Backdoor Roth IRA

Parent Cafe
101

<p>As far as kids and funding Roths, I think it’s much more than just teaching them about money. I’m all for the “put one penny in a jar” and another in another jar, all that. But this is different. It’s unlikely you are going to get your ten year old to put any of his money into the jar and not touch it till they’re 60, plus, they generally aren’t going to have much earned income till their later teens. And while they may manage to save some of their income, it probably won’t be enough to make a dent as far as investments go. Save that money and invest it well, and they are millionaires in their thirties.</p>

<p>I don’t think this plan of action is about the lesson. Now it’s great when they make enough money and can fund it themselves. My kid #1 started making great internship money at 16. I’m still waiting for kid #2 to make some decent money, but he loves his summer job and he spends the money on incidentals in college, though the pay is very low. It seems that funding a Roth for them until they can do it themselves is, financially, even smarter than saving for college. Certainly, only if you have the extra money available, probably not the best idea to go in debt for this. I think it would have been smarter to put less in our 401K’s if we had to, to fund their Roth’s, because of the time value of money.</p>

102

<p>Interesting thread.</p>

<p>We talked about doing this before the tax deadline this year, but didn’t get around to it. Both of us contribute the max we can to the company 401K program. H has a regular 401K, while I have a ROTH 401K. Both of us have a couple of older 401K accounts rolled over into IRAs - but we don’t contribute anything to these. Currently, our only contributions are to the 401K accounts. </p>

<p>We can each open up an IRA, contribute the max (5500/6500) and then convert this to a ROTH, right? We can’t directly contribute to a ROTH IRA. But I am confused about the taxes - will there be any on the conversion?</p>

<p>I didn’t even think about D contributing to an IRA. She does live very frugally and has cash in her bank account - perhaps I should suggest she start a ROTH IRA.</p>

103

<p>Converting to a roth triggers a full income tax on all former “pre-tax” contributions that you made, all at once. Plus any gains that you’ve had in the account, which are taxed at the highest rate, not the gains rate. </p>

<p>Also, if you are under 60, there are some other restrictions, I think, on your ability to withdraw from the roth IRA. Its a bit complicated, and some of the discussions aren’t that helpful. Fidelity and Vanguard have sections on the conversion process, but even those have to be read very carefully.</p>

104

<p>arisamp, I am assuming that you can’t contribute to a Roth because of income. But your income does not preclude you from opening up a non-deductible IRA and instantly converting it to a Roth, with no taxes paid on that conversion.</p>

<p>But someone mentioned that if you have other tax-deductible IRAs (I’m assuming your rolled over 401Ks were tax deductible), that complicates things and changes your basis. I don’t know how much in taxes that would trigger. It is easy for us, because the tax deductible IRAs that we had, we converted to Roths already (and paid our current tax rate for the entire amount).</p>

<p>First thing I’d consider if I was you, is if it would be worth converting those old IRA’s to Roths, because you aren’t income limited from doing that any more. I guess figuring out what your tax rate now, as opposed to retirement would be important. We figured that our tax rate in retirement would be the same or higher, and that the account was appreciating well, so it was worth it to take the painful hit to convert. </p>

<p>If your daughter has money that she knows she won’t need, she should definitely look at a Roth first, after matching employer 401K contributions, if any. Penalties if she had to cash it all out, including gains, but you can take the original amount you invested in it without penalty, at any time. I think.</p>

105

<p>Unfortunately, if you have IRAs that were funded with pre-tax dollars, the backdoor option will probably not do anything for you.</p>

<p>Example:</p>

<p>You have $50,000 in an IRA rolled over from a 401k.
You deposit $5,000 into a non-deductible IRA and roll it into a Roth.</p>

<p>After you put it in the IRA you now have $55,000 in an IRA, 90.9% of which is pre-tax.</p>

<p>So for any rollover you do into a Roth, 90.9% of it will be considered a rollover of the pre-tax money, and taxes will be immediately due. It doesn’t matter which pool the dollars actually come from.</p>

<p>In this case only $455 will be rolled into the Roth without having to pay income tax on it.</p>

<p>If you were smart and rolled all of your 401k distributions back into another 401k, the backdoor Roth will work. Otherwise, it’s a bust.</p>

106

<p>My kids have had roths since they were young and I’ve joked that they could have the info in my will. About every year I tell them where they stand. I believe they could also use the money for the down payment on a house someday. I prefer they keep it for retirement. Right now they’re only in one fund and we were just talking about at what point they should diversify. It’s a growth fund and has done great all these years. What’s really interesting is that they got set up to fund every other week, and they got on alternate weeks. Same fund, same amount of money, one has consistently outearned the other.</p>

107

<p>Notrichenough’s post has me thinking…</p>

<p>Somebody is 50 years old…</p>

<p>Has a 401k</p>

<p>Does not have to withdraw from the 401k until age 70 or 70 1/2 and has many years to withdraw after that…so there is a minimum of 20 years of compounding tax free (deferred)…Income</p>

<p>If your life expectancy is 85… You have approximately 15 years to withdraw the money according to a formula.</p>

<p>Or a person can switch to a roth…pay the tax upfront at 50… And then the income is tax free for life…</p>

<p>What am I missing? Have I written anything that is incorrect?</p>

<p>Notrichenough, why does rolling from 401k to another 401k do anything for you?</p>

108

<p>

I think the problem for most people, especially if you have significant assets in the IRA, is coming up with the money to pay the taxes, and it can push you into a higher bracket.</p>

<p>In any case, if you are paying the same tax rates now as in the future, it’s a wash.</p>

<p>Example: $100K in an IRA, 5% return for 20 years, 40% combined tax rate.</p>

<p>IRA: in 20 years you have $265,000 - take it out in one year, you get $159K after taxes.</p>

<p>Roth: after the conversion you have $60K. Twenty years later, you have $159K on which you own no tax. </p>

<p>The kicker is what your tax rate will be in the future. If it is higher than today, the Roth wins. If it is lower (and since you are retired, hopefully it will be) the regular IRA wins.</p>

<p>If you have the money to pay the taxes sitting in a savings account earning 0.1%, sure it’s a no-brainer to convert. If you have to withdraw money from the IRA to pay the taxes you incur an extra 10% hit and the conversion may not make sense.</p>

<p>

Because (at least according to my understanding, I am not a tax pro, seek the advice of a professional, blah blah blah) the amount in the 401k is not considered when converting an IRA to a Roth IRA. So in my previous example, if the $50K was in a 401K, 100% of the rollover to the Roth would be tax-free, instead of only 9%,</p>

<p>I’m not sure if the tax treatment when you die is different for a Roth and a regular IRA, I never looked into it.</p>

109

<p>My line of thinking was that the $$$$$$$$$$$$$$$$$$$$$$$$$$$$$ we paid in taxes over the past 2 years due to the Roth conversion could have been earning $$ in investments rather than paying the piper now, and perhaps it would have been worth more over the long run. But its a moot point, as its done. It was a serious ouch, though.</p>

110

<p>Ok… That does not sound right. </p>

<p>The switching of the 401k… I don’t think that works. I am not a CPA, but that doesn’t sound right. </p>

<p>You don’t have to withdraw all your assets from your 401k the first year. In my example, you have to withdraw a certain amount each year for 15 years. There is a formula and at first the withdrawals are a small amount and the withdrawals increase over the years. The tax breaks don’t stop at age 70 1/2 with a 401k. Converting to a Roth is not a no brainier. It can be a loser if you pay taxes when you convert and you are under 50. I would talk to a tax advisor. I am not a tax advisor. </p>

<p>You are losing tax free compounding when you convert on the money you paid in taxes when you convert. The younger you are, the more years of compounding you are losing. At age 70 1/2… You can see the difference in Account balances using your example. </p>

<p>I haven’t done the calculations but it looks like the time the Roth balance exceeds the 401k is a looooong, looooong time. I do want to double check and make sure I am right about the 401k after 70 1/2. </p>

<p>I am going to post this anyway because I already typed this and I don’t want to type this again. Lol</p>

111

<p>NRE, For the estate tax, IRA and Roth are treated the same, they are added to other assets to calculate the estate tax owed if any. In converting IRA to Roth, there’s also the state tax that you may have to consider depending on where you live.</p>

<p>It is not so clear cut that roth is always better than ira. If you don’t want to have a RMD and have cash to pay the tax due at conversion, roth wins. Otherwise, it is a bit more complicated from what I understand.</p>

112

<p>Ok everything I read says you only pay the taxes from a 401k when you withdraw from the 401k. So income generated in a 401k after age 70 1/2 still
Looks tax deferred. </p>

<p>Yeah… I don’t know about paying the taxes early with these Roth conversions…</p>

<p>I would love to read a mathematical analysis why it pays to convert. I know every situation is different. I can see why NJres converted. That makes sense. He is in a low tax bracket. He doesn’t lose much in compounding income by converting. </p>

<p>If you are in a high tax bracket with many years before retirement, I am not understanding the allure of roths… Mathematically. </p>

<p>Unless you have founding stock and value that stock at pennies…</p>

<p>Converting to a Roth after age 50 could be a loser…</p>

<p>I would like to be enlightened by somebody who knows. I haven’t spent time on this so I am sure I am missing things.</p>

113

<p>bd, nre - thanks for the explanations. H just started a new job - so he has rolled over all his 401K money into IRAs at either Fidelity or Vanguard. Given this, it would be significant tax hit if we had to do the backdoor ROTH conversion.</p>

<p>Couple more questions:</p>

<ol>
<li><p>Taking the hit now for the ROTH conversion would work if your tax rate in the future will be lower than your current tax rate. How do you figure out what your tax rate is likely to be?</p></li>
<li><p>Say we don’t do a backdoor ROTH. Is it still worth it to contribute $$ to a non-deductible IRA? We don’t get any tax benefits (since we already contribute to a 401K). Or would it be preferable to stick that money into a mutual fund?</p></li>
</ol>

114

<p>

If you are talking about whether 401k amounts are counted when doing the “pro rata” calculation for a Roth conversion, I googled around a bit, and I believe I am correct.</p>

<p>

[quote]
You don’t have to withdraw all your assets from your 401k the first year.

[quote]

Yes I know, I was just trying to illustrate a point. </p>

<p>

Not necessarily, because I believe you can recalculate the RMD every year based on your current life expectancy for that year.</p>

<p>

I think this all depends on where you find the money to pay the taxes that are due on the conversion.</p>

115

<p>

As my example showed, it is actually the opposite.</p>

<p>

All you can do is make assumptions based on what you think your income will be and what the tax brackets and rates will be. Basically… you have to guess.</p>

<p>

An after-tax IRA lefts your money grow tax-free, at the cost of converting long-term capital gains into ordinary income. Whether this is better or not all depends on your assumptions.</p>

116

<p>One advantage of 401k over ira/roth is if you go bankrupt, 401k is protected but not ira.</p>

117

<p>Notrichenough </p>

<p>Your example about when you pay taxes with a 401k is one of the keys to converting or not and your example is too limiting. Most people are not going to cash out of their 401k at age 70 1/2. Your calculations don’t work. 401ks do better in the real world than in your calculation.</p>

<p>I meant the percentage of the 401k that has to be withdrawn increases over time. Thanks for letting me clarify. </p>

<p>Your last point is a factor. There are many factors to consider when trying to decide to convert.</p>

<p>You are saying you get to shift your money from one 401k to another without paying a tax and then when you convert the new 401 k to a Roth you pay what in tax?</p>

<p>What are you saying?</p>

118

<p>

IRAs have $1 mil in protection in Federal bankruptcy, states vary but I think most are similar. Don’t know about you, but I have nothing to worry about. :D</p>

<p>

I think maybe you misunderstood what I was saying.</p>

<p>When you convert an IRA to a Roth, the amount that is taxable depends on what percentage of the money in all your IRAs combined has not been taxed yet. Money in a 401k does not count when making this calculation.</p>

<p>So, let’s suppose I have $50k in a 401k, $0 in pretax IRAs, and make a $5k contribution to an after-tax IRA.</p>

<p>If I convert that IRA to a Roth, 0% is taxable because 100% of my IRA assets are after-tax.</p>

<p>Now let’s suppose I rolled my 401k into an IRA. Now when I convert the after-tax IRA, only 9% is treated as a tax-free rollover 5k/(50K + 5K). Now I owe taxes on 91% of the after-tax $5k contribution.</p>

<p>

Yes.</p>

<p>

You can’t convert a 401k into a Roth IRA. What I am saying it that whether you have money in a 401k or an IRA affects the taxes to pay on converting a regular IRA to a Roth.</p>

119

<p>I don’t like this example…</p>

<p>"Example: $100K in an IRA, 5% return for 20 years, 40% combined tax rate.</p>

<p>IRA: in 20 years you have $265,000 - take it out in one year, you get $159K after taxes.</p>

<p>Roth: after the conversion you have $60K. Twenty years later, you have $159K on which you own no tax. "</p>

<p>Because people don’t take all their Ira and 401k the first year…
The amount in the Ira is understated… Money still accumulates tax deferred in the 401k for years after age 70 1-2.</p>

<p>I think the percentage that has to be withdrawn the first year is around 3 percent… But I may be wrong on that… I am close. </p>

<p>If instead of using a 100 percent withdrawal the first year… If You 6.67 percent a year the numbers change. This isn’t exact because the withdrawal rates aren’t linear but this would be better than a 100 percent cash out.</p>

<p>One factor when comparing roths and iras is what happens at death. Income taxes have ready been paid in roths. Iras maybe not. Are income taxes due at death for iras? WhAt rate is used?</p>

120

<p>

</p>

<p>No. The traditional IRA distributions are taxable to the beneficiaries, at whatever their tax rate is, when they take distributions.</p>