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

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m (General editing from top to "Mechanics" heading. Remove references to The529guy forum post as he was quoting the wiki, which is already in the public domain.)
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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''' 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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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 (ie, already taxed) 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>   
  
Note that there is no such IRA called a "Backdoor Roth IRA", because the Backdoor Roth is a <i>process</i> or <i>technique</i>, not an <i>account</i>.  Also note that the IRS does not recognize a "nondeductible Traditional IRA", because it is the <i>contributions</i> that are nondeductible, not the <i>IRA</i>.  [But we have a wiki page called [[Non-deductible traditional IRA | Non-deductible traditional IRA]] that also needs to be addressed. '''Aaaargh.'''-celia]
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Note that there is no such IRA called a "Backdoor Roth IRA", because the Backdoor Roth is a <i>process</i> or <i>technique</i>, not an <i>account</i>.  Also note that the IRS does not recognize a "nondeductible Traditional IRA", because it is the <i>contributions</i> that are nondeductible, not the <i>IRA</i>.  [But we have a wiki page called [[Non-deductible traditional IRA | Non-deductible traditional IRA]] that also needs to be addressed.]
  
 
==Definitions==
 
==Definitions==
 
First, there are two terms which need to be understood when doing backdoor Roths:
 
First, there are two terms which need to be understood when doing backdoor Roths:
  
;Traditional IRA : as used on this page, refers to each of a person's non-Roth IRAs, that are also not [[Inheriting an IRA|Inherited IRAs]]. These include [[Traditional IRA | Traditional IRAs]], [[Rollover IRA | Rollover IRAs]], [[SEP | SEP-IRAs]], and [[SIMPLE IRA | SIMPLE IRAs]], including those held at different custodians.
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;Traditional IRA : as used on this page, refers to each of a person's non-Roth IRAs, that are also not [[Inheriting an IRA|Inherited IRAs]]. These include [[Traditional IRA | Traditional IRAs]], [[Rollover IRA | Rollover IRAs]], [[SEP | SEP-IRAs]], and [[SIMPLE IRA | SIMPLE IRAs]], including those held at different custodians.  The total year-end value of ALL of these accounts will be taken into account when calculating taxes for a backdoor Roth.
  
; Basis : is the total amount of nondeductible contributions in your Traditional IRAs.<ref>{{cite web|url=https://www.irs.gov/publications/p590b|title=Publication 590-B (2017), Distributions from Individual Retirement Arrangements (IRAs)|accessdate=December 11, 2018|publisher=Internal Revenue Service}}</ref> It is a fixed dollar amount and does not grow as the account value grows. It stays steady until another nondeductible contribution is made (it increases) or a Roth conversion or withdrawal from the account removes some/all of it (it decreases) possibly along with other dollars. This is the same word, but defined slightly differently than the <i>cost basis</i> used when calculating capital gains.
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; Basis : is the total amount of nondeductible contributions in your Traditional IRAs.<ref>{{cite web|url=https://www.irs.gov/publications/p590b|title=Publication 590-B (2017), Distributions from Individual Retirement Arrangements (IRAs)|accessdate=December 11, 2018|publisher=Internal Revenue Service}}</ref> It is a fixed dollar amount and does not grow as the account value grows. It stays steady until another nondeductible contribution is made (it increases) or a Roth conversion or withdrawal from the account removes some/all of it (it decreases). This is the same word, but defined slightly differently than the <i>cost basis</i> used when calculating capital gains.
  
==Overview==
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==Overview==  
[[File:Sample-2017-Form-8606-pdf.jpg|thumb|2017 Form 8606]]
 
  
 
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 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.<ref name="529guy">{{Forum post|p=2113569|title=? "caution" section on backdoor Roth wiki, The529guy|date=07 Jul 2014}}</ref> (need another reference{{citation needed}}) 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{{citation needed}})
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However, your pre-existing Traditional IRAs will likely be entirely deductible contributions and their pre-tax earnings. When you do a Roth conversion, you cannot limit your conversion to just your nondeductible contribution.  When filing your income taxes, Form 8606 considers all your traditional IRAs as if the accounts were merged in one Traditional IRA, regardless of which account the Roth conversion money came from.
  
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 [[401(k)]], employer-sponsored 401k, or [[403(b)]], then they will no longer be subject to taxation during the Roth conversion process.<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.  Consequently, you will owe tax (at your current income tax rate) on 75% of your Roth conversion amount (see Example 3a [[#Caution|below]]). [reset link to Example 3a, if possible.] If you can transfer your pre-tax IRA funds to a solo [[401(k)]], employer-sponsored 401k, or [[403(b)]], then they will no longer be subject to taxation during the Roth conversion process.
  
 
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.
 
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.
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===Form 8606 calculations===
 
===Form 8606 calculations===
  
This chart shows how Form 8606 would be filled out for each example. To report a full backdoor in Turbo Tax (at least, and possibly other software), it is often helpful to skip the suggested order of entry, which is income first, and IRAs later. Instead, use the index of topics to report the contribution to traditional IRA first. Then go back to the income section to enter the 1099R that reports the distribution, aka conversion, to Roth. <ref>{{Forum post|t=18149&p=3792040|title=In re: Suggestions for wiki|date =19 December 2018}}</ref>
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This chart shows how Form 8606 would be filled out for each example above. To report a full backdoor in Turbo Tax (at least, and possibly other software), it is often helpful to skip the suggested order of entry, which is income first, and IRAs later. Instead, use the index of topics to report the contribution to traditional IRA first. Then go back to the income section to enter the 1099R that reports the distribution, aka conversion, to Roth. <ref>{{Forum post|t=18149&p=3792040|title=In re: Suggestions for wiki|date =19 December 2018}}</ref>
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[[File:Sample-2017-Form-8606-pdf.jpg|thumb|2017 Form 8606]]
  
 
{| class="wikitable"
 
{| class="wikitable"

Revision as of 03:57, 20 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 (ie, already taxed) contributions to a Traditional IRA, nor for converting a Traditional IRA to a Roth IRA.[1]

Note that there is no such IRA called a "Backdoor Roth IRA", because the Backdoor Roth is a process or technique, not an account. Also note that the IRS does not recognize a "nondeductible Traditional IRA", because it is the contributions that are nondeductible, not the IRA. [But we have a wiki page called Non-deductible traditional IRA that also needs to be addressed.]

Definitions

First, there are two terms which need to be understood when doing backdoor Roths:

Traditional IRA
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. The total year-end value of ALL of these accounts will be taken into account when calculating taxes for a backdoor Roth.
Basis
is the total amount of nondeductible contributions in your Traditional IRAs.[2] It is a fixed dollar amount and does not grow as the account value grows. It stays steady until another nondeductible contribution is made (it increases) or a Roth conversion or withdrawal from the account removes some/all of it (it decreases). This is the same word, but defined slightly differently than the cost basis used when calculating capital gains.

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 do a Roth conversion, you cannot limit your conversion to just your nondeductible contribution. When filing your income taxes, Form 8606 considers all your traditional IRAs as if the accounts were merged in one Traditional IRA, regardless of which account the Roth conversion money came from.

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. Consequently, you will owe tax (at your current income tax rate) on 75% of your Roth conversion amount (see Example 3a below). [reset link to Example 3a, if possible.] If you can transfer your pre-tax IRA funds to a solo 401(k), employer-sponsored 401k, or 403(b), then they will no longer be subject to taxation during the Roth conversion process.

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.

Cautions

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 IRAs of one spouse do not affect the proration of the other spouse's conversion, even when filing MFJ. Similarly, if an individual has an Inherited IRA with some basis in it as well as their own Traditional IRAs (with or without basis), the tax calculations for the Inherited IRA are done separately from the other Traditional IRAs the beneficiary may have.

When you leave an employer and you want to roll your previous employer's retirement plan to an IRA, first roll the Roth or post-tax part, if any, to a Roth IRA. Then roll the pre-tax part to a Rollover IRA (which is one of the forms of a Traditional IRA). While money is in the Rollover IRA, DO NOT make any other contributions directly to that account. This will help make it possible for a future employer plan to accept the Rollover IRA, since some employer plans do not accept money from contributory Traditional IRAs (IRAs to which you contributed directly, instead of withheld from your paycheck). In other words, keep your Rollover IRAs separated from your other IRAs.

Before you start the Rollover Roth, you should also understand IRS Form 8606 (which will be discussed below), as it will be filed with your income taxes for the year. Fill out a rough draft of the form to understand the tax implications and see if the contribution or conversion impacts anything else in your tax situation. The front of the form deals with your basis from the previous and the current year, while part of the back of the form deals with the Roth conversion. Understanding this formula will help you see what part of your Roth conversion or Traditional IRA withdrawal will be tax-free and how much will be taxed:

Variables:

ND = Amount of Basis remaining from the previous year plus Non-Deductible contributions made for the year

SB = Sum of the Balances of all your traditional IRAs at year-end plus the amount withdrawn from Traditional IRAs (but not converted) plus the amount converted

TF = The percentage of the amount you convert (or withdraw without converting) that is tax-free for the year

 TF = 100 * ( ND / SB )

Examples with Form 8606

Example 1. Anna has no Traditional IRAs. She knows she will pay the same amount of tax on $6,000 of her high income (for 2019) whether she deposits it into her taxable account or puts it in a Roth. She is ineligible to contribute to the Roth directly. So it is a no-brainer to her to put it in a Roth where it can grow tax-free. She opens up a new Traditional IRA and deposits $6,000 in it and will declare it as a non-deductible contribution when she files her taxes. A few days later, she converts all of it to her Roth. The tax-free amount of the conversion is:

 TF = 100 * [ 6,000 / 6,000 ] which is 100%.

Example 1a. Anna made the contribution right before a holiday and forgot to convert the following business day. When she remembered it, the traditional IRA balance had grown $60. So now she has a basis of $6,000 and the account value is $6,060. The tax-free amount of the conversion is:

 TF = 100 * [ 6,000 / 6,060 ] which is 99%.

If she converts it all, she will pay taxes on 1% of the conversion amount ($60). Although there is rounding in the percentage, she will be able to subtract her basis ($6,000) from the converted amount. There will be no basis left.

If she only converts the $6,000, 99% of the $6,000 basis ($5,940) will go with the converted amount and 1% of the basis ($60) will remain behind. So she would still need to pay taxes on the $60 that was converted but was not tax-free. Next year, she can convert the remaining $60 tax-free since it has a $60 basis, assuming there is no growth meanwhile. To keep things simple, she decides to convert all of it now.

Example 1b. Anna made the contribution right before a holiday and forgot to convert the following business day. When she remembered it, the traditional IRA balance had fallen $60. So now she has a basis of $6,000 and the account value is $5,940. The tax-free amount of the conversion is:

 TF = 100 * [ 6,000 / 5,940 ] which is 101%.

If she converts it all, she will pay no taxes on the conversion and the remaining basis ($60) is lost. However, if she leaves a dollar in the account and converts $5,939, she will use up $5,939 of her basis and leave $1 in the account with the remaining $61 basis. This will be useful if she has future growth (or a deductible contribution of at least $61) in her Traditional IRA since $61 of it can be converted tax-free.


Example 2. Ben has $50,000 of deductible contributions and its growth in his Traditional IRA and has some taxable money he can use to pay most of the conversion taxes, but not enough to pay taxes on converting the entire account. He also has a Rollover IRA with $350,000 that contains only a 401K rolled over from a former employer and growth since the rollover. He is not eligible to contribute to a Roth directly but wants to do a backdoor Roth. It will be his first time for a backdoor Roth and he thinks he also will like to do one in the following year as he will also convert half of the Traditional IRA each year.

Example 2a. This year, before Ben starts the backdoor Roth, he rolls over the Rollover IRA into a new 401K he has with a new employer.

Then he makes a non-deductible contribution of $6,000 to his Traditional IRA, which brings the account value up to $56,000. Then he converts half of the IRA ($28,000), saving the other half for a Roth conversion in the following year. But by the end of the year, the $28,000 remaining in the Traditional IRA grows another $4,000 giving the IRA a year-end value of $32,000. (Note that the Roth may have also grown the same amount.) The tax-free amount of the conversion is:

 TF = 100 * [ 6,000 / (32,000 + 0 + 28,000) ] = 100 * [ 6,000 / 60,000 ] which is 10%.

This makes 10% of his $28,000 conversion ($2,800) be tax free and $25,200 (28,000 - 2,800) will be taxed. It also leaves $3,200 of his basis unused (6,000 - 2,800).

Example 2b. In the following year, if he converts before the account changes value again, Ben will withdraw the amount of $32,000, but this time he withholds 15% ($4,800) for federal taxes. This is a withdrawal amount that is NOT converted and there will be a 10% penalty for early withdrawal (calculated on Form tbd) if he is not yet 59.5. He converts the remaining $27,200. A while later in the year, he makes a nondeductible contribution of $6,000 and converts it the following day. At the end of the year, his IRAs are all empty. For this following year, there will be a tax-free amount of:

 TF = 100 * [(3,200 + 6,000) / (0 + 4,800 + 27,200 + 6,000)] = 100 * [ 9,200 / 38,000 ] which is 24.21%

This makes 24.21% of his $4,800 withdrawal ($1,162) and 24.21% of his $27,200 + $6,000 conversions ($8,038) be tax free. That leaves $3,638 of the withdrawal for tax withholding ($4,800 - 1,162) and $25,162 of the two conversions ($33,200 - 8,038) to be taxed. It also leaves no basis (or any other money) in his Traditional IRA.


Example 3. Chris is nearing retirement and wants to be ready to do some large Roth conversions on her 401K before starting Social Security. She plans to roll some of it into a Traditional IRA right after she retires, but will leave it alone for this year. But to clear things up before then, she wants to 1) convert her small SEP-IRA from a former employer, 2) do a backdoor Roth, and 3) draw down an Inherited IRA from her mother.

Example 3a. Chris needs to process her own accounts separate from the Inherited IRA. Her SEP-IRA only contains $15,000 and she wants to do a $5,000 backdoor Roth. She opens up a new Traditional IRA account and makes the $5,000 non-deductible contribution to it. Between the two accounts, they total $20,000 and $5,000 is the basis. She converts the entire Traditional IRA and $5,000 of the SEP-IRA, leaving only $10,000 in the SEP-IRA at the end of the year. To calculate the tax-free part of the $10,000 in Roth conversions:

 TF = 100 * [ 5,000 / (10,000 + 0 + 10,000) ] = 100 * [ 5,000 / 20,000 ] = which is 25%.

This makes 25% of her $10,000 conversion ($2,500) be tax-free and $7,500 (10,000 - 2,500) will be taxed. It also leaves $2,500 of her basis (5,000 - 2,500) left for a future year.

Example 3b. The Inherited IRA account value is $60,000 of which $20,000 is the remaining basis. Withdrawals from an Inherited IRA cannot be converted. In the current year, Chris withdraws $40,000 (more than her Required Minimum Distribution) and the tax-free percentage of the Inherited IRA withdrawal is:

 TF = 100 * [ 20,000 / (20,000 + 40,000) ] = 100 * [ 20,000 / 60,000 ] = which is 33.33%.

This makes 33.33% of her $40,000 withdrawal ($13,333) be tax-free and $26,667 (40,000 - 13,333) will be taxed. It also leaves $6,667 of her basis (20,000 - 13,333) left for a future year.

Chris will need to file two Form 8606s for the year, one for her own accounts and one for the Inherited IRA. They will maintain separate carry-over bases.

Form 8606 calculations

This chart shows how Form 8606 would be filled out for each example above. To report a full backdoor in Turbo Tax (at least, and possibly other software), it is often helpful to skip the suggested order of entry, which is income first, and IRAs later. Instead, use the index of topics to report the contribution to traditional IRA first. Then go back to the income section to enter the 1099R that reports the distribution, aka conversion, to Roth. [4]

2017 Form 8606
Form 8606 chart
8606one.jpg
8606two.jpg

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

  1. Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs)
  2. "Publication 590-B (2017), Distributions from Individual Retirement Arrangements (IRAs)". Internal Revenue Service. Retrieved December 11, 2018.
  3. Rollovers of After-Tax Contributions in Retirement Plans, IRS, viewed August 7, 2016.
  4. Bogleheads® forum topic: In re: Suggestions for wiki. 19 December 2018

External links