of the conversion contribution includible in gross income as a result of the conversion is taken into account.

The last sentence in the above quote does seem to except backdoor Roth amounts from the 10% penalty. But then I'm not a "Biglaw Investor" and that post explicitly includes backdoor Roths. But then again one shouldn't believe everything one sees on the internet, so...?

[retiredjg]

For purposes of applying the tax, only the amount of the conversion contribution includible in gross income as a result of the conversion is taken into account.

This is the key phrase.

Keep in mind that "qualified distribution" means you are 59.5 years or older AND you made your first contribution to Roth IRA more than 5 tax years ago. However, you can take distributions that are not "qualified" and are not subject to any 5 year rule or tax or penalty. The best example is taking your direct contributions, which you can do any time for any reason without penalty. So "qualified distribution" has no bearing on this discussion.

When looking at taking money from a back door or a mega back door contribution, the money that was after tax before it got to Roth IRA is not subject to a penalty that goes away when the 5 tax year clock expires. Only the money that was subject to tax at the conversion is "clocked", but the ordering rules require that you take that money and pay the 10% penalty before you can get to the money that is not subject to the clock.

For any back door or mega back door contributions, there could be money that has an early withdrawal tax penalty and money that does not have and early withdrawal tax penalty. This is why I'm such a pest about "keeping meticulous records about how every penny gets into Roth IRA".

The only thing I can say is that I believe that Biglaw Investor is mistaken and that Kitces and Alan S are correct. You might research the Fairmark forum for more information. I believe you will find that I'm consistent with what they tell you there.

[retiredjg]

I suppose there could be a semantics explanation to this. It could be said that for every back door and mega back door, the entire thing is subject to a 5 tax year clock, but only the portion taxed at the time of conversion is subject to the 10% tax penalty.

I express that as only the portion taxed at the time of conversion is subject to the clock.

[abuss368]

1) Recharacterization is no longer allowed per new tax laws. You just have one shot.

TravelforFun

I thought recharacterization of a Roth conversion is no longer allowed.

[abuss368]

Under the new tax law, is a nondeductible contribution to a Traditional IRA and then conversion to a Roth IRA still allowed. There are no income limits?

[FiveK]

The only thing I can say is that I believe that Biglaw Investor is mistaken and that Kitces and Alan S are correct.

Very possible!

We do know that some otherwise reputable finance sites claim that one should use effect withdrawal rates for a traditional vs. Roth choice, and that is mistaken, so BI certainly could be mistaken here as well.

Thanks again!

[FiveK]

Under the new tax law, is a nondeductible contribution to a Traditional IRA and then conversion to a Roth IRA still allowed. There are no income limits?

Yes and there are none. Same caveats as always regarding the pro-rata rule.

[abuss368]

Under the new tax law, is a nondeductible contribution to a Traditional IRA and then conversion to a Roth IRA still allowed. There are no income limits?

Yes and there are none. Same caveats as always regarding the pro-rata rule.

Thanks.

[retiredjg]

Under the new tax law, is a nondeductible contribution to a Traditional IRA and then conversion to a Roth IRA still allowed. There are no income limits?

The back door is still available to people who have compensation and are not yet 70 or 70.5 years old (not sure which).

[Epsilon Delta]

The back door is still available to people who have compensation and are not yet 70 or 70.5 years old (not sure which).

You can’t make regular contributions to a traditional IRA in the year you reach 70½ and older. So the restrictions kicks in on the Jan 1st somewhere between age 69½ and 70½. And although the first sentence comes from the IRS I am reasonable certain that for our purposes the "in" should be "for" (i.e. before April 15 you can make a contribution for the prior year even if you are barred by age from making a contribution for the current year. The tax code says that that such a contribution is treated as if it were made on the prior Dec 31, so it is in the prior year.)

[Alan S.]

Regular and mega back door Roth conversions are rarely distributed within 5 years, but if they are the cost is driven first driven by the Roth IRA ordering rules for distributions, then the taxable/non taxable portions of the conversions withdrawn in under 5 years.

Oldest conversion years come out first, and within a given year the taxable portion of the conversions comes out before the non taxable. Therefore, if you do need to tap conversions and have a taxable 3 year old conversion in the Roth, that conversion must come out before your non taxable current conversion. For a fully taxable conversion under 5 years, you would owe the 10% penalty unless you qualify for a penalty exception. If you still need to pull out the newer non taxable conversion as well, you would not incur the penalty except on any gains generated before the recent back door contribution was converted. If you had a gain of 100 on a 5500 TIRA contribution, converted 5600 and then took a distribution from that 5600, the 100 of gain would come out first and be subject to the 10% penalty.

Getting back to the central question, if you think there is a chance that you will have to tap your Roth conversions within 5 years of each one, check your self kept records to see if you have older taxable conversions that would have to come out first before recharacterizing regular Roth contributions that you may be eligible to make even though the MAGI contribution phaseout rules are a pain to deal with. Another option is just to contribute after the tax year since then you will know exactly what regular contribution amount is allowed. That avoids recharacterization and will reduce converted amounts.

[abuss368]

Under the new tax law, is a nondeductible contribution to a Traditional IRA and then conversion to a Roth IRA still allowed. There are no income limits?

The back door is still available to people who have compensation and are not yet 70 or 70.5 years old (not sure which).

Thank you.

[UpsetRaptor]

#1 also has a downside if your investments surge in the mean time and you have to pay taxes on a number of months gain. More of an issue if your talking a 2018 contribution in January 2018 where it's perhaps 15 months of gains.

I have a couple sanity check questions regarding downsides to scenario #1, for my own situation. Let's say in January you make Roth contribution, and 12-15 months later oops, AGI's too high for Roth. I assume the idea is to:

1) Recharacterize the contribution to tIRA. Non-deductible since you're over the deductible tIRA limit.
2) Pay tax on any gains made in the meantime
3) Do a Roth conversion, normal back-door Roth style. Otherwise you miss out on your Roth contribution for the year, no?
4) If you have any existing tax-deferred tIRAs with gains, that's going to mess with Step 3.

Yes to all 4?

I have tIRA from years ago with tax deferred gains. Roth contribution Jan 2017 was made prior to realizing I might end up over AGI limit.

[retiredjg]

I have a couple sanity check questions regarding downsides to scenario #1, for my own situation. Let's say in January you make Roth contribution, and 12-15 months later oops, AGI's too high for Roth. I assume the idea is to:

1) Recharacterize the contribution to tIRA. Non-deductible since you're over the deductible tIRA limit.
2) Pay tax on any gains made in the meantime
3) Do a Roth conversion, normal back-door Roth style. Otherwise you miss out on your Roth contribution for the year, no?
4) If you have any existing tax-deferred tIRAs with gains, that's going to mess with Step 3.

Yes to all 4?

I have tIRA from years ago with tax deferred gains. Roth contribution Jan 2017 was made prior to realizing I might end up over AGI limit.

Yes to all 4 except it does not matter if your tIRA has gains or not.

You do have the option of getting a return of your contribution - make it as if it never happened at all - by calling the custodian and requesting it.

Do you have a 401k/403b/457 you can roll the old tiRA into? If you do, you could go with steps 1 and 2 above, get the old tIRA out of the way, and then do a Roth conversion of the non-deductible contribution.

[Epsilon Delta]

I have a couple sanity check questions regarding downsides to scenario #1, for my own situation. Let's say in January you make Roth contribution, and 12-15 months later oops, AGI's too high for Roth. I assume the idea is to:

1) Recharacterize the contribution to tIRA. Non-deductible since you're over the deductible tIRA limit.
2) Pay tax on any gains made in the meantime
3) Do a Roth conversion, normal back-door Roth style. Otherwise you miss out on your Roth contribution for the year, no?
4) If you have any existing tax-deferred tIRAs with gains, that's going to mess with Step 3.

Yes to all 4?

Nitpicking but 2) and 3) should be reversed. The recharacterization is not a taxable event. The conversion is a taxable event. The recharacterization puts gains into a traditional IRA so it sets you up for future taxes, but it does not require you to pay any taxes at this time. Converting the taxes is what converts that future tax liability into a present day tax bill.

Any amount in a tIRA can interfere with a conversion. If you move the tIRA to a 401(k) or similar it will no longer interfere. If the amount in the tIRA is small then you could convert the entire tIRA and pay the taxes to enable back-door Roths now and in the future. Exactly how small the tIRA would need to make this attractive depends on circumstances, but in the right circumstances it might make sense to convert and pay taxes on a few tens of thousands.