Backdoor Roth strategy - your thoughts

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TonyUncleJohnny
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Backdoor Roth strategy - your thoughts

Post by TonyUncleJohnny » Wed Jan 10, 2018 11:48 am

Thanks to the Wiki and threads on Backdoor Roth conversions, I now understand its basics.

Looking to get a second set of eyes on our personal situation, and thoughts on whether we would be good candidates to backdoor into Roth.

Married couple filing jointly, both age 35, 1 child. Gross income ~$300k. Expected net worth in retirement (for effective tax rate assumptions) - at least low 8 figures (owing to personal savings and expected family wealth).

Current traditional IRA balances (all contributions were pre-tax) - husband: $112k, wife: $12k.

We both max out our 401ks (Roth style), as well as 529 for child. Can't make Roth or deductible tIRA contributions due to income levels. So we invest the rest of our savings through taxable accounts. I'm trying to determine if we would instead benefit from putting the tIRA max of $11k ($5.5k x 2) into a backdoor Roth, and then what's left into taxable.

Let's assume we can't rollover our tIRA balances into our 401Ks. If we were to contribute $11k into our traditional IRA for tax year 2017, and then backdoor it into Roth, given the current tIRA balances there would be a tax bill based on a rate determined by our income + taxable portion of conversion amount.

Window of opportunity? - In the next year or two, we may have a second child and the unpaid maternity leave + wife possibly working reduced hours for a few years following second child's birth may drop our gross income temporarily from $300k to some slightly lower amount.

If we choose to make the 2017 $11k tIRA contribution for Backdoor Roth purposes, our options are,
  • Convert all tIRA balances to Roth right away, pay the tax, and be done with it.
  • Convert all tIRA balances to Roth next year or the year after when we have one more child and income (possibly) is a bit lower than 2017, thus tax rates are lower.
  • Convert just the $11k to Roth right away, but pay a tax bill due to the pro-ration rules owing to current pre-tax tIRA balances.
  • Convert just the $11k to Roth next year or the year after when we have one more child and income (possibly) is a bit lower than 2017, thus tax rates are lower.
  • Any other options I didn't think of?
Also, I think we would like to keep making these Backdoor Roth conversions every year, in which case it probably makes sense to convert all tIRA balances sooner rather than later?

All of this assumes we will have a higher effective tax rate in retirement (higher net worth and also spend (thus distributions) than currently). I realize portfolio mix at the time will determine whether the higher distributions also mean higher effective tax rate. I'm going with the assumption that it will be higher, but interested in counter arguments if any.

Curious how you would plan in this situation.

Many thanks for everyone's time.
Last edited by TonyUncleJohnny on Wed Jan 10, 2018 12:20 pm, edited 1 time in total.

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Ethelred
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Re: Backdoor Roth strategy - your thoughts

Post by Ethelred » Wed Jan 10, 2018 12:05 pm

Can you rollover the tIRAs into your 401ks?

Topic Author
TonyUncleJohnny
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Re: Backdoor Roth strategy - your thoughts

Post by TonyUncleJohnny » Wed Jan 10, 2018 12:18 pm

Ethelred wrote:
Wed Jan 10, 2018 12:05 pm
Can you rollover the tIRAs into your 401ks?
Ah yes, I forgot to list this option, but would like to exclude it for purposes of this discussion.

Will edit OP, thanks.

Spirit Rider
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Re: Backdoor Roth strategy - your thoughts

Post by Spirit Rider » Wed Jan 10, 2018 12:54 pm

I'm not sure I understand your fixation on paying income taxes. You were at least in the 28% marginal federal income tax bracket and likely additional state income taxes. Yet you made all Roth 401k contributions.

In 2018 and for the next decade at least, you will be solidly in the 24% bracket. A slightly lower income is not going to change that. Yet you want to pay more taxes by doing Roth conversions of taxable IRA assets.

We do Backdoor Roths at higher incomes, not because they are Roth, but because they are additional tax-advantaged space. Now the tax diversification is a good thing as is making taxable investments with the tax savings from pre-tax deferrals.

I question your fundamental assumption that current deferred contributions will be taxed at a higher rate than at withdrawal Yes, the tax cuts are temporary, but so we're Bush''s. Even Obama agreed to make most of them permanent.

You are also neglecting the ability to reduce the deferred balance thru distributions or make Roth conversions at lower tax rates in the early part of your retirement.

So, sorry to not exclude the 401k roller option as it is the only option (if available) that makes sense to me.

lakpr
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Re: Backdoor Roth strategy - your thoughts

Post by lakpr » Wed Jan 10, 2018 1:33 pm

I read the OP's post as saying that at retirement they are likely to have wealth at least $10 million ('low 8 figures'), and thinks that if he contributes to the traditional IRA or traditional 401-k plans he's likely to pay higher tax than now when withdrawing in retirement.

I can see why he prefers to follow the Roth 401-k option.

That said, to answer OP's question, if I were in OP's shoes and rollover of IRA funds into 401-k is truly not available:
1. keep contributing $11k per year into traditional IRAs at the beginning of the year
2. Around late November / early December of each calendar year, find out what the likely income until the end of the year is going to be
3. Convert from the traditional IRA to Roth IRA until the top of that tax bracket (or next tax bracket, if he has the appetite for higher taxes and resources to pay those taxes outside of the IRA contributions)

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TonyUncleJohnny
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Re: Backdoor Roth strategy - your thoughts

Post by TonyUncleJohnny » Wed Jan 10, 2018 4:04 pm

Spirit Rider and lakpr, Thank you both for your inputs.

Lakpr is correct. Given expected higher net worth (and high distributions, thus income) in retirement, I figure we'll be in the 32% or higher tax bracket when we retire (based on 2018 brackets).

For 2017, our marginal tax rate is 33%. For 2018 and at least a few years after, it will be 24% and even if salary increases, tIRA conversions, etc. push us into the next tax bracket, it will still be 32% (lower than 2017 and no higher than retirement).

So we should start contributions to the tIRA but not do the Roth conversion in 2017, and instead start doing it in 2018 and get it done while our incomes remain at this level and we haven't racked up a lot more in gains in the tIRA. Wouldn't that make sense?

As far as rolling over to 401k goes, doesn't that have the same problem? Distributions in retirement would be taxed at a higher rate than now. A benefit I do see is not having to create liquidity for the tax bill right now, but that is not a big concern.

If anyone can still find holes in this plan, I would both welcome and appreciate your comments. Many thanks.

lakpr
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Re: Backdoor Roth strategy - your thoughts

Post by lakpr » Wed Jan 10, 2018 4:40 pm

TonyUncleJohnny wrote:
Wed Jan 10, 2018 4:04 pm
As far as rolling over to 401k goes, doesn't that have the same problem? Distributions in retirement would be taxed at a higher rate than now. A benefit I do see is not having to create liquidity for the tax bill right now, but that is not a big concern.
Just because you are rolling over the funds into 401-k account does not mean that it has to stay there until your retirement. Check with your HR and the plan document, of course -- but it is possible for funds left in traditional 401-k plan to be converted to Roth 401-k plan. At least with my MegaCorp 401-k plan it is possible.

Each year after roll over, then, convert these funds into Roth 401-k funds little by little (up to the top of your current tax bracket), and in a few years those amounts would be gone.

There is just one catch here, you need to certify to the plan administrator that the funds you are rolling over have always been tax-deductible. If that's not the case, then you have to consider whether you want to convert the entire 112K in one go and be done with it, or at least convert it outside of 401-k plan over a multi-year period. I believe (but not entirely sure) that this is an ERISA law requirement.///

I'd suggest that you do NOT forego the opportunity to contribute to backdoor Roth for 2017. It would be gone forever after April 15th. That's 11K + future gains sheltered from the tax man!

Topic Author
TonyUncleJohnny
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Re: Backdoor Roth strategy - your thoughts

Post by TonyUncleJohnny » Wed Jan 10, 2018 9:17 pm

lakpr wrote:
Wed Jan 10, 2018 4:40 pm
it is possible for funds left in traditional 401-k plan to be converted to Roth 401-k plan.

I'd suggest that you do NOT forego the opportunity to contribute to backdoor Roth for 2017. It would be gone forever after April 15th. That's 11K + future gains sheltered from the tax man!
Indeed, I do plan to make the 2017 contribution, and each year going forward as well. Will start converting the tIRA balance in 2018 and try to get it done quickly within a year or two.

As far as Roth 401k goes, I might as well convert from tIRA to Roth IRA instead of rolling over to t401k and then converting to Roth 401k. No savings there, correct?

One more question - if I convert from Vanguard tIRA to Vanguard Roth, will all investments (index funds, individual stocks) carry over exactly the way they are, or will they be liquidated and I'd have to place the same trades again in the Roth IRA to get back to the same portfolio?

lakpr
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Re: Backdoor Roth strategy - your thoughts

Post by lakpr » Sat Jan 13, 2018 10:50 am

TonyUncleJohnny,

Wasn't able to respond to this post until now.

If you are going to convert the entire traditional IRA this year, and able to absorb the tax hit, then yes I agree that there is no savings there compared to rolling it into company 401k plan and then converting it to Roth 401k plan. But, if you are going to spread out the Roth conversion over time ( and I suggest that you do ), rolling into 401k plan is better. It allows you the flexibility to convert in smaller chunks over the years up to the top of your then-current tax bracket, which might be cheaper than converting all at once.

If you don't convert the traditional IRA all this year, nor roll it into your 401k plan, any non deductible IRA contributions that you convert to Roth IRA would be deemed as having been converted on a fractional basis. I am sure you are aware of it.

I strongly suggest that your non deductible IRA contributions be made into an account at a completely different provider than where your current IRA is. (If it is at Vanguard, open your non deductible IRA at Fidelity or Schwab etc. ).

Topic Author
TonyUncleJohnny
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Re: Backdoor Roth strategy - your thoughts

Post by TonyUncleJohnny » Tue Jan 16, 2018 5:12 pm

lakpr wrote:
Sat Jan 13, 2018 10:50 am
If you don't convert the traditional IRA all this year, nor roll it into your 401k plan, any non deductible IRA contributions that you convert to Roth IRA would be deemed as having been converted on a fractional basis. I am sure you are aware of it.

I strongly suggest that your non deductible IRA contributions be made into an account at a completely different provider than where your current IRA is. (If it is at Vanguard, open your non deductible IRA at Fidelity or Schwab etc. ).
Yes, I am aware it will have to be done on a prorated basis if the pre-tax tIRA dollars haven't been rolled back into a 401k. That said, I could still convert in smaller chunks despite not having rolled the balance into a 401k, correct? It would just have to be on a prorated basis, and perhaps a bit messy as far as record keeping until everything gets converted.

Also, how would keeping the non-deductible contributions at a different provider help?

Thanks,
T

Jamesla30
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Re: Backdoor Roth strategy - your thoughts

Post by Jamesla30 » Tue Jan 16, 2018 5:58 pm

I think you are making this a bit more complicated than necessary. Your income level currently puts you in sort of a gray zone on if traditional or roth contributions are best. It sounds like you are expecting a VERY large inheritance, because $300k income isn't going to get you into 8 figure savings at retirement. It just isn't. And remember, your tax rate is determined by your income, not your net worth. So you could have a large chunk of savings at retirement, but do you really plan on pulling out $500k plus every year when you are retired? Probably not. You will probably pull out $250k or less, and that will put you into a similar tax bracket, or maybe lower.

Usually for 401k ROTH accounts at a job, the "matching" contributions are required to be put into a TRADITIONAL 401k, only your elective deferrals ($18k) go into ROTH. Do you have both?

If I were you, and it is available, I would roll all your traditional ira balances into your traditional 401k. This will allow you to then do backdoor roth contributions on a regular basis moving forward since your traditional IRA accounts will be zero. I would keep a mix of traditional (401k) and roth balances (roth 401k and roth ira).

This will allow flexibility when you get to retirement. If your income starts to go up into the really high brackets, then just adjust your 401k contributions towards traditional 401k instead of roth 401k.

24% marginal bracket -- definitely do ROTH.
Once you start to get well into and above the 32% bracket, then do TRADITIONAL.
I would still do ROTH if you are only slightly into the 32% bracket.
This is after the backdoor ROTH contributions, which you will do every year automatically.
Last edited by Jamesla30 on Tue Jan 16, 2018 6:11 pm, edited 1 time in total.

Jamesla30
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Re: Backdoor Roth strategy - your thoughts

Post by Jamesla30 » Tue Jan 16, 2018 6:09 pm

Also, I will add that if you cannot roll your traditional IRA balances into a traditional 401k, then yes you will have to start doing conversions from traditional ira to roth ira and pay some taxes on it. I would try to fill up the 24% bracket as much as you can with conversions. So if you end up having $250k taxable income, then convert $65k from traditional to roth. This will keep you in the 24% bracket. You probably won't be able to do it all in 1 year, so you'll just have to spread it out over time. You can still make the backdoor roth contributions as it will just add to the balances and ratios of what you will owe tax on. Eventually the traditional balance will get to zero though and you won't have to worry about taxes when converting.

Topic Author
TonyUncleJohnny
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Re: Backdoor Roth strategy - your thoughts

Post by TonyUncleJohnny » Tue Jan 16, 2018 7:54 pm

Jamesla30,

All your assumptions are correct. Your explanation (both posts) makes a lot of sense. Thank you for taking the time to explain things the way you did. Cleared everything up for me quite nicely.

I've been wrestling with the same question - as much as we may have a higher net worth in the future, we may not dial up our lifestyle all that much.

How about a Solo 401K? I'm just learning that anyone with even minimal self-employment income can open one. Both my wife and I often pass on modest consulting opportunities that come our way, but I'm wondering if we should pick one up. Even if it pays just a few hundred bucks, if that allows us to open a solo 401k, and Fidelity solo 401ks it seems allow rollovers from Vanguard (and other) IRAs, in which case the solo 401k would become the parking place for our pre-tax IRA funds. And it could also house rollover pre-tax 401Ks if we were to switch employers. This would stay with us for life, unlike employer 401k plans.

If this really can be done, I would immediately open one and move all our pre-tax IRA funds to it, leaving our IRAs empty, thus allowing for a tax-free backdoor Roth conversion of (future) non-deductible Roth contributions.

Jamesla30
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Re: Backdoor Roth strategy - your thoughts

Post by Jamesla30 » Fri Jan 19, 2018 5:12 pm

TonyUncleJohnny wrote:
Tue Jan 16, 2018 7:54 pm
Jamesla30,

All your assumptions are correct. Your explanation (both posts) makes a lot of sense. Thank you for taking the time to explain things the way you did. Cleared everything up for me quite nicely.

I've been wrestling with the same question - as much as we may have a higher net worth in the future, we may not dial up our lifestyle all that much.

How about a Solo 401K? I'm just learning that anyone with even minimal self-employment income can open one. Both my wife and I often pass on modest consulting opportunities that come our way, but I'm wondering if we should pick one up. Even if it pays just a few hundred bucks, if that allows us to open a solo 401k, and Fidelity solo 401ks it seems allow rollovers from Vanguard (and other) IRAs, in which case the solo 401k would become the parking place for our pre-tax IRA funds. And it could also house rollover pre-tax 401Ks if we were to switch employers. This would stay with us for life, unlike employer 401k plans.

If this really can be done, I would immediately open one and move all our pre-tax IRA funds to it, leaving our IRAs empty, thus allowing for a tax-free backdoor Roth conversion of (future) non-deductible Roth contributions.
Your thinking is correct. However, it isn't quite that simple. In order to open a solo 401k you need to have business/self-employment income. You may also have to make regular contributions. You are already maxed out of your 401k at work, so you won't be able to make employee contributions to your solo 401k. You would be limited to 20% of net adjusted business profit (Net adjusted business profit is calculated by taking gross self employment income and then subtracting business expenses and then 1/2 of the self employment tax). So on a few hundred dollars of income, your employer (profit sharing) contribution is going to be tiny.

You would need to check with Fidelity or research what is required to open the account and keep it open. If you don't have business income or contributions in the future, you may have to close the solo 401k and roll it into an IRA, and you will end up back where you started. Or with a really high balance, end up in an even worse situation.

I know you want to do this to this to get the tIRA transferred out immediately to allow the backdoor Roth, but it sounds like a lot of headache for not much benefit. I would recommend against it.

Here is what I would do:

1. Change your 401k contributions to traditional instead of roth. Continue to max ($18k each).
2. On $300k of income, you will have deductions of $24k (standard deduction), plus $18k each (for 401ks). Plus some more for your kids. That puts your taxable income at less than $240k. Even less if your wife stops working some.
3. That means you can rollover $75k per year and still stay in the 24% bracket ($315,000 top).
4. Do this for 2 years.
5. After 2 years, you can adjust your 401k contributions back to roth to get to whatever ratio of roth balances vs. traditional balances you want moving forward.
6. Also after those 2 years, you can begin the backdoor roth conversions. In the meantime, just continue to put those contributions into a taxable account -- then you won't have to worry about ratio paperwork for conversions.

Spirit Rider
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Re: Backdoor Roth strategy - your thoughts

Post by Spirit Rider » Fri Jan 19, 2018 7:52 pm

It is that simple to adopt a one-participant 401k. All that is necessary is earned income as a self-employed individual engaged in a trade or business with the intent to make a profit in the current or any prior year. Consulting income would definitely apply.

There is no requirement for annual contributions. IRS regulations only require termination of a 401k if the business terminates. The IRS considers sole proprietorship to exist until the death of the owner.

Even then, under IRS regulations 1.401.10/11 in order for such a plan to be a qualified plan , the plan must provide that the entire interest of the plan be distributed in full including RMDs over the life of employee, their spouse and/or non-spouse beneficiaries.

Topic Author
TonyUncleJohnny
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Re: Backdoor Roth strategy - your thoughts

Post by TonyUncleJohnny » Fri Jan 19, 2018 8:17 pm

Jamesla30,

I just typed up a response and hit submit, but don't see it in the thread. Strange.

You're very generous to lay it all out for me. Your proposal makes a lot of sense, but there's a new development; we were going through some employer, 401k provider, plan, etc. changes but all that will soon be behind us, and it looks like we will be able to roll our tIRA balances into our 401ks. Following which, we should be able to make non-deductible contributions to our now empty tIRA accounts for backdoor conversion purposes.
And life will be good.

Thank you!

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