Converting to Roth by Isolating Basis - Downside?

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SweetTooth
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Converting to Roth by Isolating Basis - Downside?

Post by SweetTooth »

This is my first time posting. I would greatly appreciate some advice.

Husband age 70 has a T-IRA that contains $625,000, of which $7500 is aftertax dollars (about 1% of total T-IRA). I read about a strategy to isolate the aftertax dollars by rolling over the pretax money to an active employer retirement plan (such as a 401K or 457B) and then converting the remaining aftertax dollars to a Roth -- avoiding the pro rata situation that would normally be required when converting T-IRAs that contain "mixed" contributions.
(This article describes the strategy: https://www.kitces.com/blog/roth-ira-co ... r-plan-qcd
I've also seen it mentioned a few places in this forum.) [ Background: We plan to use his Roth IRA for inheritance purposes, and this seemed like the only way to pull the aftertax $ out of the T IRA. In recent years we started converting some of the IRA, staying within our tax bracket, but I was hoping for another way to do it. Hate to think of heirs forgetting to file the 8606 and inadvertently paying tax on aftertax money, no matter how small. :| ]

My husband's 457B plan said they are able to receive the pretax money and would place it in a separate account. (Husband is an active employee.) They said he can withdraw the $ at any time without penalty. My understanding is that if we decide to roll it back to an T-IRA, we should do it in the following tax year (2022) so that it isn't included on IRS 8606 for Dec 31, 2021.

I spoke to two people at Vanguard where the T-IRA is located, and they were skeptical of the strategy and of course they do not advise on tax matters. One person suggested it might be a lot of "process" to go through -- and asked --is it really worth it?

As far as I can tell, my husband's situation meets the criteria for the strategy to work. My questions for you:
  • Is there any downside to this strategy?
  • Would you go to the trouble to "rescue" a $7500 basis? We would need to cash out of bond funds and Wellesley before we did the rollover to the employer.
  • We would do the conversion strategy in 2021 (rollover the pretax $ to 457B retirement plan; convert the aftertax $ to Roth) and then rollover the 457B $ back to the VG T-IRA in 2022. Is there any benefit to waiting closer to end of year to do the conversion? (The only negative I can see is that the Employer's 457B charges a small annual fee .0006, calculated daily and charged monthly, about $31/mo.)
  • Has anyone successfully carried out this strategy on this forum? No hiccups?
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Duckie
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Re: Converting to Roth by Isolating Basis - Downside?

Post by Duckie »

SweetTooth, welcome to the forum.
SweetTooth wrote: Fri Jun 18, 2021 11:23 pm Hate to think of heirs forgetting to file the 8606 and inadvertently paying tax on aftertax money, no matter how small.
If you don't do the rollover you should put a written explanation and the most recent Form 8606 with your TIRA paper files every year.
My husband's 457B plan said they are able to receive the pretax money and would place it in a separate account. (Husband is an active employee.) They said he can withdraw the $ at any time without penalty. My understanding is that if we decide to roll it back to an T-IRA, we should do it in the following tax year (2022) so that it isn't included on IRS 8606 for Dec 31, 2021.
<snip>
Is there any downside to this strategy?
Would you go to the trouble to "rescue" a $7500 basis?
The only downside is that it's some effort for only $7500.
We would do the conversion strategy in 2021 (rollover the pretax $ to 457B retirement plan; convert the aftertax $ to Roth) and then rollover the 457B $ back to the VG T-IRA in 2022. Is there any benefit to waiting closer to end of year to do the conversion?
Convert as soon as the pre-tax shows up in the 457b. Don't wait until the end of the year.
The only negative I can see is that the Employer's 457B charges a small annual fee .0006, calculated daily and charged monthly, about $31/mo.
Since you plan to roll out in 2022 that fee is not an issue.
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SweetTooth
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Re: Converting to Roth by Isolating Basis - Downside?

Post by SweetTooth »

Thank you for your reply, Duckie.

Yes, it does sound like a lot of effort to get $7,500 into the Roth. Still mulling.... I'm willing to go to the effort if it maximizes tax-free growth and simplifies tax filing going forward (for us and for heirs), as long as there are no negative impacts on taxes/fees/cost/future Medicare, etc. And, it sounds like there is no other downside, other than than the effort. Since husband will likely retire in 2 years, the door will soon close on this strategy because it requires an "active" 457B.
fyre4ce
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Re: Converting to Roth by Isolating Basis - Downside?

Post by fyre4ce »

In general, rollovers are high-risk events. If the money gets rolled into the wrong type of account, it can be difficult or impossible to fix. Or if there are problems, you can accidentally cash out the account. But, if it were me, I would go through the hassle of the two rollovers (with appropriate vigilance) to get $7,500 after-tax basis into a Roth account. It would not be crazy to decide it's not worth the trouble. But I would do it.

One thing: make sure the plan is a governmental 457. Otherwise money can't be rolled out into an IRA.
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SweetTooth
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Re: Converting to Roth by Isolating Basis - Downside?

Post by SweetTooth »

Thanks, fyre4ce. Glad to hear your perspective. There are several moving parts and I definitely don't want to mess it up!
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celia
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Re: Converting to Roth by Isolating Basis - Downside?

Post by celia »

SweetTooth wrote: Fri Jun 18, 2021 11:23 pm Husband age 70 has a T-IRA that contains $625,000, of which $7500 is aftertax dollars (about 1% of total T-IRA).
This sounds like he did the first half of the Backdoor Roth process, but didn't follow through on the second half. And it sounds like you already understand the pro rata rule, since you/your software has been using Form 8606 several years to calculate the taxes. I'm 'with' you in thinking this should be cleaned up, to help make your tax life a little simpler and you already understand what needs to me done.

However, have you been planning around future RMDs and been doing Roth conversions the last few years? (If so, you are ahead of me. :) ) If he hasn't done his Roth conversion yet for this year, he should leave not only the basis, but how much additional he wants to convert in his TIRA. He should convert AT LEAST the amount that the TIRA grows each year. If he converts/withdraws less than the yearly growth, the balance is growing faster than he is withdrawing. This will make his future RMDs continue to grow faster than the RMD divisors require.
I spoke to two people at Vanguard where the T-IRA is located, and they were skeptical of the strategy and of course they do not advise on tax matters. One person suggested it might be a lot of "process" to go through -- and asked --is it really worth it?
The phone reps (at any custodian) don't know if the contributions made to a TIRA were deductible or not. (That's between you and the IRS.) All they know is that lots of customers contact them to help with a conversion or to clean up some error that was made. ASK THE CUSTODIAN HOW THEY WILL BE DOING THE TRANSFER BEFORE YOU AUTHORIZE THE TRANSACTION! One important "error" to look out for (prevent) is that the rollover from and to the TIRA should be a "direct rollover". This means the money should go from a custodian to another custodian electronically or by a check that is make out to the new custodian, "for benefit of <husband>". They may mail the check to you and you are then responsible for making a copy and forwarding it to the new custodian asap. DO NOT GET A CHECK MADE OUT TO HIM AS THIS WILL BE A "INDIRECT ROLLOVER" that prevents him from doing another direct rollover for 365 days. So, if something else comes along that he decides he wants to do with the TIRA or 457B, he may forget, and be subject to severe penalties if he does another "indirect rollover" within the next 365 days.

And I assume one of you has already cleared this with the 457B administrator (so you don't end up with a check made out to them that can't be deposited.)
:oops:
  • Is there any downside to this strategy?
  • Would you go to the trouble to "rescue" a $7500 basis? We would need to cash out of bond funds and Wellesley before we did the rollover to the employer.
  • We would do the conversion strategy in 2021 (rollover the pretax $ to 457B retirement plan; convert the aftertax $ to Roth) and then rollover the 457B $ back to the VG T-IRA in 2022. Is there any benefit to waiting closer to end of year to do the conversion? (The only negative I can see is that the Employer's 457B charges a small annual fee .0006, calculated daily and charged monthly, about $31/mo.)
  • Has anyone successfully carried out this strategy on this forum? No hiccups?
The only 'downside' is if you or a custodian make an error along the way. I assume you know that if you get a check, it needs to be in the other account within 60 days. If there is a custodian to custodian transfer and they "lose" track of the rollover, the time limit doesn't apply, since you weren't doing the physical transfer.

I would do it. In the long term, the time to do the 2 rollovers will someday be less than filing Form 8606 over the rest of his life. It will help simplify your financial life a bit. (Who is going to remember to keep reporting the remaining basis if you both have mental decline and your tax forms are handed over to a tax preparer?)

By waiting until closer to the end of the year, your 457 fees will be a little less, but the stock market will likely change as time goes on. If we have a 'bear' market this year, you may want to convert a lot more than you would have otherwise, since you can convert more shares when they are cheaper, for the same tax hit. But the converse is true, too. If the markets grow, the taxes on the excess "Roth conversion" will also grow. But don't do any rollovers in December as the custodians are very busy with year-end activities then, while employees take time off for the holidays. The rollover may end up taking longer than you expect or might only be 2 or 3 days.

Yes, lots of Bogleheads have done something similar, but it is usually in the context of fixing up a Backdoor Roth that they messed up. (A few times a year, someone will realize they were subject to the pro rata rule when they make a non-deductible contribution to a TIRA that already had pre-tax money in it. The following year when doing taxes, they come here to ask why their Roth conversion was taxed. After they learn about the pro rata rule, they roll their remaining pre-tax money into a 401K, then convert the remaining basis. After they retire, they then roll the pre-tax money back to a TIRA.)

Here a 'test' for the OP: if you understand all the nuances in this post (and I didn't make any typos), you are making a smart move and should be fine. If something is not clear, let us know BEFORE you do anything.
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.
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SweetTooth
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Re: Converting to Roth by Isolating Basis - Downside?

Post by SweetTooth »

Ha Ha-- I like your "test" Celia. Yes, I did understand the nuances of your post, so I guess I pass. :happy
We will definitely do a direct, custodian-to-custodian rollover. Glad you made that point. I'm making a list of all these items to be sure I don't forget any steps!
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SweetTooth
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Re: Converting to Roth by Isolating Basis - Downside?

Post by SweetTooth »

fyre4ce wrote: Sat Jun 19, 2021 8:26 pm One thing: make sure the plan is a governmental 457. Otherwise money can't be rolled out into an IRA.
Yes, fyre4ce -- I forgot to mention that my husband is a state employee. I asked the 457B plan administrator about rolling this money out to a TIRA and was told that I could.
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retiredjg
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Re: Converting to Roth by Isolating Basis - Downside?

Post by retiredjg »

SweetTooth wrote: Fri Jun 18, 2021 11:23 pm
  • Is there any downside to this strategy?
Seems like a fair amount of work. And there is always a small possibility that something will get glitched, causing a lot more work and a royal headache.

Keep in mind that while moving money from an IRA to a plan and back to an IRA, the money is often out of the market for 2 or 3 weeks. The market could move either way during that time. It might benefit you or it might not.

Let's assume the total tax on $7,500 is $3,000. While moving that $617,500 (twice) the market could easily move enough that you actually lose more than $3k in value while trying to rescue the $7,500.

  • Would you go to the trouble to "rescue" a $7500 basis? We would need to cash out of bond funds and Wellesley before we did the rollover to the employer.
I would not. You didn't mention the size of the portfolio but we know is is larger than $625,000. The amount of tax paid a second time on the $7,500 basis is not that large and if you do conversions on the IRA that tax will get even smaller each time.
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SweetTooth
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Re: Converting to Roth by Isolating Basis - Downside?

Post by SweetTooth »

ah yes, retiredjg - -another important consideration. I weigh future convenience probably more than I should.

That brings me to one more question:
  • If additional dividends from the funds/efts are deposited into the TIRA account AFTER the rollover/conversion takes place, I would need to withdraw that money from the TIRA so that the account balance is ZERO on 12/31/21, correct?
delamer
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Re: Converting to Roth by Isolating Basis - Downside?

Post by delamer »

SweetTooth wrote: Sun Jun 20, 2021 11:24 am ah yes, retiredjg - -another important consideration. I weigh future convenience probably more than I should.

That brings me to one more question:
  • If additional dividends from the funds/efts are deposited into the TIRA account AFTER the rollover/conversion takes place, I would need to withdraw that money from the TIRA so that the account balance is ZERO on 12/31/21, correct?
My suggestion is to wait to do the rollover until you are confident that any dividends/interest have been deposited.

Hopefully, you can pretty easily determine the distribution schedule and time it correctly.
One thing that humbles me deeply is to see that human genius has its limits while human stupidity does not. - Alexandre Dumas, fils
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retiredjg
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Re: Converting to Roth by Isolating Basis - Downside?

Post by retiredjg »

That is correct but I don't recall hearing of this. If the money is invested in funds, there will probably be no dividends/interest coming later (unless you sell between the record date and the date the dividend is paid).

It could happen if the money is in money market which pays interest at the end of the month, even if the account is empty.
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retiredjg
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Re: Converting to Roth by Isolating Basis - Downside?

Post by retiredjg »

SweetTooth wrote: Sun Jun 20, 2021 11:24 am ah yes, retiredjg - -another important consideration. I weigh future convenience probably more than I should.
If you don't want to do Form 8606 each year or pay a CPA each year to do it, you could just abandon the basis and treat it as pre-tax. The IRS is not going to come after you for paying tax on money a second time.

In reality, if you do your own taxes and if your basis is correct in your software, the software will generate the 8606 each year you need it. This is not a burden.
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SweetTooth
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Re: Converting to Roth by Isolating Basis - Downside?

Post by SweetTooth »

There is money market, too.

But even if a small amount of interest paid into the account, is the worst thing that happens is it won't get rolled over and I would need to withdraw it and pay tax on it like a regular IRA distribution (no prorata), since the account balance would be zero on 12/31/21? (Just trying to imagine every possible scenario...)
delamer
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Re: Converting to Roth by Isolating Basis - Downside?

Post by delamer »

SweetTooth wrote: Sun Jun 20, 2021 11:46 am There is money market, too.

But even if a small amount of interest paid into the account, is the worst thing that happens is it won't get rolled over and I would need to withdraw it and pay tax on it like a regular IRA distribution (no prorata), since the account balance would be zero on 12/31/21? (Just trying to imagine every possible scenario...)
Assuming you are moving the amount to be transferred into the money market?
One thing that humbles me deeply is to see that human genius has its limits while human stupidity does not. - Alexandre Dumas, fils
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SweetTooth
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Re: Converting to Roth by Isolating Basis - Downside?

Post by SweetTooth »

delamer wrote: Sun Jun 20, 2021 11:51 am
SweetTooth wrote: Sun Jun 20, 2021 11:46 am There is money market, too.

But even if a small amount of interest paid into the account, is the worst thing that happens is it won't get rolled over and I would need to withdraw it and pay tax on it like a regular IRA distribution (no prorata), since the account balance would be zero on 12/31/21? (Just trying to imagine every possible scenario...)
Assuming you are moving the amount to be transferred into the money market?
I'm sorry I wasn't clear. I meant if I proceeded with the rollover to the 457b (followed by conversion of aftertax $ to roth) and the TIRA account was zero, and then a month later some additional interest were deposited into the TIRA. I assume I should withdraw that additional interest to keep the TIRA account balance at zero by 12/31. And I assume that the withdrawal would receive the same tax treatment as any other TIRA pretax withdrawal because there would be no prorata if the account balance were zero on 12/31. Are those assumptions correct?

It occurs to me that VG might "sweep" any additional interest into the rollover. I will call them to find out.
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Duckie
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Re: Converting to Roth by Isolating Basis - Downside?

Post by Duckie »

SweetTooth wrote: Sun Jun 20, 2021 12:08 pm I meant if I proceeded with the rollover to the 457b (followed by conversion of aftertax $ to roth) and the TIRA account was zero, and then a month later some additional interest were deposited into the TIRA. I assume I should withdraw that additional interest to keep the TIRA account balance at zero by 12/31.
If any trailing dividends turn up in the TIRA just convert them. They won't be much and any taxes will be minimal.
It occurs to me that VG might "sweep" any additional interest into the rollover.
It might happen.
shess
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Re: Converting to Roth by Isolating Basis - Downside?

Post by shess »

I once did a similar thing to isolate my after-tax basis. But I was 45 and thought this would enable years of backdoor Roth contributions (in the event, I retired a few years later, so *shrug*).

At age 70, though, I'd really think twice before bothering with this, since there will most likely be a limited number of years of backdoor Roth conversions left. I mean, maybe sit down and make a sober estimate about how many years of earned income he has ahead of him, and what that will sum up to. Say you decide he'll work until 80, that's only around $80k total. I mean, it's not chump change, but given the $625k tIRA and whatever is in the 457B, is that really the big item to focus on?

And since you mention rolling things back to the tIRA later, that means you're aiming to just rescue the $7.5k, which isn't much to work with at all. I mean, it's a real dollar amount, but given a portfolio which is at least 100x that size, I wouldn't spend much time isolating that portion into a Roth IRA.

Maybe sit down and think about what the long-term plans are for that $625k in the tIRA. If you're thinking to convert a large chunk to Roth, perhaps taking additional distributions to pay taxes on the conversions, then maybe just start converting yearly to Roth and accept the pro-rata issues.
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SweetTooth
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Re: Converting to Roth by Isolating Basis - Downside?

Post by SweetTooth »

Duckie wrote: Sun Jun 20, 2021 3:28 pm
SweetTooth wrote: Sun Jun 20, 2021 12:08 pm I meant if I proceeded with the rollover to the 457b (followed by conversion of aftertax $ to roth) and the TIRA account was zero, and then a month later some additional interest were deposited into the TIRA. I assume I should withdraw that additional interest to keep the TIRA account balance at zero by 12/31.
If any trailing dividends turn up in the TIRA just convert them. They won't be much and any taxes will be minimal.
It occurs to me that VG might "sweep" any additional interest into the rollover.
It might happen.
Oh right -- of course! Thank you, Duckie.
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SweetTooth
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Re: Converting to Roth by Isolating Basis - Downside?

Post by SweetTooth »

shess wrote: Sun Jun 20, 2021 3:52 pm
And since you mention rolling things back to the tIRA later, that means you're aiming to just rescue the $7.5k, which isn't much to work with at all. I mean, it's a real dollar amount, but given a portfolio which is at least 100x that size, I wouldn't spend much time isolating that portion into a Roth IRA.
Thanks for the reality check, Shess.
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