Backdoor Roth conversion & timing calendar year

Submitted by Ruxin Lee on Mon, 2018-03-26 15:14

Hello!

In 2017, I contributed $5,500 into my Roth IRA. I later found out that I exceed the income limitations for contributing to a Roth IRA, then found out about the backdoor Roth IRA conversion.

At the end of 2017, my standing accounts was something like this:
– 401K with current employer
– Roth IRA containing Roth 401k from a prior employer, as well as the $5,500 contributed in 2017.
– T-IRA containing the 401k matched from the prior employer mentioned above.

My understanding of the steps are as follows. My questions are further below.
Step 1. Roll-over my existing T-IRA into my employer’s 401(k)
Step 2. Recharacterize my 2017 Roth IRA contribution to the “new, zero balance” T-IRA; resulting in 100% post-tax money in the T-IRA
Step 3. Convert the post-tax T-IRA to Roth-IRA.

Question. If I recharacterize my 2017 Roth contribution today (March 2018) and then I zero out my T-IRA for 2018 (also March 2018), can I perform the conversion today without being subject to the pro-rata tax rule?

Question 2. If I cannot avoid pro-rata using steps above, is this a viable option: withdraw the entire $5,500 from 2017 to avoid the penalty for contributing to the Roth, then wait until 2019 to contribute into the T-IRA? In essence, to avoid mixing the “coffee and cream” in 2018.



Submitted by Alan - IRA critic on Mon, 2018-03-26 16:03

  • Q 1 – Yes, your conversion (5500) will be tax free as long as you do a direct rollover of your pre tax TIRA balance to your current 401k plan. That TIRA balance must include the earnings from the recharacterized Roth contribution. For example, if 5700 is the amount that is transferred to your TIRA, then 200 of that is pre tax and should be transferred to your 401k along with the rollover IRA balance. In order to do that, you will have to recharacterize first. However, if the earnings are small enough on you Roth contribution you could follow your order stated above, and then just convert to Roth whatever the empty TIRA receives from the recharacterization. In the above example, you would pay taxes on the 200 of gains, not a big deal.
  • Q 2 – Yes, you can always withdraw your Roth contribution with earnings, but you will owe tax and penalty on the earnings with your 2017 tax return. Don’t know if you have filed yet, but if you have you will have to amend your 2017 return unless you had a loss on the Roth contribution. If you did request a return of your 2017 Roth contribution, you can still make a 5500 non deductible TIRA contribution for 2017 up till 4/17. You can even do that before you get the 5500 plus earnings returned to you. Whether you recharacterize OR remove the Roth contribution and make a new non deductible contribution, you will have to file Form 8606 for 2017 to report it.
  • Main thing you should avoid here is converting to Roth before the rollover to 401k is completed. The reason is that if your 401k does not accept the rollover you would be stuck with a taxable conversion. You can no longer recharacterize a conversion, just a regular contribution.
  • Where are you now with your 2017 return?

Submitted by Ruxin Lee on Mon, 2018-03-26 18:31

Ok this makes sense. We haven’t filed our 2017 taxes yet because we wanted to do the conversion first. So just to summarize, my order of operations should actually be:Step 1. Recharacterize the 2017 $5,500 Roth contribution plus any earnings into the TIRA, which currently already has some pre-tax money in it.Step 2. Rollover only the existing pre-tax money and the earnings from the $5,500 into my employer’s 401k.Step 3. Convert the remaining $5,500 in the TIRA to Roth. So now, follow-up Questions!Question 3: is this a unique scenario where you actually DO want to mix the coffee and cream? To continue our example, let’s say there’s currently $10K of pre-tax money sitting in the TIRA. If I recharacterize the post-tax $5,500 plus $200 of pre-tax gains into the TIRA, I’m left with $15,700 in my TIRA at 35% post-tax and 65% pre-tax mixture. Is this okay? If I plan to roll-in the $10,200 pre-tax money to the 401k and convert the remaining $5,500 to Roth?

Submitted by Alan - IRA critic on Tue, 2018-03-27 00:13

  • Yes, that order of transactions is fine. The mix of post and pre tax amounts is the reason you would roll the pre tax amount into your 401k. Your conversion will then be tax free and your basis is used up when you do the conversion. While you should convert ASAP after the rollover to the 401k, the conversion will be reported on your 2018 return.
  • Tax rates are going down in 2018, so if you think you can convert at a tax rate lower or perhaps about equal to your estimated rate in retirement, you might want to just convert the entire amount of the TIRA, all 15,700 even though you would owe tax on 10,200. If you chose to do that, then of course you would not have to do any rollover to your 401k. The smaller that the actual pre tax amount (the 10,200) is, the more likely you would just convert the entire balance and not bother with the rollover. 
  • As for your 2017 return, you will need to include an explanatory statement regarding what you do (either recharacterization or removal with earnings). This statement tells the IRS that you do NOT have an excess contribution which they would otherwise not know because the 1099R for the action you take will not be issued until Jan, 2019. If you opt for removal, the earnings will be taxable on your 2017 return, line 15b and 10% penalty due on the earnings. If you recharacterize to a non deductible TIRA contribution, you will have to report the non deductible contribution on a 2017 Form 8606.  Again, any conversion is not reportable until your 2018 return is done.

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