Help understanding a roth conversion
Below is an IRA tip from a recent Forbes article and a response from his current advisor.
I would like to know if it’s possible to open a non deductible IRA and convert it each year to a Roth and not have his current IRA included in the calculation in the first years conversion?
7. My income is too high to put money in a Roth IRA. You may earn too much to contribute to a Roth IRA but there is a way to get money into a Roth IRA through the backdoor. Since there’s no income limit on Roth IRA conversions you can contribute to a nondeductible IRA and then convert it into a Roth. The only catch is that if you have other pre-tax IRAs, you’ll have to pay a tax on the converted IRA on a pro-rata basis. However, you can avoid this by rolling the pre-tax IRAs into your employer’s retirement account.
Mike, regarding #7, that catch would apply to you because you have other pre-tax IRA’s. So even if you contributed $5,500 as an after-tax IRA contribution, if you then went to convert it, only $5,500/$435,000 would be tax-free. In other words, almost 99% of anything you converted would be subject to income tax now. To me it’s not worth moving the IRA to your employer retirement account to avoid this, as that’s a small benefit compared to the $435,000 being invested properly.
Permalink Submitted by Alan Spross on Tue, 2012-08-28 17:38
Advisors rarely recommend moving funds from an IRA to a 401k. That said, his point is correct if your 401k does not have low expenses or good investment options.
You also must consider other things such as:
1) How many years do you plan to do the non deductible contributions and convert them?
2) Does your plan allow you to roll incoming rollovers back out of the plan when you wish, or will you have to wait until you leave the company, reach 59.5 etc?
3) Some plan do not accept IRA rollovers and others only accept rollovers from a rollover IRA, ie an IRA that was created by an employer plan rollover.
If your plan will accept the pre tax balance in all your TIRA, SEP or SIMPLE IRAs, then it boils down to whether your investment gains would be higher in the plan or in the IRA which I presume is more directly under the control of the advisor, and can be “invested properly”.
You may also have a Roth option included in your 401k plan under which you could allocate part of your contributions to the Roth and the rest to the pre tax account.