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Taxation on the back door Roth conversion??

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  • Taxation on the back door Roth conversion??

    Ok, this has been beat to death, and I thought I knew what was going on, then the Schwab person on the phone made it sound otherwise.

    This is the first year I am above income limit for Roth, so 2 days ago I deposited $5500 into my Schwab Traditional IRA (which had a $0 balance previously, now $5500).  Goal was to call a few days later (today) and backdoor covert the $5500 to my Roth account (which has $12500 [2 years of contributions + interest])

    Woman on the phone says there is tax withholding to convert the traditional IRA to the Roth and the money put into the Roth amounts to about $4900.  Is this right?  I didn't think there was any tax hit when conversion was made?  She seemed VERY adamant that you cannot convert a tax deferred account to a tax free account without paying taxes on the move.

    That's question 1.

    Question 2 is: this year I rolled all of my previous employers 403/457/401 into a Rollover IRA and Separate Roth account with Fidelity (tied to both old and new employer)  that totals around $105k for the funds moved.  Will this have impact on Schwab Roth conversion?   As an aside, the Roth account at Fidelity has been established simply for the mega-backdoor maneuver through my employer.  The standard $5500 individual contributions I make annually are separate and with Schwab.

    Any advice on this is much appreciated.

  • #2
    1. She is Partially right, but wrong about the conversion requiring a deduction. Taxes are due, but should be paid by using other taxable money, not money inside the IRA, no withholding should be made from the conversion.That would defeat the purpose of the conversion.  BUT, see no. 2

    2. (I am assuming the rollover money is NOT in a Roth) Yes, money in another IRA is a problem. you should NOT do a backdoor Roth with money in a traditional IRA ANYWHERE. The rollover IRA counts as a traditional IRA. You can do it, but taxes become very complicated so it is not recommended. This complication is due to the pro-rata rule. You might see if you can move the rollover Ira into your current 401k plan, but it is late in the year to accomplish this. As long as there is zero balance in all traditional IRAs by Dec 31, then the backdoor Roth will be fine. If you can move the money but it won’t make it to the 401k until next year, then wait till Jan to do the Roth conversion.

    https://www.irahelp.com/slottreport/4-things-know-about-roth-ira-conversions-and-pro-rata-rule

    In summary, I would not do a backdoor Roth this year unless you are able to move the rollover account to your current 401k, and have money in taxable accounts to pay the taxes on the 5500. Or you could rollover the 100k plus into the the Roth and pay taxes on it too, as you are planning mega backdoor Roth anyway. If you can’t move the money into your 401k and don’t want to pay taxes on the 100k, you might not want to contribute to a non deductable IRA. You can withdraw the non deductable Ira contribution this year with no consequences.

    https://www.thesimpledollar.com/nondeductible-ira-contributions/

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    • #3
      1. The information from the Schwab CSR was incomplete. IRS regulations require 10% withholding of IRA distributions "by default". However, the Individual can select other withholding including 0%.

      So the 10% withholding you were quoted was the correct default and had nothing to do with your particular circumstances. In a correctly executed Backdoor Roth, you should always select 0% withholding, but...

      2. RetiredERdoc is correct. To correctly execute a Backdoor Roth, you need to have no pre-tax (traditional, SEP, SIMPLE) IRA assets. This is because a Roth conversion is subject to a pro rata taxation of your non-deductible basis and pre-tax assets in all IRA accounts combined.

      This pro rata treatment does not occur at the time of the non-deductable contribution or the Roth conversion. It is based on the total non-deductable basis converted during the tax year no matter how many times and the total of all pre-tax IRA balances on 12/31 of the tax year. This is reported on Form 8606.

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