Back-door Roth even if under limit?

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MotoTrojan
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Back-door Roth even if under limit?

Post by MotoTrojan » Wed Sep 13, 2017 2:15 pm

Current salary is comfortably below the Roth phase-out (~$10K margin) but in this particular year I sold a bunch of company stock and am now doing a recharacterization to non-deductible IRA, and then a conversion to Roth (taxable event for earnings).

If one believed there was a risk of a surprise income increase, and could contribute the full $5500 in January, would it make sense to contribute that to a Traditional IRA, and then immediately (prior to any substantial earnings being generated) converting that to a Roth? That way the money stays invested all year, and there isn't risk of the earnings becoming taxable should a spike in income occur.

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whodidntante
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Re: Back-door Roth even if under limit?

Post by whodidntante » Wed Sep 13, 2017 2:52 pm

Were you surprised when you sold the company stock?

I would do a direct roth IRA contribution unless I suspected that I would not qualify.

mega317
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Re: Back-door Roth even if under limit?

Post by mega317 » Wed Sep 13, 2017 3:15 pm

The disadvantage of Roth conversions is you can't immediately withdraw contributions penalty-free (need to wait 5 years I think). If contributed directly to a Roth you can withdraw contributions at any time. This may or may not matter to you. N/A when you're 59.5.

FactualFran
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Re: Back-door Roth even if under limit?

Post by FactualFran » Wed Sep 13, 2017 3:29 pm

Another, likely better, approach is: If your income for the year turns out to below the limit to have contributed to a Roth IRA, then recharacterize the contribution that was made earlier to a traditional IRA to a Roth, rather than doing a conversion to a Roth.

mega317
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Re: Back-door Roth even if under limit?

Post by mega317 » Wed Sep 13, 2017 3:41 pm

FactualFran wrote:
Wed Sep 13, 2017 3:29 pm
Another, likely better, approach is: If your income for the year turns out to below the limit to have contributed to a Roth IRA, then recharacterize the contribution that was made earlier to a traditional IRA to a Roth, rather than doing a conversion to a Roth.
How does this affect earnings?

FactualFran
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Re: Back-door Roth even if under limit?

Post by FactualFran » Wed Sep 13, 2017 4:09 pm

mega317 wrote:
Wed Sep 13, 2017 3:41 pm
How does this affect earnings?
It does not affect earnings. Perhaps, I don't understand what you mean by earnings.

retiredjg
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Re: Back-door Roth even if under limit?

Post by retiredjg » Wed Sep 13, 2017 4:17 pm

mega317 wrote:
Wed Sep 13, 2017 3:15 pm
The disadvantage of Roth conversions is you can't immediately withdraw contributions penalty-free (need to wait 5 years I think). If contributed directly to a Roth you can withdraw contributions at any time. This may or may not matter to you. N/A when you're 59.5.
This is partially incorrect in the situation described by the original poster. It's complicated. :D

If you contribute, do not deduct from taxable income, and convert before there are any earnings, the contribution is immediately available as if it were an ordinary contribution.

If you contribute, do not deduct from taxable income, and convert with $50 earnings, you have to pay tax and a 10% penalty on the first $50....then the next part you take out up to $5,500 (if your contribution was $5,500) is tax and penalty free.

There's more to it than that if you have ever made ordinary contributions or if you use the mega back door...but I won't go into that here.

And yes, an ordinary Roth conversion, where the whole amount is taxable, does have a 5 year clock, but that is not what this poster is considering if s/he does it right (by NOT DEDUCTING).
Last edited by retiredjg on Wed Sep 13, 2017 5:26 pm, edited 1 time in total.

MotoTrojan
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Re: Back-door Roth even if under limit?

Post by MotoTrojan » Wed Sep 13, 2017 4:18 pm

FactualFran wrote:
Wed Sep 13, 2017 4:09 pm
mega317 wrote:
Wed Sep 13, 2017 3:41 pm
How does this affect earnings?
It does not affect earnings. Perhaps, I don't understand what you mean by earnings.
I think they are wondering if those would be taxed, but now I am remembering my conversation with VG specialist who said you can recharacterize a TIRA to Roth without a taxable event... so suggestion to do that, if in doubt, is a good one.

MotoTrojan
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Re: Back-door Roth even if under limit?

Post by MotoTrojan » Wed Sep 13, 2017 4:19 pm

whodidntante wrote:
Wed Sep 13, 2017 2:52 pm
Were you surprised when you sold the company stock?

I would do a direct roth IRA contribution unless I suspected that I would not qualify.
Yes. Illiquid (private) company which had a buyback at an unexpected time, with a high enough offer for me to dump the majority of my holdings.

retiredjg
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Re: Back-door Roth even if under limit?

Post by retiredjg » Wed Sep 13, 2017 4:21 pm

MotoTrojan wrote: If one believed there was a risk of a surprise income increase, and could contribute the full $5500 in January, would it make sense to contribute that to a Traditional IRA, and then immediately (prior to any substantial earnings being generated) converting that to a Roth? That way the money stays invested all year, and there isn't risk of the earnings becoming taxable should a spike in income occur.
This will work since your contribution to tIRA will obviously be non-deductible. People who could ordinarily contribute to Roth IRA are not prohibited from using the back door if preferred.

Usual warning about documenting how every penny gets into Roth IRA (and keep all the 1099's etc.) and keeping that information until your mid 60s.

mega317
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Re: Back-door Roth even if under limit?

Post by mega317 » Wed Sep 13, 2017 4:35 pm

retiredjg wrote:
Wed Sep 13, 2017 4:17 pm
If you contribute, do not deduct from taxable income, and convert before there are any earnings, the contribution is immediately available as if it were an ordinary contribution.
Thank you, I did not know this. In that case, why would someone near the Roth contribution phase out ever do anything other than contribute to non-deductible traditional and immediately convert?

I have asked this question before and I think I was told it was the 5 year rule. Although looking back I can't find the thread so maybe I am remembering incorrectly.

retiredjg
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Re: Back-door Roth even if under limit?

Post by retiredjg » Wed Sep 13, 2017 5:24 pm

mega317 wrote:
Wed Sep 13, 2017 4:35 pm
retiredjg wrote:
Wed Sep 13, 2017 4:17 pm
If you contribute, do not deduct from taxable income, and convert before there are any earnings, the contribution is immediately available as if it were an ordinary contribution.
Thank you, I did not know this. In that case, why would someone near the Roth contribution phase out ever do anything other than contribute to non-deductible traditional and immediately convert?

I have asked this question before and I think I was told it was the 5 year rule. Although looking back I can't find the thread so maybe I am remembering incorrectly.
I don't see any reason to do anything other than the back door if a person expects to be in or near the phase out limit. It just avoids the uncertainty, the possibility of re-characterization, extra paperwork, etc.

The 5 year rules (there are 2) are very confusing and many of the comments you see about the 5 year rule are incorrect or partially correct. So you have to be cautious about that.

An ordinary conversion (pre-tax IRA to Roth IRA) does have a 5 year clock. That is what you actually said and that is true.

A true back door conversion (non-deductible contribution converted to Roth IRA) has a 5 year clock but it only applies to the part of the conversion that was taxable because of the conversion.. But to get to the "free part" you have to go through the "penalty" part. This is why I recommend that new people do the conversion before there are any earnings - to make it cleaner and easier.

I just realized part of what I said above is incorrect - I'll edit it. You can see what I crossed out if you are interested.

mega317
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Re: Back-door Roth even if under limit?

Post by mega317 » Wed Sep 13, 2017 10:42 pm

Thank you so much for the explanations and patience.

I imagine this could be gathered from the IRS although a cursory search didn't turn up these details for me. This thread made me to go to Kitces's article on the 5 year rules which doesn't address every detail but links to the relevant part of the tax code. That does seem to cover everything although requires slow and careful reading and I confess this evening I only skimmed. I will refrain from giving advice on this again until I read it carefully.

retiredjg
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Re: Back-door Roth even if under limit?

Post by retiredjg » Thu Sep 14, 2017 6:24 am

Many people have said they found the Kitces article helpful. There is also information at fairmark.com .

Here is a good place to start. http://fairmark.com/retirement/roth-acc ... -overview/

Also use the search box for 5 year rule. When using the search box, avoid the first several links because they are ads, not fairmark.com

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