"Back Door" Roth IRA Question

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billp25
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"Back Door" Roth IRA Question

Post by billp25 »

I am considering opening a Roth IRA using the "back door" Roth IRA method.

I was wondering, however, how this process works year to year. Would I need to open a new non-deductible IRA every year and convert to a Roth or could I just keep the one Roth IRA that I convert at the outset for an extended period of time and continue to put in the maximum amount each year.

Thanks in advance for any insight.
investor1
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Re: "Back Door" Roth IRA Question

Post by investor1 »

You open a tIRA and a Roth IRA. You contribute to your tIRA and convert to a Roth IRA. The accounts stay open. The balance is carried in the Roth IRA.
Default User BR
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Re: "Back Door" Roth IRA Question

Post by Default User BR »

There's no such thing as a "non-deductible IRA". There is Roth. There is Traditional. The latter can have contributions that are deductible or not depending on the contributor's income and other factors.

The IRS doesn't care whether you have one of each kind of IRA or a hundred. Whether you make contributions to the same TIRA each year or whether the conversion goes to the same Roth or not doesn't matter. Some like to use a new Roth because it makes possible recharacterization somewhat simpler. A custodian might close an empty TIRA.


Brian
FinancialDave
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Re: "Back Door" Roth IRA Question

Post by FinancialDave »

Remember, what makes this work (without extra taxes) is the fact that you have no other Traditional IRA accounts (such as from old 401ks) and that you file the proper IRS form indicating the money put into the IRA is after-tax money.

fd
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catchup
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Re: "Back Door" Roth IRA Question

Post by catchup »

With respect to the last point:
I have about 200 k in a rollover non Roth Ira.
For last couple years or so I ha ve done a back door Roth.
Is this a mistake?
I think the paperwork has been done to indicate that the contribution to trad Ira is post tax. Not sure what other taxes I should have paid. I send the accountant my year end statements so he sees the whole picture.

I do the rollover so I can build toward better diversification between our Roths and nonroths over time until I am 50/50, since there are so many unknowns about my tax rates of the near and distant future.
crumbgrabber
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Re: "Back Door" Roth IRA Question

Post by crumbgrabber »

You need to pay prorated/adjusted taxes on any gains in the traditional IRA with $200k in it, even if you did not convert this money to a Roth IRA. This could be a large tax boo-boo, so you probably should look into whether this was handled properly in your tax returns for the last few years in which you did Roth conversions. This is the one catch with the backdoor Roth conversion process.

I don't think you want to keep 50/50 trad/Roth because every year you do the back door conversion you will need to pay taxes on gains in the traditional IRAs. Also, if you are doing the backdoor Roth that sort of implies that your income is too high to be able to deduct traditional IRA contributions--if this is the case then there is no reason to keep any traditional IRAs, since you have already paid your taxes on that income, and converting to Roth means you won't pay taxes on any gains--that's the whole reason people perform the backdoor Roth conversion!
Default User BR
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Re: "Back Door" Roth IRA Question

Post by Default User BR »

catchup wrote:With respect to the last point:
I have about 200 k in a rollover non Roth Ira.
For last couple years or so I ha ve done a back door Roth.
If you (or your preparer or tax software) did the computation on Form 8606 properly, then there should have been a pro-rata calculation such that the majority of each conversion was taxable. If not, if you just paid no taxes on the conversion, then you did it wrong.


Brian
catchup
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Re: "Back Door" Roth IRA Question

Post by catchup »

Yep, I looked at 2011 taxes, and I think my accountant missed the details of the roth conversion, even though I provided all of the information.
Not sure about 2010.

Now what?
Will I be arrested for tax evasion, or will the IRS allow us to file a correction?
The reason I pay an accountant is to figure this stuff out for me.
Maybe I need to rethink the idea.

Thanks.
Default User BR
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Re: "Back Door" Roth IRA Question

Post by Default User BR »

catchup wrote:Will I be arrested for tax evasion, or will the IRS allow us to file a correction?
The reason I pay an accountant is to figure this stuff out for me.
Prosecution is unlikely. An audit from the IRS is possible. You could file amended returns. I would first discuss with the tax preparer and find out what happened.


Brian
FinancialDave
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Re: "Back Door" Roth IRA Question

Post by FinancialDave »

catchup wrote:With respect to the last point:
I have about 200 k in a rollover non Roth Ira.
For last couple years or so I ha ve done a back door Roth.
Is this a mistake?
I think the paperwork has been done to indicate that the contribution to trad Ira is post tax. Not sure what other taxes I should have paid. I send the accountant my year end statements so he sees the whole picture.

I do the rollover so I can build toward better diversification between our Roths and nonroths over time until I am 50/50, since there are so many unknowns about my tax rates of the near and distant future.
Ouch,
Taxes and penalties.

I really would not do any more, and if you have done one this year I would "unwind" it.

In your particular case if you are dead set on getting a higher proportion in the Roth, I think a straight conversion from the Rollover IRA would be much simplier, though I really don't like these conversions, expecially since you already have a salary too high for a normal Roth -- meaning you are in a fairly high tax bracket. Because of your high salary now, this is making the traditional IRA and 401k a better bet for you (IMHO.)

fd
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travellight
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Re: "Back Door" Roth IRA Question

Post by travellight »

Because of your high salary now, this is making the traditional IRA and 401k a better bet for you (IMHO.)
This may not be the case though if he/she has planned retirement so well that they will remain in the highest tax category forever though, as I understand it. In that case, it does make sense to try to do a back door ROTH as I understand it. It just has to be done properly.

I am trying to do the back door ROTH IRA for the first time and found myself in the same situation where my accountant had not filed the proper forms (8606) and I am in the elaborate process of trying to tease it all out, figure out which contributions/years were not reported to the IRS so I can get proper credit for them and have it all correct before I do the back door. It is unfortunate to have done the back door ROTH without the proper procedures. Even more work I would imagine, and possibly some fees?
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FinancialDave
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Re: "Back Door" Roth IRA Question

Post by FinancialDave »

travellight wrote:
Because of your high salary now, this is making the traditional IRA and 401k a better bet for you (IMHO.)
This may not be the case though if he/she has planned retirement so well that they will remain in the highest tax category forever though, as I understand it. In that case, it does make sense to try to do a back door ROTH as I understand it. It just has to be done properly.
Then only realistic prediction that people can make is that their tax rate will be exactly the same now as it is later, in which case the Roth and non-Roth account will have the same tax implications overall. Now most people would probably argue that they know their tax rate will not be the same, HOWEVER, I would argue there is a 50/50 chance it could go either way, due either to lower or higher income, or lower or higher tax rates - neither of which can be adequately predicted 10-30 years into the future. Heck, a person could become disabled, or lose their job tomorrow and then where would their tax rate go.

This is why I most always recommend it is good to have an equal supply of Roth and non-Roth money. This gives you the most flexibility in retirement.

fd
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catchup
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Re: "Back Door" Roth IRA Question

Post by catchup »

Based on what I know, I still am OK with working toward an equal proportion of roth and non roth ira by doing yearly backdoor roth contributions.
It means that most of the 5000 is taxable, but if I am able to keep the Roth for many years or pass it on to future generations, then it seems that it is a good investiment of 1700 dollars.

I talked to the accountant, good man, who did my taxes that last couple years, and he in fact did not know the proper rules.
I told him we will need to go back and make corrections, otherwise it is frank evasion.

He tells me I need to let him know what the year-end non-Roth IRA holdings were for each year involved.

Is this the case, or is it the amount of the non-roth holdings at the time that the roth conversion was made?

Thanks.
catchup
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Re: "Back Door" Roth IRA Question

Post by catchup »

financial dave,

Are you contradicting yoruself, or do I misunderstand you.
At first you said doing the roth conversion is a mistake, then you went on to say that you recommend having equal amounts Roth and non-roth.
Thanks.
FinancialDave
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Re: "Back Door" Roth IRA Question

Post by FinancialDave »

They are pretty much two separate situations, which when put together become much more complex.

1. Doing the Roth conversion and then essentially paying tax "twice" on "most" of the money you are converting, is not really going to save you money in the long run. I'm not really 100% sure of what actually happens in this case (and maybe someone who has actually done it can chime in), but the money you put in the IRA is already after-tax money and then you end up paying tax on a pro-rated portion of your other Rollover IRA money - what I have not investigated is if this now "taxed Rollover IRA" money now becomes after tax money. What I do know for a fact is that doing things that you don't understand can sometimes get you into problems you don't anticipate - included within this are some discussions that I have read that seem to indicate a less than 100% confidence in the whole Back Door Roth operation. Now I don't dispute that many people have done it and it seems legal enough, though others have offered if the IRS wanted to shut it down they could possibly do so in a heartbeat. Anyway that discussion is neither here nor there, I just throw it out there, with the notion in mind of Keeping it Simple. In your case if you want to do a conversion just convert some money directly out of your Rollover IRA as the tax consequence is going to be about the same and a lot less paywork is involved.

But back to your original question as to whether doing the conversion at all is recommended -- I don't think it is wise right now in your higher tax bracket as it will only create more of these higher taxes, and next year they will probably be even higher. Without doing a complete economic analysis and trying to predict the "unkowable," I leave the final choice up to you, I merely state I don't think it is your best move.

2. The above choice (not doing the conversions) does not change my suggestion that you probably need more Roth money to be able to make better choices in retirement. So if you can't do conversions right now what are your options:

a) If somehow in the future your work allows a 401k Roth - PROBLEM solved. Many companies are dong this and sometimes it just takes a few concerned employees making the suggestion and the reasons why.
b) Do like I did and make some of the conversions in the years after you are retired when you income is much lower (hopefully.) Then your conversion tax is most likely much lower as well.
c) Be mindful of the fact that if you are really in a high tax bracket now and end up being in a lower tax bracket in retirement, the whole Roth / non-Roth issue becomes less of a necessity. The reason being that the whole premiss is that Roth and non-Roth funds are equivalent given the same tax rates - when tax rates going in, or coming out, are highly different, then it skews the results to having more money in the non-Roth or Roth side. In your case if you income (or specifically your tax rate) becomes less in retirement, the 401k funds turn out to be the better choice, because you ended up paying a lot of tax to get the funds in a Roth on the front end. And yes, of course item c contradicts my "normal" suggestion to keep Roth and non-Roth funds about equal, but not everything works 100% of the time.

fd
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travellight
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Re: "Back Door" Roth IRA Question

Post by travellight »

I don't understand the costs on the front end of a Roth. If your income is low enough, you can contribute directly into a Roth IRA and I don't think there are fees to do that. Your money grows tax free and you take it out tax free so it seems like a no brainer. If your income is too high, you can do a back door roth where you transfer your gains (not yet taxed profits on your contributions) into your 401K where you will pay taxes when you withdraw in retirement. Your basis, or original contributions, which were already taxed can then go into the back door ROTH with no costs that I know of and grow tax free and withdraw tax free. At least, that is my understanding of it.

The only thing that doesn't make sense is paying to convert to a ROTH without doing the back door method, If you do a simple conversion, you will pay tax on the portion (or pro rata) of your funds that were gains and not yet taxed. Since you pay taxes based on your current income tax bracket and if you anticipate being in a lower bracket in retirement, this does not make sense to do.

SO, it seems to me that a back door Roth always makes sense, as well as a direct Roth contribution for those who are below the income threshold. I don't know why one would want a mixture of Roth and taxable for these people.
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FinancialDave
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Re: "Back Door" Roth IRA Question

Post by FinancialDave »

Travellight,

The costs on the front end of a Roth are the TAXES paid in today's dollars. If your income is high these taxes are HIGH.

The higher your income, and thus the more likely your taxes will be lower in retirement, the more money you will be wasting by putting it into a Roth now!

fd
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FinancialDave
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Re: "Back Door" Roth IRA Question

Post by FinancialDave »

The only place where the Roth starts to become a "no-brainer" is when you are currently on the very low end of the tax spectrum - for just the opposite reasons as stated above.

fd
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Default User BR
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Re: "Back Door" Roth IRA Question

Post by Default User BR »

FinancialDave wrote:1. Doing the Roth conversion and then essentially paying tax "twice" on "most" of the money you are converting, is not really going to save you money in the long run. I'm not really 100% sure of what actually happens in this case (and maybe someone who has actually done it can chime in), but the money you put in the IRA is already after-tax money and then you end up paying tax on a pro-rated portion of your other Rollover IRA money - what I have not investigated is if this now "taxed Rollover IRA" money now becomes after tax money.
The important thing to realize is that in the eyes of the IRS, you have one big traditional IRA (which includes rollover, SEP, and SIMPLE for this purpose) and one big Roth IRA. If there have been after-tax contributions to any of the traditional accounts, that basis is cumulative and shared. Whenever you do a conversion of money contained in traditional, regardless of which account it comes from, the pro-rata calculation is performed. This determines how much tax is owed on the conversion and how much of the basis is used up. So yes, by doing a partial conversion, some of the previously taxable money in the rollover becomes after-tax. That's because you just paid tax on it. So no real mystery.



Brian
FinancialDave
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Re: "Back Door" Roth IRA Question

Post by FinancialDave »

Brain,
That's what I thought and basically it becomes your nightmare to keep track of, because even though you may have liquidated the "transient" after tax IRA account, the pro-rated amount of after tax money that is left moves to your IRA rollover account that is left. It is not really complex, just a headache, and mostly I try to avoid headaches I don't need. This is just one headache I wouldn't mind paying a little extra to avoid - much like re-investing dividends in a taxable account (but that is a different subject!)

fd
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Epsilon Delta
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Re: "Back Door" Roth IRA Question

Post by Epsilon Delta »

catchup wrote: He tells me I need to let him know what the year-end non-Roth IRA holdings were for each year involved.

Is this the case, or is it the amount of the non-roth holdings at the time that the roth conversion was made?

Thanks.
End of the year. See line 6 of form 8086 (for 2011)

http://www.irs.gov/pub/irs-pdf/f8606.pdf
travellight
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Re: "Back Door" Roth IRA Question

Post by travellight »

Financialdave- there should be no taxes payable upon opening a ROTH if you have isolated the funds to the basis/contributions by doing the back door method. If you didn't differentiate and isolate the funds, then yes, you would pay taxes on the portion in the account that is not-yet-taxed, the gains. If you move those gains out though, the amount you put into the ROTH should incur no taxes with the conversion as I understand it.
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FinancialDave
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Re: "Back Door" Roth IRA Question

Post by FinancialDave »

travellight wrote:Financialdave- there should be no taxes payable upon opening a ROTH if you have isolated the funds to the basis/contributions by doing the back door method. If you didn't differentiate and isolate the funds, then yes, you would pay taxes on the portion in the account that is not-yet-taxed, the gains. If you move those gains out though, the amount you put into the ROTH should incur no taxes with the conversion as I understand it.
I guess you mis-understood. The taxes I am talking about are the taxes you paid on the earned money in the first place. These taxes are exactly equal to the same amount of money put into say a 401k and then taken out at exactly the same tax rate.


In other words you make $10,000 and get to put the whole $10,000 into the 401k.

You make $10,000, but only get to put $7500 in the Roth. Taxman gets his cut up front.

At the end of 20 years of growth, if the tax rate is exactly the same (in my example 25%) both accounts return exactly the same amount after taxes.

You can NOT isolate the funds in your other IRA rollover accounts, as was pointed out in detail above.

So when you do the back door Roth you will end up with not only the $5000 of money that was taxed as earned income, but if you have a large Rolloever IRA (say $195k) you will end up paying tax on roughly $4875 to do the conversion and be left with $4875 of after tax money in your Rollover IRA (if my quick math is correct.) Because the $5k, in your after-tax backdoor IRA, is only 2 1/2 percent of your $200k IRA total, you will be taxed on 97.5% of the conversion amount, as I see it.

If you do a straight conversion from the Rollover IRA, you will pay tax on the $5000 instead of $4875. Little consolation for the headaches involved.

fd
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travellight
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Re: "Back Door" Roth IRA Question

Post by travellight »

I had a hard time following you, financialdave.

I do agree that it is better to max out your 401K. I would prefer to do retirement funds that are pre-tax than post-tax. I just think that after maxing out the 401K, it is preferable to do a ROTH Ira or a back door ROTH than a traditional Ira.

Here is a link to my thread on it which reflects my understanding of it:

http://www.bogleheads.org/forum/viewtop ... 4#p1547004
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