Roth Re-characterization an Opportunity to Re-examine American Funds

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Gr8Time2Balive
Posts: 3
Joined: Wed Jun 13, 2018 12:15 pm

Roth Re-characterization an Opportunity to Re-examine American Funds

Post by Gr8Time2Balive » Wed Jun 13, 2018 9:55 pm

First time poster, long-time lurker. I essentially have two questions brought on by my need to re-characterize my wife and my Roth IRA contributions for 2017 (we have until October of this year to complete that). Last year, I thought our income would be much lower because I was in the middle of my MBA (focused on corporate, not personal finance), but we were fortunate to still bust the ROTH MAGI limit. We are both 32 with about $400K in total investments; ROTH IRAs are:
$109K - American Funds AMCAP (mine)
$66K - American Funds Fundamental Investors (ANCFX) (hers...but her 401K massively trumps my tiny target date TSP)

1. We now have to establish and begin contributing to Traditional IRAs. But isn't this like starting over (albiet with a $5K head startup from the 2017 contributions) in terms of the power of compounding? Is there any other option here?

2. We invest at NAV (no sales charge/load) because my wife works for a major FS company, and this is a main reason we've stuck with American Funds so long. Both funds are Morningstar 4-star funds but they are also mainly US Value stocks. I just ran our entire portfolio through TD's free X-ray tool and we are definitely over allocated to US Value and I'd like to work to re-balance. Is the IRA the right place to be doing that vs. wife's 401K, TSP, taxable Vanguard ETF account or my soon to be established 401K.

We haven't used a financial adviser for many years, and sincerely appreciate any advice in advance.

mhalley
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Joined: Tue Nov 20, 2007 6:02 am

Re: Roth Re-characterization an Opportunity to Re-examine American Funds

Post by mhalley » Thu Jun 14, 2018 12:48 am

There are certainly worse funds than American, especially if the loads are waived, but they are still much more expensive than vanguard funds. The performance of the funds may continue to overcome the higher er, or it might not. The right place to rebalance depends on the options available in your various accounts. Rebalance so that your overal er is as low as possible while maintaining your aa. Many do recommend a tilt toward value, so it might be fine to continue with the current portfolio. Value has underperformed growth lately but will most likely revert to better performance at some point.

retiredjg
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Joined: Thu Jan 10, 2008 12:56 pm

Re: Roth Re-characterization an Opportunity to Re-examine American Funds

Post by retiredjg » Thu Jun 14, 2018 9:26 am

I assume FS means "financial services" company. If that is the case, you and your wife may be limited to using certain funds or investing at certain places. Is anything like that going on?

1. We now have to establish and begin contributing to Traditional IRAs.
Since you cannot deduct the contributions, I would not use traditional IRA at all unless you plan to use the "back door". If not, put the money into a taxable account instead.

This does not fix the issue of having that one contribution to tIRA if you do the recharacterization.

Are you familiar with the back door?

Re American Funds funds....yes they are good funds, especially if you do not pay the loads. However, their expense ratios are significantly higher than index funds and this cost will make a difference over the years.


Your portfolio examination should really start with your plans at work - often a 401k or 403b. I think you might benefit from having an entire review of all your accounts. See the link at the bottom of this message for how to do that. The closer you follow the format, the more help sand the more reliable help you will get. It's some work, but people learn a lot by doing it.

MotoTrojan
Posts: 1908
Joined: Wed Feb 01, 2017 8:39 pm

Re: Roth Re-characterization an Opportunity to Re-examine American Funds

Post by MotoTrojan » Thu Jun 14, 2018 9:58 am

Gr8Time2Balive wrote:
Wed Jun 13, 2018 9:55 pm

We now have to establish and begin contributing to Traditional IRAs. But isn't this like starting over (albiet with a $5K head startup from the 2017 contributions) in terms of the power of compounding? Is there any other option here?
Nope you are not thinking about this correctly. $1M in a single account will grow just as fast as $1 being placed in 1 million different accounts. Compounding doesn't work that way; your total portfolio balance (and of course allocation) is what matters.

As stated though, a non-deductible IRA is worse than a taxable account in almost every situation. Assuming you have no pre-tax IRA assets (401k rollover, etc...) you should absolutely do a backdoor Roth, both with future contributions and this recharacterization. You'll pay regular income tax on any growth that occurred in-between the original disallowed roth contribution and the conversion back to Roth, but no biggy in the long-run. In the future when you plan to do this in advance, the conversion can happen just a couple days after the contribution, so the growth/taxes are small or non-existent.

There is really no drawback to the backdoor Roth relative to a regular Roth contribution other than a few more mouse clicks and another tax-form. For this reason, I now do only backdoor Roths even though my base salary is below the limit. This way if I sell some RSUs or receive grants I won't have to go through the trouble/tax of a recharacteriztion/conversion like you are now.

Gr8Time2Balive
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Joined: Wed Jun 13, 2018 12:15 pm

Re: Roth Re-characterization an Opportunity to Re-examine American Funds

Post by Gr8Time2Balive » Thu Jun 14, 2018 3:31 pm

I assume FS means "financial services" company.
That is correct. I have never heard anything about her being limited on choices outside her employer plan; but her employer matches so obviously we max that out. Unfortunately, after my deep dive yesterday, some of her options are not great. For example, the International option will have 50% allocation to a 5-star fund with a 25% allocation to a 3 or 2 star. I know Morningstar it not the be all, end all in terms of fund evaluation, but its an easy proxy to communicate that we'd probably be better off just going to a Vanguard International Index/ETF.


We now have to establish and begin contributing to Traditional IRAs.
Since you cannot deduct the contributions, I would not use traditional IRA at all unless you plan to use the "back door". If not, put the money into a taxable account instead.

This does not fix the issue of having that one contribution to tIRA if you do the recharacterization.

Are you familiar with the back door?
1. We will be ineligible for the traditional deduction because we will both have employer-sponsored retirement plans, correct? Not because of our income. I didn't see anything on the IRS website about income restrictions for TIRA deductions.

2. Vaguely familiar with the back door. Basically, anyone can contribute to a TIRA all year and then at the end of the year just move the money over to a ROTH and, if you had taken a deduction, the contributions are added to your income so you pay taxes on them so the distributions will be tax free at retirement. Is that the gist?
Your portfolio examination should really start with your plans at work - often a 401k or 403b. I think you might benefit from having an entire review of all your accounts. See the link at the bottom of this message for how to do that. The closer you follow the format, the more help sand the more reliable help you will get. It's some work, but people learn a lot by doing it.
Thanks. I will take a look. I'm trying to do all of this without the help of a financial advisor...though I have considered going one time to a fee only advisor just get everything set. Part of me feels like I should be able to do this stuff myself. From school, we learned all about Sharpe ratios, factor models, smart beta portfolios, all this stuff, but its a little daunting when its your own money and future on the line. I already learned my lesson about buying from financial advisors and investing in individual stocks in 2008.

Gr8Time2Balive
Posts: 3
Joined: Wed Jun 13, 2018 12:15 pm

Re: Roth Re-characterization an Opportunity to Re-examine American Funds

Post by Gr8Time2Balive » Thu Jun 14, 2018 3:52 pm

Nope you are not thinking about this correctly. $1M in a single account will grow just as fast as $1 being placed in 1 million different accounts. Compounding doesn't work that way; your total portfolio balance (and of course allocation) is what matters.
Man, you are correct. That is what my intuition was but I wanted to double check so I setup an excel but made a simple mistake which made the "1$M" (in your example) look bigger. Its the same total principal being compounded whether its together or separate.
As stated though, a non-deductible IRA is worse than a taxable account in almost every situation. Assuming you have no pre-tax IRA assets (401k rollover, etc...) you should absolutely do a backdoor Roth, both with future contributions and this recharacterization. You'll pay regular income tax on any growth that occurred in-between the original disallowed roth contribution and the conversion back to Roth, but no biggy in the long-run. In the future when you plan to do this in advance, the conversion can happen just a couple days after the contribution, so the growth/taxes are small or non-existent.
So I can back door the ROTH contributions that I am recharacterizing to a Traditional back into a ROTH? This seems dumb on the government's part. I guess I will have to pay some taxes on the growth that's occurred this year, correct? So I need to get this recharacterization done ASAP because everyday that the market is up, its costing my money.

retiredjg
Posts: 33236
Joined: Thu Jan 10, 2008 12:56 pm

Re: Roth Re-characterization an Opportunity to Re-examine American Funds

Post by retiredjg » Thu Jun 14, 2018 5:26 pm

Gr8Time2Balive wrote:
Thu Jun 14, 2018 3:31 pm
Are you familiar with the back door?
1. We will be ineligible for the traditional deduction because we will both have employer-sponsored retirement plans, correct? Not because of our income. I didn't see anything on the IRS website about income restrictions for TIRA deductions.
You will be ineligible because of being covered by work plans AND your adjusted gross income (AGI). If your AGI were much much lower, you could deduct in spite of being covered by a plan at work.

2. Vaguely familiar with the back door. Basically, anyone can contribute to a TIRA all year and then at the end of the year just move the money over to a ROTH and, if you had taken a deduction, the contributions are added to your income so you pay taxes on them so the distributions will be tax free at retirement. Is that the gist?
Not really. The back door is usually not used by people who are eligible to deduct contributions (although there is no reason they could not use it). But you have some of it right.


Thanks. I will take a look. I'm trying to do all of this without the help of a financial advisor...though I have considered going one time to a fee only advisor just get everything set. Part of me feels like I should be able to do this stuff myself. From school, we learned all about Sharpe ratios, factor models, smart beta portfolios, all this stuff, but its a little daunting when its your own money and future on the line. I already learned my lesson about buying from financial advisors and investing in individual stocks in 2008.
Do consider doing this complete assessment. You do not need to know ANYTHING about sharpe ratios, factor models, smart beta or any of that stuff. In fact for right now, you need to completely forget all that stuff exists. You need to walk first and that stuff is associated with running (or not relevant at all to setting up a good portfolio).


I think this would be a good place for you to start. https://www.bogleheads.org/wiki/Getting_started. After spending several hours there, find the wiki page for "back door roth IRA".

retiredjg
Posts: 33236
Joined: Thu Jan 10, 2008 12:56 pm

Re: Roth Re-characterization an Opportunity to Re-examine American Funds

Post by retiredjg » Thu Jun 14, 2018 5:30 pm

Gr8Time2Balive wrote:
Thu Jun 14, 2018 3:52 pm
So I can back door the ROTH contributions that I am recharacterizing to a Traditional back into a ROTH?
Yes, but there are several situations where this would be a very bad idea. We don't know enough to comment much.

This seems dumb on the government's part. I guess I will have to pay some taxes on the growth that's occurred this year, correct? So I need to get this recharacterization done ASAP because everyday that the market is up, its costing my money.
Do not rush into this. Figure it out first. If you have any other IRAs (except Roth IRA), you do not want to rush into a recharacterization and Roth conversion.

This is why I'm suggestion you need to lay out your entire financial picture before you get advice or make a decision on this.

MotoTrojan
Posts: 1908
Joined: Wed Feb 01, 2017 8:39 pm

Re: Roth Re-characterization an Opportunity to Re-examine American Funds

Post by MotoTrojan » Thu Jun 14, 2018 5:33 pm

Gr8Time2Balive wrote:
Thu Jun 14, 2018 3:52 pm


So I can back door the ROTH contributions that I am recharacterizing to a Traditional back into a ROTH? This seems dumb on the government's part. I guess I will have to pay some taxes on the growth that's occurred this year, correct? So I need to get this recharacterization done ASAP because everyday that the market is up, its costing my money.
Correct. It is strange indeed, but at-least you are paying some taxes due to the delay (in many cases a conventional backdoor Roth without the recharacterization will not have any tax liability).

As noted above, do NOT do this if you have pre-tax assets in your IRA. If all you have is the Roth, 401k, and recharacterized 2017 contribution then you are fine.

As stated, you'll pay regular income tax on any gains. Yes doing it ASAP would be my move, but you seem confident the market won't go down tomorrow (which would reduce your tax liability) :). Just be careful come tax-season to properly document this. I did this last year, not a big deal at all.

Agree with the above poster. Stop thinking about sharpe ratios etc. If all of your assets are in tax-advantaged accounts I personally would setup a 3-fund portfolio or just use target-date funds with the appropriate AA. If you have taxable assets too, use the 3-fund but keep Total US/Int in taxable with all bonds in 401k (as well as Roth if necessary).

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