Author Topic: Should I recharacterize my 2014 Roth IRA into a traditional IRA?  (Read 6167 times)

Beric01

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Should I recharacterize my 2014 Roth IRA into a traditional IRA?
« on: December 02, 2014, 01:10:17 PM »
So in the beginning of the year I made a Roth IRA contribution of $5500. Later in the year I decided to start maxing out my 401(k), and have contributed the maximum of $17500 for 2014. Now, per my understanding that 401(k) contributions reduce MAGI, my MAGI should now fall somewhere into the $60K-70K range (not 100% sure of the exact number yet). I understand that you can "recharacterize" your IRA to the other type.

I'm a very frugal person, and expect to pay low to nonexistent taxes in retirement. As such, I'm viewing my 401(k) assets as worth about their face value. I assume an IRA should be the same (I'd roll over my 401(k) to an IRA once I leave my company). So if I understand correctly, I will save about $2K on taxes by recharacterizing this to a traditional IRA. Is my understanding correct?

EDIT: I also plan to utilize the Roth ladder in early retirement, and understand having a standing traditional IRA balance could mess things up?
« Last Edit: December 02, 2014, 01:15:44 PM by Beric01 »

Gone Fishing

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Re: Should I recharacterize my 2014 Roth IRA into a traditional IRA?
« Reply #1 on: December 02, 2014, 01:25:17 PM »
That's what I am doing.  If I understand your question correctly a "standing" traditional IRA balance shouldn't mess things up at all, that is the whole idea.  You fund the Traditional and 401(k) before retirement and roll it over into the ROTH after retirement.  You just need to have 5 years of expenses in your ROTH or in taxable investments when you retire to ge your ladder started.   

FastStache

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Re: Should I recharacterize my 2014 Roth IRA into a traditional IRA?
« Reply #2 on: December 02, 2014, 01:26:00 PM »
I'm interested in following this thread, as I'm thinking of doing the same thing. I too have maxed out my 401k and roth ira.

But I like the ability of having access to the money in my Roth. I figure I may do the Roth next year too for me and my wife, giving us 33K that would be accessible to us penalty free in case anything happens.  Then starting in 2016 invest in a traditional IRA to get the tax deferment.

Given your tax bracket you should save 25% of the 5.5K if you put it in a traditional IRA.

You need to balance what do you think will be the income you need in retirement, accessibility to money, and current tax bracket imo.

MooseOutFront

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Re: Should I recharacterize my 2014 Roth IRA into a traditional IRA?
« Reply #3 on: December 02, 2014, 01:31:28 PM »
I went back and forth on this and chose Roth, but I'm in the 15% bracket.  If you're in 25% then I think the traditional IRA is the clear winner rather than voluntarily prepaying 25% in taxes now.  The only thing having a traditional roth messes up is the "backdoor roth" contribution plan that people with too high of an income to qualify for roths use to get money into a roth anyway.

Angie55

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Re: Should I recharacterize my 2014 Roth IRA into a traditional IRA?
« Reply #4 on: December 02, 2014, 02:00:57 PM »
Am I correct in thinking that if you are at the lower range of 60-70k you would choose traditional? But if you are say 65k or higher MAGI you would choose Roth? I'm in similar situation where my year end estimates are smack dab in the middle of the phaseout range. My logic is 25% tax rate, 5% state tax. If half the deduction is phased out, I'm really only saving on half the amount of taxes (so 15%). 15% tax seems to be the unofficial threshold of Roth/traditional. So if I'm in the upper half of the phaseout I should lean towards Roth contribution.

Am I understanding this correctly?

MDM

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Re: Should I recharacterize my 2014 Roth IRA into a traditional IRA?
« Reply #5 on: December 02, 2014, 02:05:39 PM »
... my MAGI should now fall somewhere into the $60K-70K range (not 100% sure of the exact number yet).
That is certainly the salary band of interest: at $60K or below you can deduct the full $5500, at $70K and above you can deduct nothing, and it's pretty much linear (i.e., $2750 is deductible at $65K) in between.  See http://www.irs.gov/Retirement-Plans/IRA-Deduction-Limits

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I'm a very frugal person, and expect to pay low to nonexistent taxes in retirement.
That is an important consideration.  If that becomes true, then doing traditional now will turn out much better for you.

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I will save about $2K on taxes by recharacterizing this to a traditional IRA. Is my understanding correct?
25% * $5500 = $1,375.  Don't know your state tax rate.

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EDIT: I also plan to utilize the Roth ladder in early retirement, and understand having a standing traditional IRA balance could mess things up?
Not sure of this understanding, as you need a traditional IRA balance to do the kind of Roth ladder discussed in http://www.madfientist.com/retire-even-earlier/ and elsewhere.
« Last Edit: December 02, 2014, 02:10:27 PM by MDM »

pzxc

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Re: Should I recharacterize my 2014 Roth IRA into a traditional IRA?
« Reply #6 on: December 02, 2014, 02:07:57 PM »
If you separately contributed the max $17.5k already to a traditional IRA, I don't think you're allowed to recharacterize the Roth as being a traditional as that would put you over the limit....?

MDM

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Re: Should I recharacterize my 2014 Roth IRA into a traditional IRA?
« Reply #7 on: December 02, 2014, 02:11:32 PM »
If you separately contributed the max $17.5k already to a traditional IRA, I don't think you're allowed to recharacterize the Roth as being a traditional as that would put you over the limit....?
The $17.5K went to a 401k.  No problem putting another $5500 to an IRA.

Beric01

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Re: Should I recharacterize my 2014 Roth IRA into a traditional IRA?
« Reply #8 on: December 02, 2014, 02:53:25 PM »
Am I correct in thinking that if you are at the lower range of 60-70k you would choose traditional? But if you are say 65k or higher MAGI you would choose Roth? I'm in similar situation where my year end estimates are smack dab in the middle of the phaseout range. My logic is 25% tax rate, 5% state tax. If half the deduction is phased out, I'm really only saving on half the amount of taxes (so 15%). 15% tax seems to be the unofficial threshold of Roth/traditional. So if I'm in the upper half of the phaseout I should lean towards Roth contribution.

Am I understanding this correctly?

This is what I'm thinking. But perhaps if I end up somewhere on the $60-70K MAGI continuum, then I can split the difference and do half Roth, half traditional up to the deductible limit? Apparently I don't need to make the decision to recharacterize until tax time next year.

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EDIT: I also plan to utilize the Roth ladder in early retirement, and understand having a standing traditional IRA balance could mess things up?
Not sure of this understanding, as you need a traditional IRA balance to do the kind of Roth ladder discussed in http://www.madfientist.com/retire-even-earlier/ and elsewhere.

I finally found an article explaining what I was talking about, though I'm not sure I understand it. This is a potential concern as I expect to have a fairly large 401(k) balance when I FIRE.

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The IRS does not allow converters to specify which dollars are being converted as they can with shares of stock being sold; for the purposes of determining taxes on conversions the IRS considers a person’s non-Roth IRA money to be a single, co-mingled sum.

Hence, if a person has any funds in any non-Roth IRA accounts, it is impossible to contribute to a Traditional IRA and then “convert that account” to a Roth IRA as suggested by various pundits and the Wikipedia piece referenced above – conversions must be performed on a pro-rata basis of all IRA money, not on specific dollars or accounts.



25% * $5500 = $1,375.  Don't know your state tax rate.

Yeah, it's coming off the top of my taxable income, and as a single filer with no deductions it's closer to 40% marginal when you include insane state taxes, Social Security and the like.
« Last Edit: December 02, 2014, 02:56:28 PM by Beric01 »

MDM

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Re: Should I recharacterize my 2014 Roth IRA into a traditional IRA?
« Reply #9 on: December 02, 2014, 03:08:59 PM »
This is what I'm thinking. But perhaps if I end up somewhere on the $60-70K MAGI continuum, then I can split the difference and do half Roth, half traditional up to the deductible limit? Apparently I don't need to make the decision to recharacterize until tax time next year.
Yes, you can wait on the recharacterization.  You can split the difference up to whatever limit the IRS allows.  It will be half if and only if your MAGI is exactly $65K.

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I finally found an article explaining what I was talking about, though I'm not sure I understand it. This is a potential concern as I expect to have a fairly large 401(k) balance when I FIRE.
This is an issue if you are (or would be if counting tIRA distributions) in a high tax bracket.  If you really will "pay low to nonexistent taxes in retirement" then you will be ok.  The trick is to keep the conversions low in any given year so you stay in a low tax bracket.


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Yeah, it's coming off the top of my taxable income, and as a single filer with no deductions it's closer to 40% marginal when you include insane state taxes, Social Security and the like.
Can't help with the insane state taxes, and yes you will save on those with a tIRA - but Soc. Sec. & Medicare ignore IRAs and 401ks (as in SS & Medicare tax you before IRA and 401k deductions are taken) so no savings there.

skyrefuge

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Re: Should I recharacterize my 2014 Roth IRA into a traditional IRA?
« Reply #10 on: December 02, 2014, 04:48:49 PM »
EDIT: I also plan to utilize the Roth ladder in early retirement, and understand having a standing traditional IRA balance could mess things up?

No. The article you reference (which is a very good one) is talking about "backdoor" Roth conversions, not the "Roth IRA Conversion Ladder" that you'll want to be doing in retirement.

They're really the same thing, with the same tax effects, but the expectations are different, and the expectations are what matters here.

In both cases, you're converting a portion of a Traditional IRA into a Roth IRA, and you're taxed on the amount of Traditional pre-tax money that you're converting.

In the "conversion ladder", you're completely expecting to be taxed on the conversion (though you expect the tax to be at a low rate), so it's no big deal.

But in the "backdoor", you're expecting no tax on the conversion. If you want to do a "backdoor" conversion in the first place, that means you have income that puts you in a fairly high tax-bracket, so it generally doesn't make sense to do a conversion at that time if you're going to be taxed on it. And if you don't have any pre-tax IRA money, you will not be taxed, because the "backdoor" conversion converts post-tax Traditional IRA money into Roth IRA money. That's the case under which the "backdoor" conversion makes sense. However, if you have a separate pre-tax IRA, then you must pay tax on the "backdoor" conversion even if in your mind the conversion amount came from your post-tax money; in the IRS's mind, it came from the combination of your pre-tax and post-tax money, and is taxed accordingly.

So while a pre-tax Traditional IRA won't mess up the Roth conversion ladder, it can prevent "backdoor" Roth conversions that you might want to do in the future. I don't really know if that's a strong enough reason to avoid creating a pre-tax IRA pot right now, but I think it probably isn't in most cases.

skyrefuge

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Re: Should I recharacterize my 2014 Roth IRA into a traditional IRA?
« Reply #11 on: December 02, 2014, 05:42:20 PM »
Why would you ever do this??  If you max out your 401k, you get no tax benefit to contributing to a traditional IRA.

No, you're extremely confused and wrong.

There is no connection between "maxing out your 401(k)" and the tax-deductability of IRA contributions. The income level at which you are allowed to contribute to a tax-deductible IRA is lowered if you are covered by a 401(k) plan (regardless of if, or how much, you contribute to it), but you can still make tax-deductible contributions if your income is low enough (and in the OPs case, it likely is).

In other words, you still have to pay income tax on the traditional IRA contribution PLUS pay income tax when the money comes out of the traditional IRA.

No, paying income tax on the full amount on both ends never happens. If your income level prevents you from making tax-deductible contributions to your IRA, then you can make non-deductible contributions. At withdrawal, non-deductible contributions are taxed only on their earnings (as ordinary income). It's not a great tax benefit, or one that works out in all situations, but it's untrue to say that there "is no tax benefit to contributing to a traditional IRA" even if non-deductible contributions are your only option.

If you max out your 401k you are better off putting the $5500 in a Roth IRA, so at least it's already there, especially if the whole point was for the money to end up in a Roth IRA anyway via a Roth ladder.

Hey, you finally said something sort of correct! If Roth IRA contributions are possible, that's always a better choice than non-deductible Traditional IRA contributions. But even when the goal is for all your money to end up in a Roth IRA, that doesn't mean putting it there initially is always the best choice. For people using the Roth ladder strategy, putting in tax-deductible accounts during the accumulation stage is likely the more optimal path.

michaelrecycles

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Re: Should I recharacterize my 2014 Roth IRA into a traditional IRA?
« Reply #12 on: December 05, 2014, 09:50:23 AM »
Hey Beric, I was in your boat last year. I pulled the trigger after reading the Mad FIentist article and others' experiences on how easy the recharacterization was with Vanguard. As you alluded, it would be useful to wait until you get your W-2 to figure out your MAGI and the deductability of any tIRA contribution.
On the other hand, you could split the difference or simply leave the Roth alone and contribute to the tIRA in the future. The Roth does have the benefit of pulling out contributions any time, and you could view those contributions as a secondary emergency fund.

Angie55

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Re: Should I recharacterize my 2014 Roth IRA into a traditional IRA?
« Reply #13 on: December 05, 2014, 10:05:02 AM »
Thanks for this thread. Re characterizing my contributions will save me about $1500 in taxes! I had no idea you could split them between the two up to the deductible threshold. Luckily this didn't apply last year for me so nothing missed.


MustachioedPistachio

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Re: Should I recharacterize my 2014 Roth IRA into a traditional IRA?
« Reply #14 on: December 12, 2014, 09:27:17 AM »
While not technically a recharacterization, has anyone withdrawn Roth principal contributions from previous years to make a tIRA contribution in the current year? I've perused Pub. 590 and can't seem to find anything that explicitly forbids it.

As a side note, this distribution would also reduce the amount of retirement contributions used to calculate the Saver's Credit (if I interpreted the instructions for that form correctly), effectively "cancelling out" the whole transaction, but there's more tax savings for us (MFJ) in simply reducing our AGI.

I've plenty of tIRA space to fill, and a pending home purchase will usurp most of our additional funds through April...

Thanks everyone!

MDM

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Re: Should I recharacterize my 2014 Roth IRA into a traditional IRA?
« Reply #15 on: December 12, 2014, 01:14:26 PM »
While not technically a recharacterization, has anyone withdrawn Roth principal contributions from previous years to make a tIRA contribution in the current year? I've perused Pub. 590 and can't seem to find anything that explicitly forbids it.

As a side note, this distribution would also reduce the amount of retirement contributions used to calculate the Saver's Credit (if I interpreted the instructions for that form correctly), effectively "cancelling out" the whole transaction, but there's more tax savings for us (MFJ) in simply reducing our AGI.

I've plenty of tIRA space to fill, and a pending home purchase will usurp most of our additional funds through April...

Thanks everyone!
DJstash, welcome to the forums.

Can't help w/ the Saver's Credit part, but for the rest: the IRS cares only that you have enough "earned income" to cover your IRA contribution, and that your MAGI is less than the applicable (i.e., single vs. MFJ) limit.  Beyond that, the specific source of the funding is immaterial.
If the withdrawn Roth principal is your only income then you may not contribute to a tIRA because that income is not "earned."  But if you have >$5500 in earned income (and are within the MAGI limit) you could contribute $5500 to a tIRA - whether you took that $5500 from your earned income or withdrew $5500 from Roth principal.

Cromacster

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Re: Should I recharacterize my 2014 Roth IRA into a traditional IRA?
« Reply #16 on: December 12, 2014, 01:47:14 PM »
While not technically a recharacterization, has anyone withdrawn Roth principal contributions from previous years to make a tIRA contribution in the current year? I've perused Pub. 590 and can't seem to find anything that explicitly forbids it.

As a side note, this distribution would also reduce the amount of retirement contributions used to calculate the Saver's Credit (if I interpreted the instructions for that form correctly), effectively "cancelling out" the whole transaction, but there's more tax savings for us (MFJ) in simply reducing our AGI.

I've plenty of tIRA space to fill, and a pending home purchase will usurp most of our additional funds through April...

Thanks everyone!

You probably could do this.  Personally I would just leave it as is.  Unless you really need that 5,500 reduction to qualify for something.  The actual value of the Savers Credit depends on how much you earn.  If you are at the top, 60k I think, you get a credit of $400 if you contribute the max.
Edit: and at best the Savers Credit is worth 2,000. (Both scenarios are married filing jointly)

A removal of principle from a Roth would not affect your MAGI in any way.
« Last Edit: December 12, 2014, 02:04:15 PM by Cromacster »

MustachioedPistachio

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Re: Should I recharacterize my 2014 Roth IRA into a traditional IRA?
« Reply #17 on: December 12, 2014, 06:59:15 PM »
Thanks guys, I appreciate it. It's not a necessity, so I'll likely leave it be.

I've been a lurker on the blog for nearly a year, but this is my first foray into the forum. Solid gold!