IRA, 401k and contribution limits

[veegsy]

Hello,

I have some questions that I hope someone can clarify.

1) If both my spouse and I contribute to our employer 401k plans, and we also want to fund tIRA accounts, then the max MAGI is 101K in order to get full deductions from the tIRA accounts, correct?
https://www.irs.gov/retirement-plans/plan-participant-employee/2018-ira-contribution-and-deduction-limits-effect-of-modified-agi-on-deductible-contributions-if-you-are-covered-by-a-retirement-plan-at-work

2) This does not apply for Roth IRA, correct? The MAGI for max Roth contributions is still 189K, even if we both have 401k accounts?

3) If this is the case, and considering our MAGI is about 180K, I'm also reading up on backdoor Roth. But how can backdoor Roth contributions be made if you have to first fund tIRA accounts (and we make above the 101K limit)? Is it okay because we aren't claiming any tax deductions, so the tIRA is just functioning as a normal taxable account for the short time that it holds the funds?

Hope I understand correctly and asked questions that make sense -- it's all a little confusing!

[terran]

1) Correct. That's based on the table you posted.

2) Correct. That's based on this table

 3) Right, so note that while the table in (2) is telling you that you cannot contribute if you're over a certain MAGI, the table in (1) is telling you that you can't deduct contributions if you're over a certain AGI. It doesn't make a lot of sense to contribute to an IRA that you can't deduct since you don't get a tax benefit and will pay normal tax rates (instead of capital gains rates as you would in a taxable account) on any gains, except that you can convert IRA balances to Roth IRA balances: otherwise known as the backdoor Roth.

Do note that any conversions of previously deducted IRA balances to Roth will incur tax at your marginal rate (and you need to still convert the full amount, paying taxes out of other funds, or you'll also pay a 20% penalty). IRA balances that have not be deducted only incur tax on gains since you contributed, so do it quickly and it's little different from contributing straight to Roth. However, any conversions happen proportionally from previously deducted and not deducted based on the balance of each, so if you have previously deducted IRA balances (including a rollover from a previous 401k), the backdoor Roth might be a less attractive option.

Make sense?

[veegsy]

Thank you for clarifying questions 1 and 2! Very helpful.

I do have a follow-up regarding your last point:

Do note that any conversions of previously deducted IRA balances to Roth will incur tax at your marginal rate (and you need to still convert the full amount, paying taxes out of other funds, or you'll also pay a 20% penalty). IRA balances that have not be deducted only incur tax on gains since you contributed, so do it quickly and it's little different from contributing straight to Roth. However, any conversions happen proportionally from previously deducted and not deducted based on the balance of each, so if you have previously deducted IRA balances (including a rollover from a previous 401k), the backdoor Roth might be a less attractive option.

So if I have a tIRA with a balance of $100K from various 401k rollovers, then I can't simply contribute $5,500 to the tIRA and roll over the $5,500 through the "backdoor" to the Roth account? I have to roll over the total $105,500? I feel I misunderstood, because Mad Fientist describes a process where he rolls over just a small sum every year from tIRA to Roth, so that must be possible?

https://www.madfientist.com/how-to-access-retirement-funds-early/#roth-conversion-ladder

[terran]

You can roll over small sums every year, but the rollover will come from both previously deducted (which you pay tax on) and non deductible (only pay tax on the gains between contribution and rollover) in proportion to the balance of each. The only way to move the whole $5500 non-deductible contribution is to also move all of the previously deducted balance (and pay tax on it). This isn't usually ideal because the fact that you can't contribute directly to Roth means you're in a relatively high tax bracket now, so you'll probably be in a lower tax bracket when you stop working, so you should wait and convert then. Usually the advice if you have existing deducted IRA balances is to just skip IRAs and invest in taxable.

You might still have a couple of options though. You could check and see if your current 401k allows incoming rollovers from rollover IRAs. If it does, and the investment options are acceptable you could roll over the IRA and then proceed with the backdoor Roth.

Also, IRA's are individual accounts, so if your spouse doesn't have any previously deducted IRA balances (s)he can still do a backdoor Roth even if you can't.

The Madfientist link is describing something different than a backdoor Roth. He's describing a process that you might consider once you're in a lower tax bracket (probably in retirement) of rolling over previously deducted IRA funds to Roth and paying the tax. Then, once five years has passed you can withdraw these rollovers (but not gains on the rollovers) without paying tax or penalty. It's a way of getting around the penalties for withdrawing IRA funds before the age of 59.5. This one is commonly called a Roth conversion ladder.

I know all this stuff can be confusing, but I'm sure you'll get it, and if not, post more questions.

[terran]

I just dug this link up for another thread. It might help you better understand the backdoor Roth with a more comprehensive explanation than I've offered: https://www.bogleheads.org/wiki/Backdoor_Roth_IRA

[veegsy]

This is incredibly helpful, thank you! This forum is such a great resource.

[veegsy]

Do note that any conversions of previously deducted IRA balances to Roth will incur tax at your marginal rate (and you need to still convert the full amount, paying taxes out of other funds, or you'll also pay a 20% penalty). IRA balances that have not be deducted only incur tax on gains since you contributed, so do it quickly and it's little different from contributing straight to Roth. However, any conversions happen proportionally from previously deducted and not deducted based on the balance of each, so if you have previously deducted IRA balances (including a rollover from a previous 401k), the backdoor Roth might be a less attractive option.
[...]
You can roll over small sums every year, but the rollover will come from both previously deducted (which you pay tax on) and non deductible (only pay tax on the gains between contribution and rollover) in proportion to the balance of each. The only way to move the whole $5500 non-deductible contribution is to also move all of the previously deducted balance (and pay tax on it). This isn't usually ideal because the fact that you can't contribute directly to Roth means you're in a relatively high tax bracket now, so you'll probably be in a lower tax bracket when you stop working, so you should wait and convert then. Usually the advice if you have existing deducted IRA balances is to just skip IRAs and invest in taxable.

I know this is a very late reply, but I discovered that there is a very simple solution to this issue. You can simply open a new Traditional IRA with Vanguard. You will then have two tIRAs, one for the rollovers (that were tax deducted) and one for the new contributions that you can use to convert to Roth. This will keep the money separate and thus avoid the issue. This is an easy and elegant solution it seems.

[MDM]

I know this is a very late reply, but I discovered that there is a very simple solution to this issue. You can simply open a new Traditional IRA with Vanguard. You will then have two tIRAs, one for the rollovers (that were tax deducted) and one for the new contributions that you can use to convert to Roth. This will keep the money separate and thus avoid the issue. This is an easy and elegant solution it seems.

Easy, elegant, and completely ineffective. :(

See line 6 of Form 8606, where you must "Enter the value of all your traditional, SEP, and SIMPLE IRAs."

If, however, you can roll the IRA into a 401k, that will work.

[veegsy]

Easy, elegant, and completely ineffective. :(

See line 6 of Form 8606, where you must "Enter the value of all your traditional, SEP, and SIMPLE IRAs."

If, however, you can roll the IRA into a 401k, that will work.

Thank you MDM, that's disappointing. But also not intuitive. If you have done it by the books inside of your accounts, and it's just a matter of an IRS document that doesn't break down the accounts, the fact remains that you still have done it properly and you don't owe any extra taxes. If audited they could see that there were separate accounts. Have anyone actually tested and been burnt by this?

[terran]

Easy, elegant, and completely ineffective. :(

See line 6 of Form 8606, where you must "Enter the value of all your traditional, SEP, and SIMPLE IRAs."

If, however, you can roll the IRA into a 401k, that will work.

Thank you MDM, that's disappointing. But also not intuitive. If you have done it by the books inside of your accounts, and it's just a matter of an IRS document that doesn't break down the accounts, the fact remains that you still have done it properly and you don't owe any extra taxes. If audited they could see that there were separate accounts. Have anyone actually tested and been burnt by this?

Why would the fact that they're different accounts mean you've done it legally when the form explicitly instructs you to include all accounts?

Allowing you to separate accounts in the way you've described would be counterintuitive because it would completely negate the purpose of the whole form and the corresponding rule that previously deducted contributions must be converted in proportion to non-deducted contributions since people would just use separate accounts. You definitely wouldn't come out of an audit victorious on that one.

[MDM]

Easy, elegant, and completely ineffective. :(

See line 6 of Form 8606, where you must "Enter the value of all your traditional, SEP, and SIMPLE IRAs."

If, however, you can roll the IRA into a 401k, that will work.

Thank you MDM, that's disappointing. But also not intuitive. If you have done it by the books inside of your accounts, and it's just a matter of an IRS document that doesn't break down the accounts, the fact remains that you still have done it properly and you don't owe any extra taxes. If audited they could see that there were separate accounts. Have anyone actually tested and been burnt by this?

Search the bogleheads forum for "CP2000" - many people were erroneously audited but had the paperwork to back up their returns.  It appears you are contemplating something illegal - perhaps think again and don't do that.

[veegsy]

Thanks for replies, don't worry I'm not contemplating doing this, I'm still in the research stage and figuring out best paths forward, and sometimes the best way to do that is to stress-test certain ideas so I can learn how the system and rules work. I hear what you are saying -- per the document it won't work. But my understanding of the rule is this: Don't let people put deducted contributions into a Roth. And everything I understand of the practical execution in the earlier example, it should work: no deducted contributions would be converted to Roth. The two pots of money (deducted IRA rollovers and non-deducted IRA contributions) would never even mix. It's a blanket rule that negates would-be appropriate conversions. But the IRS documents would have to be changed to reflect that. Again, I'm not acting on it.

Now, the larger question that even makes backdoor Roth possible is a rule (or loophole) that doesn't make much sense to me (from the IRS's perspective) as it just overrides the income limits they have set forth. So they are restricting the flow of money in form 8606 in a way that I argue doesn't need to be restricted if it's been done properly, but I actually think the overarching mechanism probably should be restricted, if the IRS think that income limits on Roths are of value. Just an observation.

Thanks for the clarifications!