Traditional IRA Converting to Roth IRA?

[Joel]

Is there a requirement for the amount of time that funds must be in a traditional IRA before it can be converted to a roth IRA?

I am currently on the edge of the 15%/25% tax bracket. Based on the expected raises I will be receiving, I can say without certainty that I will be in the marginal 25% tax bracket next year.

However, in the current year, I have about 5k in LT capital gains that is causing my marginal rate to be 30%. For each dollar of ordinary income going up, that is being taxed at 15% and causing my qualified LT capital gains to be taxed at 15%. 15% + 15% = 30%.

I normally make a maxed out roth IRA conversion the January or February after the tax year. So my plan is to do a 5500 roth IRA conversion in february 2014 for tax year 2013. However, I was thinking in february 2014 I could do a traditional IRA contribution to save the 30% marginal tax rate in the current year, and then immediately do an IRA conversion into the roth IRA. The conversion will be taxed at 25% next year.

My retirement rule of thumb has been to put anything into a roth that can be taxed at under 25%. I certainly do not want to pay 30% taxes this year, as I don't see that being my marginal tax rate for at least 6-7 years, and certainly not during retirement.

Is there something that says it must be in the account for 30 or 60 days, or anything like that?

If the conversion does not make sense, I will likely try to up my 401k contributions to get back to the 15% marginal bracket and keep contributing the 5500 to my roth ira.

[Joel]

Anyone?

The more I look, the more I find nothing about a holding requirement which leads me to believe that my best bet is to contribute to the 2013 ira in 2014, and days later convert that into a roth ira. That way I can continue maxing out my roth ira annually, and save the 5% in taxes this year.

[matchewed]

Hmmm something doesn't seem right. How does an additional 5k in Long Term Capital Gains bump you into a marginal rate of 30%? Long Term Capital Gains for anyone in the 25% bracket and above is 20% in 2013 to my knowledge. You don't add your LT capital gains tax level to your income tax level to determine your marginal tax rate. Each dollar of income doesn't give a crap about your LT capital gains tax except to adjust the rate between the 15% and 25% bracket.

As for the IRA to Roth IRA transition - You'll have to pay the income tax on the balance you are transferring. Isn't that just a mild form of kicking the can down the road? What is wrong with increasing your 401k contributions to reduce your income tax as you suggested?

[Joel]

Okay, so to explain it further. I have 32k in ordinary income (after exemptions and st. deduction). I have 7k in LTCG and Qualified dividends. 39k total.

The limit for 15% is 36,250. Anything beyond that is at 25%. LTCGs and Qualified dividends are taxed at 0%, if your taxable income falls below the 15% line. Any dollars above 36,250 are taxed at 15%.

The LTCGs are straddling the 15%/25% bracket range. As such, for each additional dollar of ordinary income earned, it is taxed at 15% and one of my LTCGs dollars that was being taxed at 0% jumpes across the limit and is also taxed at 15%. Therefore, my marginal tax rate is actually 30% as a result.

That is why I want to lower my taxable income in 2013 (avoid 30%) and raise it in 2014 (pay 25%) for an automatic 5% tax savings. I know I will be entirely into the 25% tax bracket at work with the raise I will be receiving this year and my promotion bonus that will happen mid-next year.

I am already maxing out my Roth IRA contribution at 5,500 per year, and contribute 10% to my 401k at work. Cash flow wise, it would be difficult to contribute much more than that to my 401k. It's a stretch to be able to contribute 10% per paycheck. So, that makes the 401k option difficult. I would have to raise my 401k contributions to 17% for the remainder of the year. However, the money that will fund my Roth IRA is tied up until early 2014 in order to have LTCGs and not STCGs. Therefore, I would be contributing it post-2013 in the 3.5 month window that you are allowed to.

It's only a couple hundred bucks I would be leaving on the table if I did nothing, but I want to keep that money in my pocket.

[Joel]

Needless to say, because I know my intentions, it feels like their should be some type of wash sale-like requirements on converting traditional IRAs to roth IRAs. However, it may be a loophole that is not closed. That's what I'm hoping for and what it appears like based on all the research I have done.

[matchewed]

Also I want to make sure we're working on the same definition. You've stated your LTCG is 7k. You've made 7k in excess of (profit) the initial investment right?

More reading and research is saying yes it does count for taxable income and you will pay 15% of whatever amount of LTCG puts you over the 36250 line. So you are effectively trying to avoid paying a (roughly w/ 2750 *.15= 412) $400 dollar tax bill.

And no your marginal tax rate would be 15% and any capital gains which put you over the bracket would be taxed separately at 15%. You do not add them together to get your tax rate. The easiest thing to do is make sure your income after deductions does not pass 36250. I think you can do what you're saying but you may need more information.

So let's assume you're able to reduce your taxable income by 3k by contributing a lump sum to an IRA in 2013. You then roll that over to a Roth IRA later in 2014 and have to pay taxes on it. Given that you said you will be in the 25% tax bracket but you will have to figure out what your income is for 2014 and add the 3k to it. Then figure out how much more taxes you have to pay on that 3k. If that is in excess of $400 dollars your plan is a wash.

Also it's a bit of a long term plan and tax rates may change. Also the usual disclaimer I'm not a tax dude. If you're trying to do some fancy tricks you may want to talk to a tax professional.

*Edit* - Thinking about this more has lead me to the conclusion that all your work to avoid the $400 tax bill on LTCG will lead you to an additional $750 tax bill for your IRA to Roth IRA rollover (.25*3000).

[Joel]

Read this post again.

I am trying to save an immediate 5%.

Okay, so to explain it further. I have 32k in ordinary income (after exemptions and st. deduction). I have 7k in LTCG and Qualified dividends. 39k total.

The limit for 15% is 36,250. Anything beyond that is at 25%. LTCGs and Qualified dividends are taxed at 0%, if your taxable income falls below the 15% line. Any dollars above 36,250 are taxed at 15%.

The LTCGs are straddling the 15%/25% bracket range. As such, for each additional dollar of ordinary income earned, it is taxed at 15% and one of my LTCGs dollars that was being taxed at 0% jumpes across the limit and is also taxed at 15%. Therefore, my marginal tax rate is actually 30% as a result.

That is why I want to lower my taxable income in 2013 (avoid 30%) and raise it in 2014 (pay 25%) for an automatic 5% tax savings. I know I will be entirely into the 25% tax bracket at work with the raise I will be receiving this year and my promotion bonus that will happen mid-next year.

I am already maxing out my Roth IRA contribution at 5,500 per year, and contribute 10% to my 401k at work. Cash flow wise, it would be difficult to contribute much more than that to my 401k. It's a stretch to be able to contribute 10% per paycheck. So, that makes the 401k option difficult. I would have to raise my 401k contributions to 17% for the remainder of the year. However, the money that will fund my Roth IRA is tied up until early 2014 in order to have LTCGs and not STCGs. Therefore, I would be contributing it post-2013 in the 3.5 month window that you are allowed to.

It's only a couple hundred bucks I would be leaving on the table if I did nothing, but I want to keep that money in my pocket.

[Joel]

For each additional dollar of ordinary income I receive right now, the ordinary income is taxed at 15%, and it's bumps a dollar of ltcg above the limit causing that dollar to be taxed at 15% as well.

I've done the calculation, it's 30%. It's not what you would expect, but it's what happens when you are straddling the limit with ltcg.

[matchewed]

I was wrong about adding the ltcg to your income, you are right. I still don't think it is considered 30% because no where are you being taxed 30%, you are being taxed 15% on two different sources of income.

But to go back to my concern about this idea you have, are you sure you're not just trying to avoid paying a small tax bill in the near future only to have a larger one in the far future?

[Joel]

It is a marginal 30% tax in the reality that an additional dollar earned of reduced results in 30% taxes for a small window.

Basically, I can prevent paying 30% taxes this year, and pay 25% taxes on those dollars next year. Kicking the can down the road, but mainly to not be taxed 30%. A guaranteed 5% return.

I could leave it in my 401k and then I would be potentially paying more taxes down the road. But converting the taxes to a Roth in 2014 is dealing with it now. I do want a mix of traditional and Roth for when I retire so I have flexibility, but I want to continue contributing 5500 to my Roth IRA each year and 10% to my 401k each year. No less than that. When I can afford it, I might do more, but I might also put in into other investments in case I retire early.

As my numbers are estimates, it's possible I will receive a bonus or additional income this year, I might end up being bumped even higher to where the marginal dollars are at 25% and at that point I won't worry. But if I need to up my 401k contributions to 50% the last 3 months, I want to be prepared to do so.

[Joet]

I don't think there's any need to go through the [expensive] route of converting a 401k/IRA to a Roth at this point.

My reasoning: as long as all your IRAs are "sheltered' or rolled-into your current 401k [eg former employer 401ks] you're good. You're trying to avoid the pro-rata conversion problem of converting an IRA to a Roth [looks at all IRA assets---not your 401k though---and nabs you for current federal taxes on the conversion]

I believe you are fully in the 'not fully contributing' to the 401k zone [sub 17,500 + employer match, if any] and as such I think contributing to an Ira/Roth outside of that [unless your employer 401k is truly miserable] is a bit of a fools errand.

If you are 'truly mustachian', there should be ample years between ages 40-67 or so to convert your 401k to a Roth well within the zero % income bracket [vs your 15-25% ish now]. If you arent planning the ER/FI route perhaps your plan is indeed best.

The 401k deduction in your tax bracket is still super-worthwhile. Say your income is 40k [did you say your AGI is 32k?], then if you contributed 17.5k+ employer match to your 401k, your total AGI is around 20k. Your federal/state tax bill will be truly miniscule.

Now I know it's kind of a zero-sum game--aka take the deduction now vs later generally speaking, but I'm assuming there is a FI/ER plan somewhere. Wait for those years to convert 401k/IRA to Roth when you have the zero income years to do it in. Win/Win.

Alternatively, wait till your income/household income goes up a bit, contribute the max to the 401k AND then contribute to the IRA limit [currently 5,500], then follow the backdoor-roth conversion provision and convert to a Roth. Just speaking from personal experience, ever since they opened up the backdoor-Roth provision I sheltered all my IRA assets in my employer 401k and have been contributing ~25k in post-tax funds into my 401k that I convert 1x/yr to my Roth. The current law allows up to 51k deferred this way and I normally come within 1 or 2k of hitting that limit (401k+match+post-tax 401k <=51k). Eg 25k/yr into the 401k [tax advantaged] and 25k into the Roth via a single annual conversion of post-tax 401k deductions. Add on the normal 5/5.5k IRA-->Roth conversion and annually I put 25k into the 401k and 30k into a Roth. Unfortunately my spouse doesnt have that post-tax 401k deduction or allow in-service withdrawls that allows this. Otherwise we'd do it there too. This option has allowed me to convert a bit of my tax-advantaged funds into Roth-space which sounds like a good idea. But I'm not terribly optimistic that future legislation won't find a way to tax the gains in my Roth.

As far as "how long to hold the IRA" prior to conversion, opinions vary. Theres a good thread on bogleheads on this topic. Personally I think you are well within the law as stated if you invest in an IRA for as long as it takes the funds to clear and then immediately convert to a Roth. Other investors are more cautious and suggest a 6 month holding period. I personally do not want to fill out an extra form on my taxes [for potential gains--or losses prior to the conversion].

these are my humble $0.01

Also as an aside: I was not aware that a deductible IRA was ever eligible for a conversion to a Roth [eg anything with a basis], apologies if that is not what you are saying. Basically the options are A) take the deduction now in your taxes, or later. In the 15% bracket we can almost always assume the future tax rate will be higher [esp with what 17T in debt looming growing ~1t/yr]. However I suspect your circumstances will be different and you will

1) be able to contribute even MORE to your current 401k if you fore-go the non-deductible Roth IRA
2) wait for a future 0 income year to start converting some of your 401k to a Roth while paying 0% federal taxes [as opposed to a 8-10% net and 15/25 marginal or whatever you are paying now]

[Joel]

You can convert a traditional IRA to a roth IRA. I'm not aware of the holding period. That is what I am asking about.

I am putting 5500 in my roth IRA every year. I want to keep it that way. Especially considering how close I am to the 15% tax bracket. My income will only go up in the future. In fact, within the next 5 years, I fully expect to be in the 28% bracket.

The most I can afford is 10% into my 401k at this point. From a cash-flow perspective, that is all I can do. This is why raising my 401k contributions enough to reduce my taxable income to the level it needs to be is not very practical. I would have to do 18% for the rest of the year, and I can't do that. 10% is pushing it at this point, all the budget will allow.

My roth IRA contribution is tied up in my brokerage account, and it will not be long-term until 2014, meaning I can't cash out until then. Another reason why the increased 401k contributions plan would be difficult. This is why I want to do my proposed solution, if it's possible. I want to contribute the full 5500 to my roth. It's more money towards retirement than 5500 to a traditional. In fact, most of my retirement money at this point is tied up in a my roth IRA. So I wouldnt be getting the admiral shares if I left it in my traditional.

Needless to say, all the advice I have been given is not what I am asking for. I understand the tax implications. I'm an accountant, and I get it. I'm 90% sure there are no requirements for the conversion, I just was hoping to double-check. Instead I've received all sorts of responses telling me I'm not being taxed at 30% marginal, and that I should be putting the full amount into my 401k. Please read the above posts as to WHY I am doing this before you respond next time.

Or at least know what the hell you are talking about.

[velocistar237]

Is there a requirement for the amount of time that funds must be in a traditional IRA before it can be converted to a roth IRA?

No.

Search for "backdoor Roth" as an example.

[Joet]

a decent article on the topic [more slanted towards backdoor roth than conversions, does speak to the time aspect however which I guess is the OPs question vs any actual discussion of whether the conversion makes any financial sense or not which is apparently not for discussion]

So does the strategy of contributing to a non-deductible IRA and converting it to a Roth IRA to avoid the Roth IRA contribution income limit constitute a step transaction scenario? The reality is that the application of the step transaction doctrine is done on a case-by-case basis, and depends on a subjective interpretation of the facts and circumstances of the client's particular situation. What do the courts look for in evaluating the potential of a step transaction? Simply put, they are looking for a series of transactions, all inter-related, where the final outcome of the overall series of transactions was to accomplish the equivalent of another single-step (or fewer steps) transaction. In the case of a client who contributes to a non-deductible IRA, specifically for the purpose of converting it, and does those multiple steps precisely because it is a way to try to avoid the Roth IRA contribution income limits, then it seems clear that the step transaction doctrine could be applied. In point of fact, it is exactly these kinds of scenarios - multiple related transactions done to obfuscate the tax consequences of the same event in a single transaction - that the step transaction doctrine was designed to address (in the interests of reducing "abusive" tax avoidance strategies)!

The easiest way to make the case that the step transaction doctrine shouldn't apply is the passage of time, and the possibility that the tax and economic situation could change between the steps. Although a pre-meditated to decision to contribute to a non-deductible IRA with the specific intention to convert it shortly thereafter can be viewed unkindly by the IRS over any time period, an individual who has contributed to non-deductible IRAs in the more distant past and now chooses to convert is less likely to face scrutiny than someone who completes the conversion just a few days later. Many taxpayers choose to implement the strategy by converting a prior year's non-deductible IRA contribution, and then making a new non-deductible contribution for the current year, specifically to introduce at least some economic uncertainty to the situation, reducing the likelihood of step transaction treatment.

It's also notable that step transactions are not something that is typically captured in the "automatic reporting" processes for non-deductible IRA contributions and Roth conversions on IRS Forms 1099-R and 5498 and the tax return itself with a supporting Form 8606. Accordingly, many clients may choose to "take the gamble" and proceed with such a transaction anyway, under the auspices that there is a low probability they will be caught. While that may be true, it does not change the fact that the client would face a high risk of losing, if he/she was caught, if the IRS and/or the courts decided to view the transaction through the lens of the step transaction doctrine.

In the end, the contribute-and-then-convert strategy is not expressly prohibited by the tax code, but the IRS does have the right to tax a transaction according to its true economic reality. And if the express goal and intent of the client is merely to circumvent the clear intent of the law, and is done in a manner that blatantly disregards it, beware. While the reality is that the likelihood of getting caught is extremely low, when the IRS believes that a transaction is abusive, not only do they act to shut it down, but they don't always provide leniency for those who have already tried to take advantage of it in the past.

[RHINO]

When I left my last company I took my static IRA with Fidelity and moved it into a ROTH with Fairholme with no cost -- I believe Fidelity had to move it through an escrow and the transaction had to be completed within 30 days or else I would incur fees/taxes.