Timing of Backdoor Roth Contribution and Avoiding the Pro Rata Rule

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gmc4h232
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Timing of Backdoor Roth Contribution and Avoiding the Pro Rata Rule

Post by gmc4h232 » Tue Jan 01, 2019 10:54 pm

Greetings all and Happy New Year! We have the potential to exceed the Roth IRA income limits in 2019 due to a change in how my company calculates my profit sharing. I wont know for sure where our income will shake out in this regard until probably November 2019. I typically like to make standard Roth contributions on Jan 1, but in light of this new development, I am wondering what my strategy should be for this year's contribution.

My wife and I each have existing traditional IRAs worth about 120k between our two accounts. Should we go ahead and roll these into our respective employer's 401k plans to avoid the pro rata rule and just go ahead and make a backdoor roth contribution? Or should we set up solo 401ks to roll these accounts into (are the fees typically less)? Or should we wait until I know for sure whether our income is going to exceed the contribution limits. I really dont want to wait until november to max out the contribution.

Both our 401ks offer VBTLX and some other reasonable, low cost vanguard funds, but they will certainly charge additional fees.

teddytimtam
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Re: Timing of Backdoor Roth Contribution and Avoiding the Pro Rata Rule

Post by teddytimtam » Tue Jan 01, 2019 11:17 pm

You can go ahead and do a traditional IRA contribution then rollover to a Roth IRA. Then you don't have to worry about the pro rata rule if your income exceeds the limit.

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celia
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Re: Timing of Backdoor Roth Contribution and Avoiding the Pro Rata Rule

Post by celia » Tue Jan 01, 2019 11:44 pm

The pro rata rule will apply in any year you:
1) do a Roth conversion,
2) have a balance in any of your non-Roth IRAs at the end of the year and
3) carry forward basis from the previous year or made a non-deductible contribution to a traditional IRA.

We've been working on a new/upgraded wiki page that explains Backdoor Roths. Since the wiki page is expected to change its location soon, I'll point you to the discussion of the wiki page instead and you can link to the wiki page from that.
viewtopic.php?f=2&t=265828&p=4281542#p4281542
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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celia
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Re: Timing of Backdoor Roth Contribution and Avoiding the Pro Rata Rule

Post by celia » Tue Jan 01, 2019 11:53 pm

gmc4h232 wrote:
Tue Jan 01, 2019 10:54 pm
Should we go ahead and roll these into our respective employer's 401k plans to avoid the pro rata rule and just go ahead and make a backdoor roth contribution?
That would be the best choice if they accept Traditional IRAs that you contributed to. (Not all 401Ks accept them.)
Or should we set up solo 401ks to roll these accounts into (are the fees typically less)?
You would first have to set up a side company where you receive compensation, to be eligible. The company would then have to set up the plan.
Or should we wait until I know for sure whether our income is going to exceed the contribution limits. I really dont want to wait until november to max out the contribution.
That won't get you out of the pro rata rule. The timing isn't the problem, but the 3 situations I listed.
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.

nolesrule
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Re: Timing of Backdoor Roth Contribution and Avoiding the Pro Rata Rule

Post by nolesrule » Wed Jan 02, 2019 8:41 am

If you are trying to avoid pro-rata taxation, you should wait until the pre-tax TIRA balances have completed their moves into employer 401k accounts. This will save you from having to undo things in the case that the rollovers are not accepted. And one should consider that the conversion step of the backdoor Roth is no longer reversible.

ryman554
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Re: Timing of Backdoor Roth Contribution and Avoiding the Pro Rata Rule

Post by ryman554 » Wed Jan 02, 2019 9:11 am

nolesrule wrote:
Wed Jan 02, 2019 8:41 am
If you are trying to avoid pro-rata taxation, you should wait until the pre-tax TIRA balances have completed their moves into employer 401k accounts. This will save you from having to undo things in the case that the rollovers are not accepted. And one should consider that the conversion step of the backdoor Roth is no longer reversible.
While this general advice is correct, and probably good, better even after reading it a second time, remember that the pro-rata rule only applies to values on Dec 31 in the year of the conversion.

The IRS does not care in what order you do things, just that all the dust has settled (and, presumably that value of your pre-tax IRA is 0) by Dec 31.

The point made above, that the roth conversion is not reversible, is important now. Please make sure your pre-tax monies are safely in the 401(k). I second the notion that things get sub-optimal for you otherwise.

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gmc4h232
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Re: Timing of Backdoor Roth Contribution and Avoiding the Pro Rata Rule

Post by gmc4h232 » Wed Jan 02, 2019 10:06 am

What are folks' opinions about opening solo 401ks to roll these tIRAs into? Are there usually plan fees associated with solo 401ks? Paperwork hassles? Any other drawbacks?

I've been intrigued by solo 401ks for a long time. Maybe this will give me a good excuse to finally pull the trigger. I'm sure I could scrounge up some side income to open a side business for me and my wife.

nolesrule
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Re: Timing of Backdoor Roth Contribution and Avoiding the Pro Rata Rule

Post by nolesrule » Wed Jan 02, 2019 10:20 am

They are free at most of the standard providers. You would need self-employment income in order to be able to open a solo 401k.

You would also need a provider that allows incoming rollovers from IRAs.

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gmc4h232
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Re: Timing of Backdoor Roth Contribution and Avoiding the Pro Rata Rule

Post by gmc4h232 » Wed Jan 02, 2019 11:16 am

nolesrule wrote:
Wed Jan 02, 2019 10:20 am
They are free at most of the standard providers. You would need self-employment income in order to be able to open a solo 401k.

You would also need a provider that allows incoming rollovers from IRAs.
Any recommendations on providers? I think i read somewhere (whitecoatinvestor maybe) that vanguard does not accept rollovers, but fidelity, schwab and etrade do?

nolesrule
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Re: Timing of Backdoor Roth Contribution and Avoiding the Pro Rata Rule

Post by nolesrule » Wed Jan 02, 2019 11:36 am

gmc4h232 wrote:
Wed Jan 02, 2019 11:16 am
nolesrule wrote:
Wed Jan 02, 2019 10:20 am
They are free at most of the standard providers. You would need self-employment income in order to be able to open a solo 401k.

You would also need a provider that allows incoming rollovers from IRAs.
Any recommendations on providers? I think i read somewhere (whitecoatinvestor maybe) that vanguard does not accept rollovers, but fidelity, schwab and etrade do?
That is correct about Vanguard. I moved from Vanguard to Fidelity for that reason a few years ago. I don't know anything about the other providers.

You cannot open one unless you actually have (or have had in the past) self employment net income.

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gmc4h232
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Re: Timing of Backdoor Roth Contribution and Avoiding the Pro Rata Rule

Post by gmc4h232 » Mon Dec 30, 2019 8:38 pm

Following up on this thread after I let a whole year go by. Here is where I landed:

Due to a large year end profit share, our MAGI for 2019 exceeds the limits for a regular Roth IRA contribution, so this is what I did:

1. Made regular $6,000 roth IRA contribution in February with the hopes of not exceeding MAGI limits.
2. Found out we were going to exceed MAGI limits for regular roth contribution
3. Got some side income and set up a Solo 401k at Fidelity for the wife and myself
4. Rolled our VG tIRAs into solo 401ks at Fidelity
5. Recharacterized roth contributions + about $1000 growth to tIRA contributions
6. Converted wife's tIRA with $7k balance from recharacterization to roth IRA
7. Tried to convert my tIRA ,but an outgoing transfer of residual dividend to Fidelity currently has it held up to where the conversion wont occur until 2020.

My question is - what differential tax impact is there by having to wait to convert my tIRA until 2020 along with my 2020 backdoor contribution? There shouldnt be any should there? I would just be paying tax on the $1000 gain from the 2019 amount correct since the $12,000 in basis would be after tax?

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FiveK
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Re: Timing of Backdoor Roth Contribution and Avoiding the Pro Rata Rule

Post by FiveK » Tue Dec 31, 2019 7:06 am

gmc4h232 wrote:
Mon Dec 30, 2019 8:38 pm
My question is - what differential tax impact is there by having to wait to convert my tIRA until 2020 along with my 2020 backdoor contribution?
The gains will be taxed at your 2020 marginal rate instead of your 2019 marginal rate, the gain amount itself will differ by whatever the investment does in the wait time, and the tax on the 2020 conversion will be due in 2021.

While there could be significant differences, it could also be that your marginal rates will be identical and the gain difference minimal, leading to a very small differential tax impact.

livesoft
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Re: Timing of Backdoor Roth Contribution and Avoiding the Pro Rata Rule

Post by livesoft » Tue Dec 31, 2019 7:15 am

gmc4h232 wrote:
Mon Dec 30, 2019 8:38 pm
My question is - what differential tax impact is there by having to wait to convert my tIRA until 2020 along with my 2020 backdoor contribution? There shouldnt be any should there? I would just be paying tax on the $1000 gain from the 2019 amount correct since the $12,000 in basis would be after tax?
You use extra ink on your Form 8606 because you have to put a number on Line 6.
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Mtmp8888
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Re: Timing of Backdoor Roth Contribution and Avoiding the Pro Rata Rule

Post by Mtmp8888 » Mon Jan 13, 2020 9:19 pm

So... as long as my all TIRA is $0 in balance at the end of December 31... any n/d TIRA conversion to Roth in the same year doesn’t apply to the pro rata rule?

lakpr
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Re: Timing of Backdoor Roth Contribution and Avoiding the Pro Rata Rule

Post by lakpr » Mon Jan 13, 2020 9:47 pm

Mtmp8888 wrote:
Mon Jan 13, 2020 9:19 pm
So... as long as my all TIRA is $0 in balance at the end of December 31... any n/d TIRA conversion to Roth in the same year doesn’t apply to the pro rata rule?
It is not that the prorata rule does not apply, it is that with all balance in the tIRA being non-deductible, the taxable portion comes out to be zero. Say $1000 in n-d-tIRA. $1000/($1000+$0) = 100%, so 100% of the conversion is non taxable.

Mtmp8888
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Re: Timing of Backdoor Roth Contribution and Avoiding the Pro Rata Rule

Post by Mtmp8888 » Tue Jan 14, 2020 10:54 am

$1000/($1000+$0)
The "$0" in the equation above is the total balance in all tIRAs in Dec 31, isn't it?

For example timeline in 2019:
1/1/2019 - rollover IRA $60K (the actual rollover IRA from previous employer happened in 2018)
5/1/2019 - n-d-tIRA (separate account than the rollover IRA) $6K
6/1/2019 - reverse rollover IRA to current 401K (current employer 401K allows this). Rollover IRA account is now $0
7/1/2019 - convert n-d-tIRA to Roth IRA. tIRA account is now $0
12/31/2019 - rollover IRA and tIRA accounts are both $0

During filing 2019 tax return... the Roth conversion calculation: $6K/($6K + $0) = 100% of the convertion is non-taxable.

Do I understand this correctly? :D

lakpr
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Re: Timing of Backdoor Roth Contribution and Avoiding the Pro Rata Rule

Post by lakpr » Tue Jan 14, 2020 11:40 am

Mtmp8888 wrote:
Tue Jan 14, 2020 10:54 am
$1000/($1000+$0)
The "$0" in the equation above is the total balance in all tIRAs in Dec 31, isn't it? Yes, that's almost correct. The $0 is the pre-tax amount in the tIRA as of December 31.

For example timeline in 2019:
1/1/2019 - rollover IRA $60K (the actual rollover IRA from previous employer happened in 2018)
5/1/2019 - n-d-tIRA (separate account than the rollover IRA) $6K
6/1/2019 - reverse rollover IRA to current 401K (current employer 401K allows this). Rollover IRA account is now $0
7/1/2019 - convert n-d-tIRA to Roth IRA. tIRA account is now $0
12/31/2019 - rollover IRA and tIRA accounts are both $0

During filing 2019 tax return... the Roth conversion calculation: $6K/($6K + $0) = 100% of the convertion is non-taxable.

Do I understand this correctly? :D Yes, you understood it perfectly.

Mtmp8888
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Re: Timing of Backdoor Roth Contribution and Avoiding the Pro Rata Rule

Post by Mtmp8888 » Tue Jan 14, 2020 12:38 pm

What would happen if one contribute to n-d-tIRA for previous (before April 15 current year) and current year in current year and do conversion to Roth IRA in current year while total pre-tax tIRA balance last Dec 31 year isn't $0?

Based on my understanding so far... I think it goes like this...

Timeline:
12/31/2018 - total tIRA $0
12/31/2018 - total pre-tax rollover IRA $55K

2/1/2019 - contribute to n-d-tIRA for 2018 $5,5K
3/1/2019 - contribute to n-d-tIRA for 2019 $6K
3/15/2019 - convert all n-d-tIRA to Roth IRA ($11,5K). tIRA account is now $0

4/1/2019 - file 2018 tax return... the Roth conversion calculation: $5.5K/($5.5K+$55K) = 9% of the conversion is non-taxable; 91% of $5.5K ($5,005) is taxable. This ain't good - it's like paying double taxes on the after-tax $5.5K.

6/1/2019 - reverse rollover IRA to current 401K (current employer 401K allows this). Rollover IRA account is now $0
12/31/2019 - rollover IRA and tIRA accounts are both $0
4/1/2020 - file 2019 tax return... the Roth conversion calculation: $6K/($6K + $0) = 100% of the conversion is non-taxable.


Yay/nay?

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anon_investor
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Re: Timing of Backdoor Roth Contribution and Avoiding the Pro Rata Rule

Post by anon_investor » Tue Jan 14, 2020 1:00 pm

Mtmp8888 wrote:
Tue Jan 14, 2020 12:38 pm
What would happen if one contribute to n-d-tIRA for previous (before April 15 current year) and current year in current year and do conversion to Roth IRA in current year while total pre-tax tIRA balance last Dec 31 year isn't $0?

Based on my understanding so far... I think it goes like this...

Timeline:
12/31/2018 - total tIRA $0
12/31/2018 - total pre-tax rollover IRA $55K

2/1/2019 - contribute to n-d-tIRA for 2018 $5,5K
3/1/2019 - contribute to n-d-tIRA for 2019 $6K
3/15/2019 - convert all n-d-tIRA to Roth IRA ($11,5K). tIRA account is now $0

4/1/2019 - file 2018 tax return... the Roth conversion calculation: $5.5K/($5.5K+$55K) = 9% of the conversion is non-taxable; 91% of $5.5K ($5,005) is taxable. This ain't good - it's like paying double taxes on the after-tax $5.5K.

6/1/2019 - reverse rollover IRA to current 401K (current employer 401K allows this). Rollover IRA account is now $0
12/31/2019 - rollover IRA and tIRA accounts are both $0
4/1/2020 - file 2019 tax return... the Roth conversion calculation: $6K/($6K + $0) = 100% of the conversion is non-taxable.


Yay/nay?
You have to look at the year of conversion not the year the contribution is meant for to determine whether a pro rata tax may apply. In your example there were 0 conversions in 2018, so no need to look whether the pro rata tax would apply. In 2019, there was a conversion but by 12/31/2019 the TIRA balance was $0, so if you only converted after-tax funds, then no pro rata tax would apply. You just have to make sure the Form 8606 is filled out properly, there is an extra line (assuming it will be the same for the unreleased 2019 forms) you have to fill out to indicate you made a 2019 contribution in 2020. Paperwork wise, it is cleaner if the after-tax contribution is made in the same calendar year (e.g. 2019 contribution is made in 2019). But you can make your 2019 contribution in 2020 and still accomplish the same backdoor Roth, the Form 8606 is just filled out slightly differently.

lakpr
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Re: Timing of Backdoor Roth Contribution and Avoiding the Pro Rata Rule

Post by lakpr » Tue Jan 14, 2020 1:17 pm

Mtmp8888 wrote:
Tue Jan 14, 2020 12:38 pm
What would happen if one contribute to n-d-tIRA for previous (before April 15 current year) and current year in current year and do conversion to Roth IRA in current year while total pre-tax tIRA balance last Dec 31 year isn't $0?

Based on my understanding so far... I think it goes like this...

Timeline:
12/31/2018 - total tIRA $0
12/31/2018 - total pre-tax rollover IRA $55K

2/1/2019 - contribute to n-d-tIRA for 2018 $5,5K
3/1/2019 - contribute to n-d-tIRA for 2019 $6K
3/15/2019 - convert all n-d-tIRA to Roth IRA ($11,5K). tIRA account is now $0

4/1/2019 - file 2018 tax return... the Roth conversion calculation: $5.5K/($5.5K+$55K) = 9% of the conversion is non-taxable; 91% of $5.5K ($5,005) is taxable. This ain't good - it's like paying double taxes on the after-tax $5.5K. As been pointed above by anon_investor, your Roth conversion took place in 2019, so all you do on Form 8606 for 2018 is that you contributed $5.5k non-deductible amount

6/1/2019 - reverse rollover IRA to current 401K (current employer 401K allows this). Rollover IRA account is now $0
12/31/2019 - rollover IRA and tIRA accounts are both $0
4/1/2020 - file 2019 tax return... the Roth conversion calculation: $6K/($6K + $0) ($5.5k + $6k)/($5.5k + $6k + $0) = 100% of the conversion is non-taxable. You did two conversions, both on the same day, on 3/15/2019, for a total of $11.5k


Yay/nay?

Mtmp8888
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Re: Timing of Backdoor Roth Contribution and Avoiding the Pro Rata Rule

Post by Mtmp8888 » Tue Jan 14, 2020 3:07 pm

Thank you so much for your explanation @lakpr and @anon_investor!

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gmc4h232
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Re: Timing of Backdoor Roth Contribution and Avoiding the Pro Rata Rule

Post by gmc4h232 » Wed Jan 15, 2020 10:13 pm

livesoft wrote:
Tue Dec 31, 2019 7:15 am
gmc4h232 wrote:
Mon Dec 30, 2019 8:38 pm
My question is - what differential tax impact is there by having to wait to convert my tIRA until 2020 along with my 2020 backdoor contribution? There shouldnt be any should there? I would just be paying tax on the $1000 gain from the 2019 amount correct since the $12,000 in basis would be after tax?
You use extra ink on your Form 8606 because you have to put a number on Line 6.
So it looks like fidelity added my 2019 recharacterized amount to my solo 401k as part of the initial transfer, so now i have to get that back in order to convert it to roth.... So this money has/will take the following route:
VG Roth IRA ---->Recharacterization---->VG tIRA----->Rollover---->Fidelity Solo 401k (current status)----->Rollover----->VG tIRA----->VG Roth IRA.


I knew I was going to screw this up. Any thing here look against the rules, or any negative tax implications from going this route? No issues whatsoever with my wife's conversion.

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