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Christine Benz is Morningstar's director of
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Backdoor Roth IRAs Could Cost Some
Investors at Tax Time
This maneuver could spell trouble for those with other IRA assets.
By Christine Benz | 01-03-11 | 06:00 AM | Email Article
You may have seen several mentions of the so-called backdoor IRA during the past
year and a half. Despite its illicit-sounding name, this maneuver is perfectly legal
and it can help you diversify your retirement portfolio's tax treatment.
However, if you have other IRA
assets that haven't been taxed
yet, you need to think twice
before engineering a backdoor
Roth. If you don't, your new
Roth IRA could cost you a lot
more in taxes than you had
planned.
The Maneuver
Before getting into how a
backdoor Roth can be costly from a tax standpoint, let's first discuss how this
move, when properly executed, works and how it can be beneficial for savers in
certain instances.
First, it's worth noting that a backdoor Roth is only appropriate for those who earn
too much to contribute to a Roth the conventional way: For 2010, the maximum
adjusted gross income cutoff for married couples filing jointly is $177,000 and the
income limit caps out at $120,000 for single filers. If your household's income is
below those thresholds, you can get into a Roth through the front door.
But assuming that your income is higher than that, you can take advantage of the
fact that beginning in 2010, there are no longer any income limits on who can
convert a traditional IRA to a Roth. Don't ask me why Congress has left open this
gaping loophole, because it doesn't lead directly to new tax revenues, but for now
it provides a way for higher-end investors to get new assets into a Roth.
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Say, for example, a 55-year-old with an adjusted gross income of $185,000 and no
other traditional IRA assets puts $6,000 into a traditional nondeductible IRA. (The
"nondeductible" piece means that his contribution consists of money that has
already been taxed; he can't deduct his contribution on his tax return because he
earns too much.) He could then immediately convert that IRA to a Roth, thereby
ensuring tax-free withdrawals on that money in retirement.
Normally, the big hitch with an IRA conversion is that converters owe taxes on the
part of their IRAs that haven't been taxed yet such as any deductible contributions
or investment earnings, including money rolled over from a traditional 401(k). But
assuming the backdoor converter doesn't see the value of his IRA shoot up
between the time he opens his account and the time he converts, his tax bill on
the conversion would be minimal or even zero. That's because he already paid
taxes on his contribution, and he'll have limited to no investment gains on which
he'll owe taxes at that point. In addition to avoiding taxes on the conversion, he'll
also have gotten some of his retirement assets into the tax-free withdrawal
column, which is beneficial for people like him who have, up until now, earned too
much to contribute to a Roth IRA.
The Maneuver Gone Awry
Remember, however, that the above example hinged on the fact that the backdoor
IRA converter had no other traditional IRA assets. But let's take a look at another
example--one with other IRA assets in the mix--to illustrate how setting up a
backdoor IRA can spell extra taxes.
Let's assume a 32-year-old woman who earns $200,000 a year and has $20,000
in traditional IRA assets puts $5,000 into a traditional nondeductible IRA, seeking
to take advantage of the backdoor conversion option. At first blush, it seems like
this converter shouldn't owe any taxes, either. Her contribution to the new IRA, as
in the previous example, was already taxed, and if she makes the conversion right
away, before her investment goes up in value, she wouldn't owe any taxes on
investment gains, either.
But here's where the tax pain comes in. Her other traditional IRA assets consist
entirely of money that she had rolled over from an old 401(k) plan, meaning that
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Backdoor Roth IRAs Could Cost Some Investors at Tax Time http://news.morningstar.com/articlenet/article.aspx?id=364861
2 of 6 4/7/2014 11:08 PM
money has never been taxed. (With traditional 401(k)s, you're not taxed upon
your initial contribution and you're not taxed on your investment gains until you
begin taking money out.)
Because of those other IRA assets, the tax she'll owe upon conversion will depend
on percentage of taxable versus tax-free assets in all of her IRA accounts, not just
the one she just opened.
In her case, $20,000 of her IRA assets haven't yet been taxed totals and her new
nondeductible IRA contribution of $5,000 already has. That means that 80%, or
$4,000, of her recent $5,000 contribution would be taxable upon conversion; only
$1,000 (the other 20%) would not be.
All of this means that if you have other traditional IRA assets, or SEP and SIMPLE
IRAs, you'll need to proceed carefully before opening up a traditional nondeductible
IRA with an eye toward immediately converting to a Roth. This maneuver can work
beautifully for those with no other IRA assets, but it can be a tax headache with
those who do. Check with a tax advisor before proceeding. You may also be able to
conduct a series of partial conversions over a period of time, thereby limiting the
tax hit in any one year.
It's also worth noting that you have an escape hatch if you would like to do a
backdoor IRA but have other IRA assets that you've rolled over from a previous
employer's 401(k). Assuming your new employer also has a 401(k) plan that
allows you to do so, you could roll the IRA assets into that plan, thereby reducing
or eliminating the taxes owed upon conversion of a new backdoor Roth. Of course,
the merits of this strategy will depend entirely on the quality and fees associated
with the new plan.
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Backdoor Roth IRAs Could Cost Some Investors at Tax Time http://news.morningstar.com/articlenet/article.aspx?id=364861
4 of 6 4/7/2014 11:08 PM
Berel55
Mar 17 2014, 5:10 PM
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Do you have to consider an inherited IRA as well..
Berel53
LawyrsGunsNMony
Mar 6 2013, 7:33 PM
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Renting in NYC, I'm considering this:
After you retire, move to an income tax free state, become self
employed (your business doesn't need to earn any real money) &
start up an individual 401(k) with a fund company such as TRP which
will allow you to roll all your IRA $ into the individual 401(k), then
Roth it all. If you can stand living in your tax free state for more
than a year you could do this over several years to stay in a low
bracket. To avoid any delays you could start your business the year
b4 you retire.
If you own your house & want to keep it, renting it out shouldn't be
a big deal.
ddfell
Apr 18 2012, 11:39 PM
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I think the key is, if you have several IRAs and only one - or some-
of them are non-deductible, you could potentially get quite a tax bill
from Roth conversion. Basically it depends on the total "basis" you
have in non-deductible IRAs and what percentage that is of your
total IRA dollars (across all accounts). But if the non-deductible IRA
is your only IRA or has a significant portion of your total IRA funds -
it might be workable. Playing with Form 8606 can give you a pretty
clear picture of how it will play out.
dragonpat
Feb 14 2011, 5:19 PM
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"O.K., say you do this. What happens next year? Can you contribute
to the Roth you created even though your income is over the limit?
or do you have open a new IRA every year and then convert it to
another Roth? "
The nondeductuble IRA that I cleaned out in 2010 by converting the
contents to a Roth was still there with zero in as of Jan 1, 2011 at
WellsTrade. I just put $6000 in it in Jan 2011 and I am filling out the
paperwork to clean it out again and convert it to the Roth I Opened
in 2010. I did not have to open any new IRAs in 2011.
rar456
Feb 14 2011, 2:46 PM
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O.K., say you do this. What happens next year? Can you contribute
to the Roth you created even though your income is over the limit?
or do you have open a new IRA every year and then convert it to
another Roth?
dragonpat
Feb 14 2011, 1:54 PM
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"My understanding is that, tax accountant conversations with the
IRS have indicated that they will not allow back door Roth
conversions in the same year as the non deductible IRA deposit"
What IRS ruling or publication covers this belief of your accountant?
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Rohit33410
Jan 6 2011, 12:37 PM
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I deliberately did not convert my old company's 401(k) into an IRA
because I had intended to convert my non deductible IRA into Roth -
which I did.
Question to Christine - if in a future year I convert my 401(k) into
IRA is there any tax consequence for having converted a past (2010)
non deductible IRA into Roth?
drzaius17
Jan 5 2011, 7:31 AM
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i'm looking at 8606, and maybe i'm not doing it right, but the
example given doesn't seem right, if the woman is converting all her
assets. if the womans 20k is from 401K rollover, then she obviously
pays taxes on it. her ira basis is 5000 from 2010 contribution, as the
rollover is not included in her basis. assuming she converted 5000 at
no loss/gain, then she converted 25000 to roth (line 8). 5000/25000
is 0.2. line 11=25000 x 0.2 = 5000 = non taxable portion of
conversion. in part 2 you redundantly do the same math. line 16 is
line 8= 2500 then you subtract the 5000 on line 17 (same as line
11). she pays taxes on the 20000 from the rollover, but not
necessarily more on backdoor roth.
did i do this right?
Rathgar
Jan 4 2011, 10:57 AM
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Great article. Also Yogi knows his stuff !
Fee-OnlyAdvisor
Jan 4 2011, 9:56 AM
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My understanding is that, tax accountant conversations with the IRS
have indicated that they will not allow back door Roth conversions in
the same year as the non deductible IRA deposit.


1-10 of 23 Comments Oldest First | Newest First
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