Difference between revisions of "User:Celia/Backdoor Roth"

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m (LadyGeek moved page User:Celia/Backdoor Roth IRA to User:Celia/Backdoor Roth without leaving a redirect: Correct title)
(Add and correct some terminology. For example, change "nondeductible Traditional IRA" to "Traditional IRA". Add generic definitions for "Traditional IRA" and "Basis" near the top since they are used throughout the page..)
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{{Under construction| comment=Discussed in {{Forum post|t=265828|title=Wiki: Backdoor Roth IRA (conversion formula)}}}}
 
{{Under construction| comment=Discussed in {{Forum post|t=265828|title=Wiki: Backdoor Roth IRA (conversion formula)}}}}
A '''Backdoor Roth IRA''' is a technique for contributing to a [[Roth IRA]] when your income exceeds the contribution limit.  There is no income limit on contributing to a nondeductible [[Traditional IRA]], nor on [[Roth IRA conversion|converting]] a Traditional IRA to a Roth IRA.<ref>[https://www.irs.gov/publications/p590a/ch01.html Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs)]</ref>
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A '''Backdoor Roth''' is a two-step <i>process</i> for contributing to a [[Roth IRA]] when your income exceeds the income eligibility limit for Roths.  There is no income limit for making nondeductible contributions to a [[Traditional IRA]], nor for [[Roth IRA conversion|converting]] a Traditional IRA to a Roth IRA.<ref>[https://www.irs.gov/publications/p590a/ch01.html Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs)]</ref>
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{{Notice| Two terms need to be understood when doing backdoor Roths:
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<b>Traditional IRA</b>, as used on this page, refers to each of a person's non-Roth IRAs, that are also not Inherited IRAs.  These include Traditional IRAs, Rollover IRAs, SEP-IRAs, and SIMPLE IRAs, including those held at different custodians.
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<b>Basis</b> is the amount of nondeductible contributions remaining in the Traditional IRAs. (need IRS defn and citation)}}
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{{Notice| Read this comprehensive tutorial: [{{{url|http://thefinancebuff.com/the-backdoor-roth-ira-a-complete-how-to.html}}} Backdoor Roth: A Complete How-To], by forum member [[The Finance Buff|tfb]].}}
 
{{Notice| Read this comprehensive tutorial: [{{{url|http://thefinancebuff.com/the-backdoor-roth-ira-a-complete-how-to.html}}} Backdoor Roth: A Complete How-To], by forum member [[The Finance Buff|tfb]].}}
 
==Overview==
 
==Overview==
When you make a Backdoor Roth IRA contribution, you are making a nondeductible contribution (i.e., already taxed) to a Traditional IRA before making a Roth conversion. However, your pre-existing (non-Roth) IRA funds in Traditional, [[SEP]], and [[SIMPLE IRA | SIMPLE IRAs]] will likely all be deductible contributions and their pre-tax earnings. When you make a Roth conversion, you cannot limit your conversion to just your nondeductible contribution.<ref name="529guy">[http://www.bogleheads.org/forum/viewtopic.php?p=2113569#p2113569 ? "caution" section on backdoor Roth wiki], by forum member The529guy, direct link to post.</ref>
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When you do a Backdoor Roth, you first make a nondeductible contribution (i.e., already taxed) to a Traditional IRA. After that transaction has been completed (usually in one business day), you do a Roth conversion.  
  
When filing your income taxes, the money you convert will be representative of all the money in all of your Traditional, SEP, and SIMPLE IRA accounts, regardless of which account the Roth conversion money comes from.<ref name="529guy" />
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However, your pre-existing Traditional IRAs will likely be entirely deductible contributions and their pre-tax earnings. When you make a Roth conversion, you cannot limit your conversion to just your nondeductible contribution.<ref name="529guy">[http://www.bogleheads.org/forum/viewtopic.php?p=2113569#p2113569 ? "caution" section on backdoor Roth wiki], by forum member The529guy, direct link to post.</ref> (need another reference)  When filing your income taxes, the money you converted will be representative of all the money in all of your Traditional IRAs, regardless of which account the Roth conversion money came from.<ref name="529guy" /> (need better source)
  
For example: If your nondeductible contribution is only 25% of all the money in your Traditional, SEP, and SIMPLE IRA accounts, then only 25% of your Roth conversion amount will be tax-free. The remaining 75% of your Roth conversion amount will represent the deductible (pre-tax) money across all of your Traditional, SEP, and SIMPLE IRAs.<ref name="529guy" />
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For example: If your nondeductible contribution is only 25% of all the money in your Traditional IRAs, then only 25% of your Roth conversion amount will be tax-free. The remaining 75% of your Roth conversion amount will represent the deductible (pre-tax) money across all of your Traditional IRAs.<ref name="529guy" />  Consequently, you will owe tax (at your current income tax rate) on 75% of your Roth conversion amount (see example [[#Caution|below]]). If you can transfer your pre-tax IRA funds to a solo 401k, employer-sponsored 401k, or 403b, then they will no longer be subject to taxation during the Roth conversion process.<ref name="529guy" />
  
Consequently, you will owe tax (at your current income tax rate) on 75% of your Roth conversion amount (see example [[#Caution|below]]). If you can transfer your pre-tax IRA funds to a solo 401k, employer-sponsored 401k, or 403b, then they will no longer be subject to taxation during the Roth conversion process.<ref name="529guy" />
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However, in the cases where part of the conversion amount was taxed, some of your basis is considered to have been converted tax-free while some still remains with the rest of your Traditional IRAs.  Some of this basis will hang around until all of your Traditional IRAs (as defined here) are empty and you will have to file Form 8606 each year until then.
  
 
==Mechanics==
 
==Mechanics==
To make a backdoor contribution, first make a regular contribution to a Traditional IRA with your IRA custodian.  You do not specify to the custodian whether the IRA is deductible or not; it is just treated as an IRA. Non-deductible simply means that you do not deduct the IRA contribution on your 1040 tax form (the transaction is recorded on form 8606 and submitted with your tax return).
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<b>Contribute</b>
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To do a backdoor Roth, first make a regular contribution to a Traditional IRA with your IRA custodian.  You do not need to tell the custodian whether the contribution is deductible or not; it is just treated as an IRA contribution. (The custodian does not know (or care) if any contribution is deductible or not.  That is known only to you, the IRS (and your state, if you file state income taxes), and your tax preparer.  In fact, you can change your mind as to any contribution being deductible or not, up until the time you file your tax return.)
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Non-deductible simply means that you do not deduct the IRA contribution on your 1040 tax form (the transaction is recorded on form 8606 instead and submitted with your tax return). This nondeductible contribution will be called your "basis" if you don't yet have any or be added to your existing "basis", when you prepare your taxes.  One important thing to know about your basis, is that it does not grow, except by making additional nondeductible contributions.  All the growth for the Traditional IRA will instead be pre-tax.
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<b>Convert</b>
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As soon as the contribution posts, convert to a Roth IRA. The Roth account may be an existing or new account. Accomplish this transaction by selling the shares in your Traditional IRA and using the funds to buy shares (or merely deposit cash) in a Roth IRA.<ref group="note">Vanguard buy / sell account transactions are implemented as a fund exchange. Go to the traditional IRA and select "Exch" which is listed next to "Buy" and "Sell." Identify the shares to be sold. Then select the Roth account on the right hand side, and select the destination fund.</ref>
  
As soon as the contribution posts, convert to a Roth IRA. The Roth account may be existing or new. Accomplish this transaction by selling the shares in your Traditional IRA and using the funds to buy shares (or merely deposit cash) in a Roth IRA.<ref group="note">Vanguard buy / sell account transactions are implemented as a fund exchange. Go to the traditional IRA and select "Exch" which is listed next to "Buy" and "Sell." Identify the shares to be sold. Then select the Roth account on the right hand side, and select the destination fund.</ref>
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If you didn't have any pre-existing Traditional IRAs and your contribution was nondeductible, you pay tax only on the growth above the amount contributed. If you held the Traditional IRA for only a few days, the tax should be minimal.
  
Since your initial contribution was non-deductible, you pay tax only on the difference between the converted value and the amount contributed, and since you held the Traditional IRA for only a few days, the tax should be trivial.  Thus, even though you are over the limit, you are in essentially the same situation as if you had made a contribution to the Roth IRA.
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If you had pre-existing Traditional IRAs, and your contribution was nondeductible, the contribution amount is considered your basis and it will be pro-rated over all conversions and withdrawals, until the Traditional IRAs are empty.  
  
 
==Caution==
 
==Caution==
If you have any other (non-Roth) IRAs, the taxable portion of any conversion you make is prorated over all your IRAs; you cannot convert just the non-deductible amount.<ref>[https://www.irs.gov/retirement-plans/rollovers-of-after-tax-contributions-in-retirement-plans Rollovers of After-Tax Contributions in Retirement Plans], IRS, viewed August 7, 2016.</ref> In order to benefit from the backdoor, you must either convert your other IRAs as well (which may not be a good idea, as you are usually in a high tax bracket if you need to use the backdoor), or else transfer your deductible IRA contributions to an employer plan such as a [[401(k)]] (which may cost you if the 401(k) has poor investment options).
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If you have any other Traditional IRAs, the taxable portion of any conversion you make is prorated over all your IRAs; you cannot convert just the non-deductible amount.<ref>[https://www.irs.gov/retirement-plans/rollovers-of-after-tax-contributions-in-retirement-plans Rollovers of After-Tax Contributions in Retirement Plans], IRS, viewed August 7, 2016.</ref> In order to benefit from the backdoor, you must either convert your other IRAs as well (which may not be a good idea, as you are usually in a high tax bracket if you need to use the backdoor), or else transfer your deductible IRA contributions to an employer plan such as a [[401(k)]] (which may cost you if the 401(k) has poor investment options).
  
 
Because IRAs are ''Individual'' accounts, the IRA holdings of one spouse do not affect the proration of the other spouse's conversion, even when filing MFJ.
 
Because IRAs are ''Individual'' accounts, the IRA holdings of one spouse do not affect the proration of the other spouse's conversion, even when filing MFJ.

Revision as of 01:46, 9 December 2018

A Backdoor Roth is a two-step process for contributing to a Roth IRA when your income exceeds the income eligibility limit for Roths. There is no income limit for making nondeductible contributions to a Traditional IRA, nor for converting a Traditional IRA to a Roth IRA.[1]

Overview

When you do a Backdoor Roth, you first make a nondeductible contribution (i.e., already taxed) to a Traditional IRA. After that transaction has been completed (usually in one business day), you do a Roth conversion.

However, your pre-existing Traditional IRAs will likely be entirely deductible contributions and their pre-tax earnings. When you make a Roth conversion, you cannot limit your conversion to just your nondeductible contribution.[2] (need another reference) When filing your income taxes, the money you converted will be representative of all the money in all of your Traditional IRAs, regardless of which account the Roth conversion money came from.[2] (need better source)

For example: If your nondeductible contribution is only 25% of all the money in your Traditional IRAs, then only 25% of your Roth conversion amount will be tax-free. The remaining 75% of your Roth conversion amount will represent the deductible (pre-tax) money across all of your Traditional IRAs.[2] Consequently, you will owe tax (at your current income tax rate) on 75% of your Roth conversion amount (see example below). If you can transfer your pre-tax IRA funds to a solo 401k, employer-sponsored 401k, or 403b, then they will no longer be subject to taxation during the Roth conversion process.[2]

However, in the cases where part of the conversion amount was taxed, some of your basis is considered to have been converted tax-free while some still remains with the rest of your Traditional IRAs. Some of this basis will hang around until all of your Traditional IRAs (as defined here) are empty and you will have to file Form 8606 each year until then.

Mechanics

Contribute

To do a backdoor Roth, first make a regular contribution to a Traditional IRA with your IRA custodian. You do not need to tell the custodian whether the contribution is deductible or not; it is just treated as an IRA contribution. (The custodian does not know (or care) if any contribution is deductible or not. That is known only to you, the IRS (and your state, if you file state income taxes), and your tax preparer. In fact, you can change your mind as to any contribution being deductible or not, up until the time you file your tax return.)

Non-deductible simply means that you do not deduct the IRA contribution on your 1040 tax form (the transaction is recorded on form 8606 instead and submitted with your tax return). This nondeductible contribution will be called your "basis" if you don't yet have any or be added to your existing "basis", when you prepare your taxes. One important thing to know about your basis, is that it does not grow, except by making additional nondeductible contributions. All the growth for the Traditional IRA will instead be pre-tax.

Convert

As soon as the contribution posts, convert to a Roth IRA. The Roth account may be an existing or new account. Accomplish this transaction by selling the shares in your Traditional IRA and using the funds to buy shares (or merely deposit cash) in a Roth IRA.[note 1]

If you didn't have any pre-existing Traditional IRAs and your contribution was nondeductible, you pay tax only on the growth above the amount contributed. If you held the Traditional IRA for only a few days, the tax should be minimal.

If you had pre-existing Traditional IRAs, and your contribution was nondeductible, the contribution amount is considered your basis and it will be pro-rated over all conversions and withdrawals, until the Traditional IRAs are empty.

Caution

If you have any other Traditional IRAs, the taxable portion of any conversion you make is prorated over all your IRAs; you cannot convert just the non-deductible amount.[3] In order to benefit from the backdoor, you must either convert your other IRAs as well (which may not be a good idea, as you are usually in a high tax bracket if you need to use the backdoor), or else transfer your deductible IRA contributions to an employer plan such as a 401(k) (which may cost you if the 401(k) has poor investment options).

Because IRAs are Individual accounts, the IRA holdings of one spouse do not affect the proration of the other spouse's conversion, even when filing MFJ.

For example, suppose you have just created a new traditional IRA, and you add $5,000 of non-deductible contributions to it. You'd like to convert this IRA to a Roth IRA via the backdoor.

Suppose you also have another traditional IRA with $15,000 in deductible pre-tax contributions. These contributions may have come from a 401(k) rollover, or from standard deductible traditional IRA contributions from earlier years when you were eligible to make deductible contributions to a traditional IRA.

To compute the tax due, you would need to take $5,000 and divide it by $20,000 (the total value of all your traditional IRAs), to get the percentage of the conversion that will be tax-free. In this case, it is 25%. Therefore, the other 75% of your conversion--in this case, $3,750--would be taxable.

This can be viewed with the following formula:

Variables:

C = Amount to Convert to Roth

B = Balances of all pre-tax IRAs

TF = The percentage of the amount you're computing this would be tax-free

TF = 100 * [ C / (C + B)]

Using the numbers from the case study above results in:

100 * [ 5,000 / (5,000 + 15,000) ]

which is 25%.

If the $15,000 traditional IRA could be transferred into a 401(k), then the formula becomes:

100 * [ 5,000 / (5,000 + 0) ]

which is 100%, meaning that 100% of the conversion amount ($5,000) is tax-free.

Notes

  1. Vanguard buy / sell account transactions are implemented as a fund exchange. Go to the traditional IRA and select "Exch" which is listed next to "Buy" and "Sell." Identify the shares to be sold. Then select the Roth account on the right hand side, and select the destination fund.

See also

References

External links