Author Topic: ELI 5 backdoor Roth IRAs.  (Read 413 times)

politenessman

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ELI 5 backdoor Roth IRAs.
« on: July 03, 2018, 12:39:21 PM »
My apologies if this has been asked before but my search didn't really answer my questions and no amount of googling seems to help.
I've noodled this for a while and I can't seem to get my head around it, so I am looking for help to understand what all this is about. I'll preface this by saying that both my wife and I currently max out our 401k contributions and I believe the 401ks have nothing to do with the IRAs if I do the backdoor Roth.

So the numbers:
My income is currently $93,000 with 27% going to my 401k so I guess my adjusted income is about $68,000
My wife's income is $150,000 with 16% deduction for her 401k and x% for health insurance. (I don't know what 'x' is)

We file married jointly so I think out adjusted income is somewhere about $180k-$190k. Frankly I don't think it matters because any IRA contributions are NOT tax deductable at this income level, and we earn too much to open a Roth IRA. This means if I want a Roth, I have to do the backdoor conversion.

My wife has an old IRA that was created by rolling her old 401ks from previous jobs into. She has about $50k in there. I have an old IRA that I no longer contribute to that was also created from older 401ks from previous jobs. It has about $9k in there.

So to my questions:

1. I believe that if I convert my IRA to a Roth, I pay tax on the entirety of the $9K (as it was funded with pretax dollars). Give that we file jointly, does this mean that we also pay tax on the wife's $50k?

2. I THINK the advantage in having the Roth is that if I use post tax dollars to further fund it, when it comes to my retirement income, the monies that I draw are tax exempt, including the interest that the account has earned. Is this true?

3. I can contribure $6500 to the Roth (I am 52). Can I contribute more than that?

4. Can I also have a traditional IRA at the same time that I also contribute to? (Another $6500)

5. What am I missing and what is there that I do not know that I should know about this?

EvenSteven

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Re: ELI 5 backdoor Roth IRAs.
« Reply #1 on: July 03, 2018, 01:00:19 PM »
1. If you are not converting her traditional IRA to a Roth, then no. If you are also converting her traditional IRA to a Roth, then yes. If you folks are doing back door Roths, then you can convert all your traditional IRAs to Roth right away and pay tax on it, or you can pay taxes each year on the conversion in proportion to the amount on the IRA that is still pre-tax money (the pro-rata rule).

Edit for clarity: I believe the pro-rata rule applies to you and your spouse separately. So clearing out your traditional IRAs should clear the path for you to do backdoor Roth conversions.

2. Yes.

3. Well, you cannot contribute to a Roth IRA because your income is too high, but you can contribute 6500 to a non-tax deductable IRA. The back door Roth is when you convert that to a Roth. Your wife can also make her own contribution to her own Roth IRA.

4. Nope, 6500 total contribution per year for all IRAs.

5. Conversions will not be available for withdrawal penalty free for 5 years on Roth conversions, as opposed to instantly like Roth contributions.
« Last Edit: July 03, 2018, 01:21:22 PM by EvenSteven »

terran

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Re: ELI 5 backdoor Roth IRAs.
« Reply #2 on: July 03, 2018, 01:10:15 PM »
1) If you convert your IRA to Roth you will owe state and federal tax just as if you had earned that money in the year of the conversion. This is not a backdoor Roth, this is a conversion. Since your tax rate will likely be lower in retirement (maybe not, but probably) this isn't a great idea as it means you'll pay more tax now instead of less tax then. You may still want to do it as it would let you contribute to a backdoor roth (we'll get to that later), but maybe your wife shouldn't since she has a larger balance. You might check to see if either of your 401(k) plans would let you roll the IRA into them. Even if they won't let you roll in IRA contributions they may let you roll in rollovers from previous a previous 401(k). This would let you proceed with a backdoor Roth without paying tax on your current IRA balances now.

2) Yes, all contributions (including conversions) and the gains on those contributions in a Roth IRA are tax free in retirement.

3) Yes, the current limit for those over 50 is $6500 per person as long as you (or your spouse) has at least that much earned income. (edit: right, as EvenSteven said, you're right about the limit, but your income probably means you can't contribute directly to Roth).

4) You can also have a traditional IRA, but the contribution limit is combined between them, so only $6500 total for each you and your wife.

5) From what you've described (and I could be wrong), I think you may not quite understand what a backdoor Roth IRA contribution is.

As you've said, you're over the income limits to be able to deduct IRA contributions from your income. You can still contribute to an IRA at any income, but this would normally be a bad idea since you won't get a current year deduction, and you'll pay tax on the gains at normal income tax rates, which are higher than capital gains rates in a regular brokerage account. As you'll see this ability to contribute at any income can still be useful.

As you've also said, you're very near (likely over) the income limit to contribute directly to a Roth IRA.

As you've also said, IRA balances can be converted to Roth IRA. What you haven't said is that if the IRA contribution was not deductible when you made the contribution (as would be the case if you contributed this year), you would pay tax on the gains since contributing, but not the original contribution. What this means is that you could contribute to your IRA (anyone can contribute, only those with low enough income can deduct the contribution), and then immediately (before there are much if any gains) convert to Roth thereby essentially making it as if you had contributed to Roth in the first place (even though your income won't let you contribute directly to Roth).

The complication comes from the fact that you have existing previously deducted IRA balance. As you've said, if you convert previously deducted IRA balances (including rollovers from previous 401(k) plans), you'll owe tax on those conversions. What you may or may not know is that if you make a non-deductible contribution to an IRA and convert some of your IRA balance to Roth, the conversion is considered to come proportionally from the deductible and non-deductible balances. So, if you're wife added a $5500 non-deductible contribution to her $50k balance and then converted that $5500 to Roth, about 10% would come from the non-deductible contribution which would not be taxable and about 90% would come from the previously deducted balance and would be taxable.

So that's why this would all be great if you had no current IRA balance, and maybe not so great since you do. So the first step is to see if you can get rid of the IRA balance by rolling it into your 401(k). If not, then you need to decide if paying the tax so that you can make backdoor roth contributions for yourself (maybe since you have a small balance) and you wife (probably not since she has a large balance) in the future makes sense.

This might help: https://www.whitecoatinvestor.com/backdoor-roth-ira-tutorial/
« Last Edit: July 03, 2018, 01:50:54 PM by terran »

politenessman

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Re: ELI 5 backdoor Roth IRAs.
« Reply #3 on: July 03, 2018, 03:28:10 PM »
Thank you both for the detailed answers, it is helping!

Quote
5) From what you've described (and I could be wrong), I think you may not quite understand what a backdoor Roth IRA contribution is.

LOL, Yup, hence this thread. I have no idea about this stuff and I'm attempting to learn but for some reason I get stuck with IRAs, and can't get my head around it.
So the obvious follow on question is this - what is the difference between a Roth Conversion vs a backdoor Roth. Perhaps this definition is a fundamental piece that I am missing.

Going forward, I think that given both our IRAs are created from 401K roll overs, we are going to roll them into our existing 401ks. This is going to be a major pain in the ass - I tried this a while back with mine and Chase put up every barrier known to man to keep the transfer failing, to the point where I gave up. Guess I have to try again.

So, given that neither the wife nor I can open a Roth IRA, I suppose the first step is to open and fund a tradition IRA; which appears to be easy to do. We can both fund our IRAs with $6500 each.
Great.

And then what? That is the other part that I do not understand. Why would I do this and how do I continue to contribute (is that the definition issue I mentioned above?).
Then once I retire, I can draw funds, tax free including the gains - I get that bit and that sounds like a great idea.
I guess I'm missing the middle bit if that makes sense?

politenessman

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Re: ELI 5 backdoor Roth IRAs.
« Reply #4 on: July 03, 2018, 03:40:31 PM »
Oh Wait - I get it now, I get it! (I think and I hope!)

Once the old roll over IRA is cleared and gone away, eliminating any tax issues; I can fund a new traditional IRA account at $250 per pay period ($6500/yr) non deductible (post tax dollars) because of our income levels. My wife can also do the same (assuming she gets her old roll over IRA into her 401k as well)

Once I have the traditional IRA fully funded (for instance, Dec 30th this year for example) I convert the funds to a Roth IRA by simply transferring the balance from the traditional IRA account to a Roth Account.

And there I make the investments in accordance with my investment strategy, and just let the whole thing build year over year. Rinse and repeat once per year.

Is that right?

terran

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Re: ELI 5 backdoor Roth IRAs.
« Reply #5 on: July 03, 2018, 03:48:05 PM »
Yep, sounds like you've got it!

I suppose you could convert after every contribution to avoid tax on the gains (since there would be less time for gains to accumulate), but that might be more trouble than it's worth. If you have the money available I would just contribute the full amount at once and do the conversion rather than contributing each pay period, but if not your plan works too.

You'll need to file form 8606 in the year in which you make the conversion (see the White Coat Investor post I linked to).

politenessman

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Re: ELI 5 backdoor Roth IRAs.
« Reply #6 on: July 03, 2018, 03:54:01 PM »
Yep, sounds like you've got it!

I suppose you could convert after every contribution to avoid tax on the gains (since there would be less time for gains to accumulate), but that might be more trouble than it's worth. If you have the money available I would just contribute the full amount at once and do the conversion rather than contributing each pay period, but if not your plan works too.

You'll need to file form 8606 in the year in which you make the conversion (see the White Coat Investor post I linked to).

Sadly I don't have enough to do the whole $6500 in one fell swoop - I have to do it bit by bit, especially this year. Next year may be different. If I just deposit the money into the traditional IRA and let it sit, rather than specifying any investments, I shouldn't have that much in the way of gains - maybe a dollar or two.

Thank you so much for your help, it was invaluable.

terran

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Re: ELI 5 backdoor Roth IRAs.
« Reply #7 on: July 03, 2018, 04:16:50 PM »
Sadly I don't have enough to do the whole $6500 in one fell swoop - I have to do it bit by bit, especially this year. Next year may be different. If I just deposit the money into the traditional IRA and let it sit, rather than specifying any investments, I shouldn't have that much in the way of gains - maybe a dollar or two.

No worries, that works too.

Something to think about: would you rather have gains that you have to pay taxes on, or no gains to pay taxes on? On average, the market goes up, so the earlier you invest the better (on average, being the key phrase of course).

politenessman

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Re: ELI 5 backdoor Roth IRAs.
« Reply #8 on: July 03, 2018, 04:22:20 PM »
you make a valid point! :)
Ok, change in strategy, I convert as soon as the funds go in.

terran

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Re: ELI 5 backdoor Roth IRAs.
« Reply #9 on: July 03, 2018, 08:50:18 PM »
you make a valid point! :)
Ok, change in strategy, I convert as soon as the funds go in.

Like I said, that might be more trouble than it's worth. My point was actually that maybe you should invest, then pay tax on whatever gains you have: the fact that there were gains means you still have more money that if you hadn't invested in the first place. You could convert a few times if you wanted.

Or, you could invest in a brokerage account, then sell and do the backdoor Roth all in one lump sum (contribute all at once and convert right away). Any gains in the meantime would be short term which would be taxed at the same rate as the conversion gains, but losses could be written off against other capital gains, or against regular income.

All of this is just optimization at the margins though, so just do whatever doesn't make you too crazy.