Backdoor Roth as Emergency Fund - Withdrawal Penalty?

[BostonBorg]

I've been convinced by the good people on this site and other readings to use a Roth IRA as an emergency fund in order to avoid losing the tax advantage space every calendar year. Currently my wife and I have ~2-3 months in cash and we're looking to grow that to a ~6 month reserve. We earn too much to contribute directly and hence, will be using the backdoor Roth approach. My question relates to the 10% penalty and/or 5 year wait rule for Roth IRA withdrawals, specifically on conversions. I've looked at various other posts and I'm confused if there is or isn't a penalty.

Quick notes:
-Wife has ~$1k in an old ROTH IRA. Believe it's currently worth less than her original contribution amount
-No other IRA (Roth or traditional).
-Plan on putting $5500 each through backdoor in 2013 and completing rollover in 2013 as well.

I think I understand the following
-Direct contributions to a ROTH can always be taken out tax and penalty free (I have none, ? amt for wife)
-Conversions require 5 year wait period for penalty free withdrawal. But is that true for the non-deductible portion that was converted from a TIRA?

If there is a 5 year wait period for the conversion withdrawal is it still recommended to use the backdoor ROTH as an emergency fund holder?

[wahoowad]

Good question. Posting to subscribe

[nordlead]

So your MAGI is over $188k. Just fix your budget, build the EF and max out your tax advantaged space. You make enough money to easily do that. $11k out of $188k is only 6%. I have to assume you are already maxing out your 401ks (or equivalent) as it makes no sense to contribute to a Roth if you are in a high (28%) tax bracket and have tax deferred space available.

I'm not sure how the conversion works, but you can contribute to the tIRA for 2013 up until April 15 2014. So, I think you can just contribute in early April, then convert. If I'm right, then I would just build the EF over the next few months, then backdoor the Roth IRAs for 2013 in April, and then backdoor the Roth IRAs for 2014 a month or two later. You never have to consider the Roth IRA as the EF and you maximize your tax advantaged space.

[dublin]

also interested in the OP's question - been wondering this myself

[Alan S.]

The 5 year holding requirement for a Roth conversion to avoid the 10% penalty does not apply to the non taxable portion of a conversion, therefore if the conversion is almost totally non taxable, the Roth is still suitable as an emergency fund, preferably a second tier emergency fund that you would be less likely to touch than the first tier.

Here is an example for a Roth owner who has 1,000 in regular contributions in their Roth, did a backdoor conversion of 5,700 of an original non deductible TIRA contribution of 5,500. Roth owner needs the full Roth balance of 7,000 since the Roth has grown by $300 .
1) First out is the 1,000 tax and penalty free
2) Next out is 200, which is the taxable portion of the conversion (taxable portion comes out before the non taxable portion). This will be subject to the 10% penalty of $20
3) Next is the 5,500 non taxable portion of the conversion - no tax or penalty
4) Last is the $300 of earnings - subject to both tax and penalty. Therefore, you might opt to leave the earnings alone.

If your Roth conversion was fully non taxable and only 5,500, the first 6,500 of the above Roth distribution would be tax and penalty free, but you still need to file an 8606 to report it.

[BostonBorg]

The 5 year holding requirement for a Roth conversion to avoid the 10% penalty does not apply to the non taxable portion of a conversion, therefore if the conversion is almost totally non taxable, the Roth is still suitable as an emergency fund, preferably a second tier emergency fund that you would be less likely to touch than the first tier.

Here is an example for a Roth owner who has 1,000 in regular contributions in their Roth, did a backdoor conversion of 5,700 of an original non deductible TIRA contribution of 5,500. Roth owner needs the full Roth balance of 7,000 since the Roth has grown by $300 .
1) First out is the 1,000 tax and penalty free
2) Next out is 200, which is the taxable portion of the conversion (taxable portion comes out before the non taxable portion). This will be subject to the 10% penalty of $20
3) Next is the 5,500 non taxable portion of the conversion - no tax or penalty
4) Last is the $300 of earnings - subject to both tax and penalty. Therefore, you might opt to leave the earnings alone.

If your Roth conversion was fully non taxable and only 5,500, the first 6,500 of the above Roth distribution would be tax and penalty free, but you still need to file an 8606 to report it.

Thanks Alan. Is there a place in the IRS code that specifies this? I tried to read through the standard, but couldn't navigate the exact conclusion even though that's what I read elsewhere. I got the part about withdrawal order, but couldn't find whether or not the entire conversion was subject to the penalty or not. And it seems like each conversion has it's own 5 year clock.

Nordlead:
Our budget does allow for growing our EF and we are maxing out the 401k. But we can't build up the EF as fast as you suggest, hence the need to use the ROTH as a temporary EF holder.

[travellight]

Always good to hear from Alan on this topic.

[BenCharles]

I have this same question as well. I can only do non-deductible TIRA contributions due to being over the income limit. I am very interested in Roth investment space because it is so limited compared to tax deferred space. I have a good emergency fund with respect to our monthly spending/saving/student loan repayment, but would love to have access to the Roth space for part of the emergency fund, but only if I could avoid a penalty on withdrawal of the contributions if needed.

First question: To clarify, if I make a 5000 nondeductible contribution to a TIRA for 2014, then convert to Roth before April 15th, will I have a 5000 contribution basis I can access without a 10% penalty?

Second question: norlead mentioned that tax deferred space should be filled before Roth contributions/conversions. But for emergency fund use and maximizing Roth space, is there a place for doing this? I am not maxing out my 403b.


Thanks, Ben

[dublin]

I have this same question as well. I can only do non-deductible TIRA contributions due to being over the income limit. I am very interested in Roth investment space because it is so limited compared to tax deferred space. I have a good emergency fund with respect to our monthly spending/saving/student loan repayment, but would love to have access to the Roth space for part of the emergency fund, but only if I could avoid a penalty on withdrawal of the contributions if needed.

First question: To clarify, if I make a 5000 nondeductible contribution to a TIRA for 2014, then convert to Roth before April 15th, will I have a 5000 contribution basis I can access without a 10% penalty?

Second question: norlead mentioned that tax deferred space should be filled before Roth contributions/conversions. But for emergency fund use and maximizing Roth space, is there a place for doing this? I am not maxing out my 403b.


Thanks, Ben

To your first question - in short, yes, backdoor Roth contributions (which is what you're describing - non-deductible TIRA converted to Roth) do indeed become immediately available to withdraw without penalty

To your second question - in my opinion, yes, it can make sense to make Roth contributions even while not maximizing tax-deferred space, if the money you're contributing would otherwise be sitting in a taxable savings account as an 'emergency fund'. I have done this in the past (since my Dec 2013 post in this thread).

[grabiner]

The 5 year holding requirement for a Roth conversion to avoid the 10% penalty does not apply to the non taxable portion of a conversion, therefore if the conversion is almost totally non taxable, the Roth is still suitable as an emergency fund, preferably a second tier emergency fund that you would be less likely to touch than the first tier.

Thanks Alan. Is there a place in the IRS code that specifies this? I tried to read through the standard, but couldn't navigate the exact conclusion even though that's what I read elsewhere. I got the part about withdrawal order, but couldn't find whether or not the entire conversion was subject to the penalty or not. And it seems like each conversion has it's own 5 year clock.

IRS Publication 590-B, Distributions from IRAs, page 30:

If, within the 5-year period starting with the first day of your tax year in which you convert an amount from a traditional IRA or rollover an amount from a qualified retirement plan to a Roth IRA, you take a distribution from a Roth IRA, you may have to pay the 10% additional tax on early distributions. You generally must pay the 10% additional tax on any amount attributable to the part of the amount converted or rolled over (the conversion or rollover contribution) that you had to include in income (recapture amount). A separate 5-year period applies to each conversion and rollover.

The penalty only applies to the portion "that you had to include in income". Thus, if you contributed $5500 in 2014 and converted $5600 (including $100 in income), and contributed $5500 in 2015 and converted $5700 (including $200 in income), you can withdraw $5500 penalty-free. The next $100 would come out of the taxed portion of the 2014 conversion, and would be subject to the 10% penalty if withdrawn before 2019. The next $5500 would be penalty-free because it would come out of the untaxed portion of the 2015 conversion, and the next $200 would be subject to the 10% penalty if withdrawn before 2020.

[Epsilon Delta]

The penalty only applies to the portion "that you had to include in income". Thus, if you contributed $5500 in 2014 and converted $5600 (including $100 in income), and contributed $5500 in 2015 and converted $5700 (including $200 in income), you can withdraw $5500 penalty-free. The next $100 would come out of the taxed portion of the 2014 conversion, and would be subject to the 10% penalty if withdrawn before 2019. The next $5500 would be penalty-free because it would come out of the untaxed portion of the 2015 conversion, and the next $200 would be subject to the 10% penalty if withdrawn before 2020.

I think you've got the ordering rules slightly wrong. See page 33 of pub 590B The taxable part of each conversion comes out first and is subject to penalty. So the first $100 gets a $10 penalty (till 2019) then $5,500 penalty free, then $200 with a $20 penalty and then $5,500 penalty free. Anything further is earnings and subject to both penalty and ordinary income tax until age 59.5 (or other qualifying event).

[grabiner]

The penalty only applies to the portion "that you had to include in income". Thus, if you contributed $5500 in 2014 and converted $5600 (including $100 in income), and contributed $5500 in 2015 and converted $5700 (including $200 in income), you can withdraw $5500 penalty-free. The next $100 would come out of the taxed portion of the 2014 conversion, and would be subject to the 10% penalty if withdrawn before 2019. The next $5500 would be penalty-free because it would come out of the untaxed portion of the 2015 conversion, and the next $200 would be subject to the 10% penalty if withdrawn before 2020.

I think you've got the ordering rules slightly wrong. See page 33 of pub 590B The taxable part of each conversion comes out first and is subject to penalty. So the first $100 gets a $10 penalty (till 2019) then $5,500 penalty free, then $200 with a $20 penalty and then $5,500 penalty free. Anything further is earnings and subject to both penalty and ordinary income tax until age 59.5 (or other qualifying event).

This is correct; I checked the rule, and the taxable portion is considered to come out first. The rule I was thinking of is that earnings are taxed after all contributions, including conversions.

I don't worry about this because I make my non-deductible IRA contributions to a money-market fund, then roll them to the correct fund in the Roth a few days later, so I don't have any taxable conversions from market fluctuations.