Backdoor ROTH screw up...WWYD

[Bott1637]

So about this time last year my mother asked me what to do with more money she wanted for retirement after maxing out her work accounts.  She was told by the financial person at work she didn't qualify for a ROTH due to income limits (she's a PA).  I asked if she had any IRA money out there and she said only and annuity (which I scolded her about) and a brokerage account.  So I told her about the backdoor ROTH.  So she contributed last year money for the 2015 tax year and later last year money for the 2016 tax year.  Well mom doesn't know her accounts as it turns out her annuity and brokerage account are inside an IRA.  So she is saddled with the pro rata crap.  Tax hit on the conversion with pro rata is about 3K.  The money added and converted this year can be re-characterized from what I understand back to a non-deductible IRA contribution which halves the tax bill to 1.5k. I figure this option sucks as then you have a few thousand bucks in an IRA you have to work with.  I recommended just paying the taxes now on the full rollover pointing out the fact that she was going to have to pay tax on the money in that IRA some day anyway.  She is a physician assistant so is likely to be about in the same tax bracket now as she will be in retirement.  So what would you recommend?

[DMFA]

Does she have an indie 401(k) into which she can roll all the previously un-taxed IRA money into?  That takes care of your pro-rata rule right there, going forward.

When did the conversion take place, 2016?  What was the amount converted (I assume $11,000) and the total in pre-tax (Traditional, SEP, SIMPLE) IRAs as of 2016-12-31?

The backdoor Roth is already a non-deductible Traditional IRA contribution followed by a Roth conversion.  You contribute just like any other Traditional IRA contribution, you just don't deduct it on your taxes.  This creates a basis for non-deducted contributions, which ideally would never be taxed (since you paid them already), but do become taxed on conversion if there is pre-tax money in there too (hence, the pro-rata rule).

Re-characterization refers to changing to/from Roth/Traditional, not for Traditional contributions being pre-/post-tax.  I don't know the exact specifics on this or if the time limit has expired to do it, but you should hopefully be able to:

• Recharacterize the Roth conversion


• Open an indie 401(k) if she has 1099 income (i.e. self-employment)


• Roll all pre-tax IRA money into the 401(k)


• Convert the post-tax (non-deducted) to Roth, just like a backdoor IRA

Or, just take the tax hit and put it in Roth anyway.  The 12/31 balance is the number used for figuring the pro rata tax on Roth conversion of non-deducted IRA contributions.  Of course, if you're taxed $3,000 on $11,000 of conversions that have already been taxed (double-hit), that's not particularly advantageous.

...though I'm not sure that annuity within the IRA could be part of a trustee-to-trustee transfer; it might need to be liquidated, which could have its own tax hit.

Most of your question is answered, albeit in a difficult-to-understand form, in IRS Pub 590-A.

[The White Coat Investor]

Bott1637 wrote:

So about this time last year my mother asked me what to do with more money she wanted for retirement after maxing out her work accounts.  She was told by the financial person at work she didn’t qualify for a ROTH due to income limits (she’s a PA).  I asked if she had any IRA money out there and she said only and annuity (which I scolded her about) and a brokerage account.  So I told her about the backdoor ROTH.  So she contributed last year money for the 2015 tax year and later last year money for the 2016 tax year.  Well mom doesn’t know her accounts as it turns out her annuity and brokerage account are inside an IRA.  So she is saddled with the pro rata crap.  Tax hit on the conversion with pro rata is about 3K.  The money added and converted this year can be re-characterized from what I understand back to a non-deductible IRA contribution which halves the tax bill to 1.5k. I figure this option sucks as then you have a few thousand bucks in an IRA you have to work with.  I recommended just paying the taxes now on the full rollover pointing out the fact that she was going to have to pay tax on the money in that IRA some day anyway.  She is a physician assistant so is likely to be about in the same tax bracket now as she will be in retirement.  So what would you recommend?

Click to expand...

What a mess. It's all so straightforward....except the pro-rata bit.

Annuities inside an IRA. Gotta love that. Thank you annuity salesman.

Easiest way out is to convert everything. But that probably means surrendering the annuity and of course is going to have a tax bill. But if it is a tiny IRA, might be a great option.

Next easiest way is to reverse as much as you can and then do it right and just pay the pro-rata taxes on the rest. Her "work account" is probably a 401(k) and the IRA can be rolled in there, but you're going to have to read up on her annuity and see what the penalties are for surrendering that.

If she really wants to keep the annuity in the IRA, I think that probably means passing on the Backdoor Roth IRA. She can still save for retirement in a taxable account, of course, and at PA incomes and retirement amounts, that could be pretty darn tax-efficient.