cashout rollover IRA to avoid roth IRA conversion taxes?

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MPAndy222
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cashout rollover IRA to avoid roth IRA conversion taxes?

Post by MPAndy222 » Thu Mar 31, 2016 6:48 pm

Hi - first time poster here (still have a lot to learn!),

Question: Would it be best to take the 10% penalty to cash out a small rollover IRA account to avoid roth IRA conversion taxes?

Situation: My wife (age 29) rolled an old 401k worth $4300 into a vanguard rollover IRA account. We don't qualify for roth IRA (33% tax bracket) so I am in the process of converting TIRA to roth IRA. From my understanding the rollover IRA counts as a TIRA and would thus be taxable (however it can't be converted to a roth IRA). I'm considering cashing out the rollover IRA and taking the 10% penalty to hopefully avoid pro rata taxes every year for the next 30 years. I'm concerned that the backdoor roth IRA will likely be closed in the near future, however, which would negate any potential savings of cashing out the rollover IRA. What should I do? Would I be able to roll a rollover IRA back into a company 401k?

Debate: Is the backdoor roth IRA conversion going to last very much longer?

Alan S.
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Re: cashout rollover IRA to avoid roth IRA conversion taxes?

Post by Alan S. » Thu Mar 31, 2016 7:47 pm

Not a good idea.

Cashing out a TIRA will result in tax, penalty, and loss of tax deferral.

Converting will result in just tax, no penalty, and continued deferral of taxes until Roth is fully qualified and tax free.

For many, if a rollover of the pre tax IRA balance into your current employer plan is possible, if you do that then you can convert your non deductible contribution tax free each year.

There have been hundreds of posts trying to handicap the chances of legislation no longer allowing conversion of IRA basis. For those that think this is a real threat, you would just want to take advantage of the back door while you can. In no way is any such legislation going to be retroactive.

livesoft
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Re: cashout rollover IRA to avoid roth IRA conversion taxes?

Post by livesoft » Thu Mar 31, 2016 7:49 pm

MPAndy222 wrote:... (however it can't be converted to a roth IRA).
As mentioned, it should not be cashed out. Instead, it should be converted to a Roth IRA.
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David Jay
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Re: cashout rollover IRA to avoid roth IRA conversion taxes?

Post by David Jay » Thu Mar 31, 2016 8:00 pm

MPAndy222 wrote:I'm considering cashing out the rollover IRA and taking the 10% penalty to hopefully avoid pro rata taxes every year for the next 30 years.
Either I don't "get" what you are saying or your understanding is not correct.

1. If you convert the $4300 from the rollover to a Roth, you will pay your marginal tax rate (33%) on the $4300 one time. You can choose to pay that "out of pocket" so the entire $4300 is converted. After that, the $4300 and all future gains in the account will be completely tax free (there is a 5 year qualification period for gains). I don't see any annual pro-rata taxes.

[edit]2. If you withdraw the funds (instead of the Roth rollover) you pay the same 33% and then also pay a 10% penalty. Unless you need the money now, I do not know why you would choose choice #2 over #1

3. If you leave the money in the rollover, you pay no taxes until you withdraw the funds. When you withdraw the funds (after age 59 1/2) you pay your marginal tax rate at the time of withdrawal - one would expect you to be in a "lower than 33%" bracket in retirement.

That being said, you likely can roll the funds back into the 401K at the new employer, check with the corporate benefits manager.
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MPAndy222
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Re: cashout rollover IRA to avoid roth IRA conversion taxes?

Post by MPAndy222 » Fri Apr 01, 2016 4:17 am

Excellent, it looks like I'll be able to roll the rollover Ira back to the company 401k. Thanks for the great advice. One more question - I contributed to the 2015 TIRA after December 31, 2015. Vanguard let me do the backdoor conversion to the Roth (in 2016). Since I missed the December 31st deadline for conversion should I avoid contributing to a TIRA in 2016? Can I convert both 2015 TIRA and 2016 TIRA contributions to a Roth in the same year?

ryman554
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Re: cashout rollover IRA to avoid roth IRA conversion taxes?

Post by ryman554 » Fri Apr 01, 2016 8:29 am

MPAndy222 wrote:Excellent, it looks like I'll be able to roll the rollover Ira back to the company 401k. Thanks for the great advice. One more question - I contributed to the 2015 TIRA after December 31, 2015. Vanguard let me do the backdoor conversion to the Roth (in 2016). Since I missed the December 31st deadline for conversion should I avoid contributing to a TIRA in 2016? Can I convert both 2015 TIRA and 2016 TIRA contributions to a Roth in the same year?
You can convert any tIRA (excepting inherited) to ROTH at any time. Regardless of year contributed. This includes your rollover IRA. Just fill out form 8606 and you will pay taxes only on the previously non-taxed monies.

Assuming your tIRA contributions are non-deductible, it is a good tax efficiency idea to contribute and convert as close together as possible. No reason to delay. you are also not limited to a single conversion event in a year. Whatever floats your boat.

One element of form 8606 is the value of the tIRA account as of december 31 of the tax year (2016). If you want to avoid pro-rata issues, you want that number to be 0 (or less than 49 cents). Which means you need all of the funds out of the tIRA by the end of the year, however you manage to do that. Conversions to ROTH, 401(k) roll-ins, whatever.

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