Back Door ROTH IRA

Submitted by David Dunn on Thu, 2020-03-05 00:22

FACTS:

Client age 57, single, employed and contributing maximum each year to 401k plan, around $500k W-2 income most years. Client plans to work 15 more years.
Inherited IRA $134,000
Traditional IRA $243,000 (all deductible contributions)
Roth IRA $12,000
401k $130,000

STRATEGY:
Would like to make a 2019 back door Roth IRA contribution taking the following steps:

1. Via direct transfer rollover the proceeds of the $243,000 Traditional IRA to the existing 401k plan, thus making the Traditional IRA balance $0.

2. After step 1 complete, and prior to April 15, 2020, contribute $7,000 to a 2019 Traditional IRA.

3. Immediately convert the Traditional IRA to a ROTH IRA prior to April 15, 2020. When this is done will be taxed on any gain. However, since the $7,000 will be invested in cash inside the Traditional IRA, and since the conversion will take place within a few days of the contribution, there will be next no taxable gain.

QUESTIONS:

1. I am assuming that because the Traditional IRA balance will be $0 at the time of the Roth IRA conversion, the only potential tax liability on the Roth conversion would be on any growth of the $7,000. Do you concur?

2. I am assuming the Inherited IRA Balance is not considered in the Roth conversion. In other words none of the Inherited IRA Balance needs to be converted. Do you concur?

3. Let’s assume that $20,000 of the $243,000 Traditional IRA are non-deductible contributions. Let’s assume the gain/earnings on the $20,000 to be $10,000. I would assume the most efficient strategy would be to rollover the entire $243,000 traditional IRA to the 401k, which would include both deductible and non-deductible contributions and earnings. Then, when distributions are eventually made from the 401k, that the exclusion formula be used to calculate the non-taxable portion of the distribution. I’m curious if there is any compelling reason to separate out now, at the time of this Roth IRA conversion, the non-deductible contributions plus earnings portion.



Submitted by Alan - IRA critic on Thu, 2020-03-05 00:57

  1. No. Taxation of the conversion is based on the TIRA value on 12/31/2020, not on the value on the date of the conversion. That means that no rollovers from employer plans into the TIRA should be done anytime before the end of the year. Your statement is correct if you substitute “at the end of 2020” for “at the time of the Roth conversion”.
  2. Agree the inherited IRA balance is not considered (does not go on line 6 of Form 8606). In addition, an inherited IRA cannot be converted unless owned by the surviving spouse.
  3.  Rollover of IRA non deductible contributions to a qualified plan is not allowed by the tax code, and if it happens by accident the qualified plan must distribute the funds back out with earnings. In this example, only 223k could be rolled into the 401k, leaving the 20k IRA basis in the IRA to be converted tax free. Since all IRAs are treated as one combined account and there is a special rule that makes the pre tax amount the first dollars distributed, the first 223k regardless of how many owned IRA account there are, is deemed to be pre tax IRA money that the 401k can accept. Therefore, client should first roll 223k from the IRA to 401k, then convert the 20k (which includes the 7k ND contribution) to the Roth IRA. Using this order eliminates the risk that the 401k will not accept the IRA rollover after client has already converted 20k, and that would result in the conversion being mostly taxable (92%) on Form 8606. 

Submitted by David Dunn on Thu, 2020-03-05 01:30

Thank you for your thoughtful and helpful answers.  I had a question about your answer in section 3, as followsTherefore, client should first roll 223k from the IRA to 401k, then convert the 20k (which includes the 7k ND contribution) to the Roth IRA1. Why did you say the 20k includes the 7K?  Can’t the client rollover the 223k TIRA first to the 401k, then convert the 20k non-deductible portion of the TIRA to the Roth IRA (an pay no tax doing so), then make the $7,000 2019 TIRA contribution, then convert the $7,000 TIRA to the Roth IRA?2. What does “ND” stand for when you say “7K ND contribution?3. Client would also like to make 2020 back door Roth IRA contribution.  I am assuming this process can take place AFTER everything else above has been completed OR could do concurrently with the 2019 back door Rorth IRA contribution? THANK YOU   

Submitted by Alan - IRA critic on Thu, 2020-03-05 02:20

ND = non deductible.  Yes, if the 20,000 does not include the current ND contribution, the contribution can be done later and converted, and client ends up with 27,000 in the Roth IRA, paying no taxes. The current year contribution can be done either before or after the IRA to 401k rollover and can be done after that with the order you stated. 

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