Back Door Roth with Large IRA Rollover
Greetings,
My wife and I are above the income limit for a roth contribution. Thus, my wife and I each make a non deductible IRA contribution, and then convert to a roth. For Myself, I have a 401k and no other IRA’s. It is an easy conversion with no detailed computations, regarding pro-rata conversions.
My wife has a $200,000 IRA rollover. We are both 40. She no longer works, and cannot roll her rollover IRA back into a 401k or company plan to avoid the pro-rata taxes on her conversion.
Based on my wife’s age, and the fact that we want to continue to get more money growing tax-free in a roth, does this strategy make sense? Is it foolish to use the back door roth strategy to get money into her roth, even though we must pay taxes on the majority of her yearly $5000 conversion? (Yes, We are correctly using seperate monies to pay the taxes on the conversion)
If this is a viable strategy for her at this point, then I would assume that at some point down the road, when my wife is in her mid to upper 50’s, that it would no longer make sense to do these virtually fully taxable conversions. What would be the primary deciding factors on when to stop making these taxable conversions for my wife?
Thanks,
Mark
Permalink Submitted by Alan Spross on Mon, 2012-04-23 05:01
The main factor here is the same as for any taxable Roth conversion, ie will the current taxes for the conversion be at a rate that is lower, about the same, or higher than your expected marginal rate in retirement. If you are in the “about the same” situation, then you should target a small portion of your retirement accounts for the Roth option just to provide tax diversification. If your current rate appears to be lower than in retirement, then she might convert a modest amount each year along with the non deductible contribution. I suppose if your wife is through working or plans to return to work is a large factor in addressing these tax rates. Your tax rate in retirement is likely to be higher if you are an aggressive saver than just a modest saver. If you jointly accumulate 1mm in pre tax retirement accounts along with SS and modest other savings, you will probably in the future version of the 25% bracket once RMDs begin. Also consider whether you will retire in a higher income tax state or lower one than where you live now.
Another factor is the amount of your own workplace contributions, ie if you are maxing those out or not, and if you have access to Roth 401k option, have after tax amounts in your non Roth account that are eligible for distribution or eligible for an in plan Roth rollover.
Your own annual non taxable Roth conversion is more of a no brainer, but it is hard to say whether your wife should make the contributions and convert a certain amount or just make the contributions and wait to see if things change such that the decision is more clearer with respect to converting.
Permalink Submitted by Mark Fletcher on Mon, 2012-04-23 12:10
Thank you for your reply.
Some more things I want to clarify, starting with your statement(below). Much appreciated.
[color=#408000]”If you are in the “about the same” situation, then you should target a small portion of your retirement accounts for the Roth option just to provide tax diversification. If your current rate appears to be lower than in retirement, then she might convert a modest amount each year along with the non deductible contribution[/color]
So I think you are saying if we will be in a lower, or similar tax bracket, in the future, it is a wise decision to continue with the $5000 back door roth fo her, in BOTH situations? I am just slightly confused in your use of the term “small portion” and “modest amount.” (they seem to mean the same to me). Thank you
Future/Down the road questions, (Ie my wife is 55 or older):
Is my thinking here correct, based on what you have said? It would probably be an easier guestimate( when my wife is 55 and beyond) whether to make this back door roth contribution? I guess we would discontinue this ONLY if we saw that paying the taxes at [u]then existing rates[/u] are clearly lower than our future rates will be? What I am saying is I think it would be easier to predict our personal tax future rates when we are closer to retiring, and also the future fed tax rates (sort of). Am I thinking along the right limes? And lastly, won’t the amount of time that lapses between when we convert, and when we actually pull the money out of the roth, factor into this equation somnehow?
Thanks again
Permalink Submitted by Alan Spross on Mon, 2012-04-23 16:44
By “targeting a small amount”, I meant an eventual target % of your retirement assets to be in a Roth IRA. For example, 20% Roth, 80% pre tax. This would be a long range target to be reached at some point before RMDs must begin at 70.5. To get there I suggested “convert a modest amount each year”. It is not possible to be more specific, but an example would be that she would convert more in a year where your marginal rate is lower due to lower income, higher itemized deductions etc. What is lower vrs higher is subjective and should be reviewed annually. For example, if you received a large salary increase, inheritance, etc your future rates could all be higher than what they were, making the last year before this increase lower in comparison. Many people who are near the top of a given bracket convert only enough to get to the top of the bracket and NOT spill over into the next bracket. Conversely, if you won 100,000 in the lottery that would be a one time windfall and would boost your tax rate for that year only and you would not want to convert anything that year.
An obvious statement, but will make it anyway – Your tax rate for a given year representing the cost of a conversion can be easily determined, but your average rate in retirement is a crap shoot. People talk all the time about tax rates rising in the future to address the deficit, but the fact is that your joint financial situation is much more important in determining your future tax rate than national averages. If you are a saver and socking away large amounts in pre tax 401k contributions every year vrs spending the money on second homes, expensive cars etc, and if your health holds up, chances are you will accumulate enough to result in high taxable incomes when RMDs begin. In this situation you would convert more to hold those RMDs down. Conversely, if you want to retire early when you have just enough to fund a basic retirement of 30 years, then you would convert much less, or probably nothing. Since you do not know what may happen, having an eventual target % figure will provide tax diversification for you.
Making the non deductible contribution is a way of socking away more money in your IRA even when you do not know if or when you will convert it. It won’t hurt anything if you never convert it because it will be returned tax free on a pro rated basis for life, but if you do convert it will provide something to convert. Right now, the funds available for conversion are limited to your wife’s 200k unless your plan allows you to do an in plan Roth conversion. But you generally will not be able to roll your plan over until your separate from employment. But her annual contribution would probably be the last priority in your total contributions unless you thought she would return to work and could roll that 200k over into her 401k plan. If that were a good possibility, then making the annual 5k contribution would be beneficiary since she could convert the total after tax amounts to a Roth tax free once the pre tax balance in her IRA was rolled into an employer plan.
With respect to some detailed illustrations regarding conversions, here is a 10 page report by a noted IRA authority, Bob Keebler. While it addresses 2010 conversions and the two year income split, you can ignore that part of the article and deal with the long term effects only.
http://tax.cchgroup.com/images/fot/JORP_10-03-07_Keebler-Bigge.pdf
Permalink Submitted by Mark Fletcher on Mon, 2012-04-23 19:04
Thanks again for your well thought response. It will take me some time to fully digest the 10-page hotlink, but I will read it numerous times.
I believe we are going to continue to have my wife make a yearly $5000 non-deductible contribution, and then immediately convert it to a Roth. I like the idea of having ‘diversification’ of retirement plan types. And I desire to get more saved for our retirement than just my yearly 401k max, and my yearly back door roth contribution of $5000.
Further Questions …..re wife:
Is this going to be an accounting nightmare for my accountant/us?. Can you easily explain the process (re 8606)? I want to understand this so I can always doublecheck my accountant’s work. Also, if he retires before me, I want to be able to explain this to the next accountnat.
Is this scenario below correct? Could you please explain or clarify?:
It seems accountant will need to use form 8606 yearly,and this will document an increased basis(?) in my wife’s rollover IRA. And then, down the road, when she takes money OUT of her IRA rollover , some of it will actually be considered basis(?). Thus she should not pay taxes on 100% of her withdrawls. (not sure if I am using the term basis correct.). Does the accountant also complete a form 8606 as money is LEAVING her IRA rollover, so I will always know how much of this we have already paid taxes on? My major concern is I don’t want to pay taxes on the same money twice, and if I have paid taxes yearly for her back door conversions, I feel like this is a distinct possibility for error.
Permalink Submitted by Alan Spross on Mon, 2012-04-23 19:57
The 8606 is commonplace and fairly routine, particularly since all accountants use tax software. Just be sure he knows that your wife made a non deductible contribution, the date and year it was for, and that he picks up the line 14 amount from any prior 8606 and puts that amount on line 2 of the new one.
If you use the same accountant every year, his tax program will capture the information from the prior year 8606. Therefore, the key is just to start the cycle off correctly. Some of the basis is used in any distribution or conversion and the unused portion is shown on line 14 and is available for future years. If her starting basis is -0- and she makes a 5k non deductible contribution, then only 5/205 (2.44%) of any conversion is non taxable. It is the same % no matter how much she converts.
In years that she makes no non deductible contribution OR takes any distributions (conversion is a distribution), there is no 8606 to be completed, but that line 14 amount showing the remaining basis is brought forward for the next year any distribution is taken. If she converts 5,000 and only uses $122 of her basis, her remaining basis is 4,878 and a new contribution of 5,000 would bring the total for the next year to 9,878. So the next conversion will have a larger portion tax free. This ratio is also affected by whether the large rollover IRA investments gain or lose money. If there are gains, the tax free % of a distribution is smaller and if there are losses it is larger.
The only way you would pay double taxes would be if the 8606 was not filed correctly. Some people forget to file these for years, but the IRS is currently allowing these forms to be filed retroactively with no penalty, but the possibility of non deductible TIRA contributions goes all the way back to 1987, so reconstructing this correctly would be a major research project. But if you start out correctly, it is easy to keep track of things. From the math you can see that it is more tax efficient to convert the IRA of the spouse with the highest basis % first. In your case, your basis is 100% so you automatically convert your contributions right after making them. For her it is only 2.44% or so, a very small % of basis so her conversions would be lower priority to yours. There could never be a disadvantage for you to convert, but for her you must factor in those long range planning considerations.