Non deductible IRA question

[DMFA]

xrayvsn wrote:

Thank you so much for the very detailed response.   Does make a lot of sense what you propose in the benefits of rolling over everything into a 401k plan despite higher costs.

 

Given my income, I am at the highest tax bracket.   A final question would be does it still make sense for me to do the roth conversion now and basically have it taxed at a higher rate or leave it in traditional IRA and withdrawals would presumably be at a lower tax rate in retirement?

Or is this a moot point since my traditional IRA contribution was not deductible due to phaseout of income anyway?

 

Thanks

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There is no tax for a Roth conversion of a non-deducted Traditional contribution *if* there is no other pretax IRA money (Traditional deducted, SIMPLE, SEP) on 12/31 of the year in which the conversion takes place (regardless of the year for which the contribution was made).  Hence the bracket doesn't matter.

Backdoor Roth IRA is still superior to investing in a standard taxable brokerage account.  You can't take the IRA deduction anyway, so why pay any tax when you can pay none at all?

The steps are:

1. Make non-deductible contributions for prior year if able (and this year if able)


2. Convert from Traditional IRA to Roth an amount equal to all non-deductible basis


3. Rollover entire remainder of Traditional IRA to a qualified plan like 401(k) or 403(b) prior to end of year


4. Continue annual cycle of non-deductible Traditional IRA contribution and its subsequent tax-free Roth conversion

...and none of that should be taxed.

Insignificant minutiae alert: There is a very small possibility you may gain a couple dollars between contribution and conversion.  If you're in the 37% bracket, I think you should probably be able to afford the $0.74 tax on $2 of gains. ;-)  On the other hand, if you invest in equities in the Traditional IRA and convert its shares to Roth, you might earn a little bit more, but when you figure that a security earning even 26% a year averages 0.5% in a week (which some brokerages hold funds for prior to allowing them to leave), you *might* be paying taxes on $27.50 of gains ($10 of taxes).  Also, look out for any distributions such as dividends the Traditional IRA might receive while the money was sitting in it that might be paid to the account later in the year; it might not *technically* stay at zero, meaning you might have 0.1% or so of the conversion end up being taxable.  Again, tiny stuff that should come out in the wash.

[xrayvsn]

Thank you so much for the very detailed response.   Does make a lot of sense what you propose in the benefits of rolling over everything into a 401k plan despite higher costs.

 

Given my income, I am at the highest tax bracket.   A final question would be does it still make sense for me to do the roth conversion now and basically have it taxed at a higher rate or leave it in traditional IRA and withdrawals would presumably be at a lower tax rate in retirement?

Or is this a moot point since my traditional IRA contribution was not deductible due to phaseout of income anyway?

 

Thanks

[cgossage]

xrayvsn wrote:

My IRA is currently in Vanguard with essentially no expenses except the fund expenses (all index so typically less than 10 basis points).    I believe if I did a rollover to my employee 401k plan, I think it would add another 40-50 basis points (not 100% on that, might be a little less).

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Let's say you get an equal return in both the IRA and 401k other than the 0.50% of extra fees, but in one scenario you are contributing $5,500 per year to a taxable account and the other a Roth.  Assuming a 7% return and 3% dividend yield you will end up making an extra $60,500 in the Roth after 20 years.  If you wait another 20 years (40 years total) before touching either the brokerage or the Roth after retirement, this gap will expand to $300,000.

You will give some of this money back in the way of extra fees in your 401k.  In 20 years, the difference will be $39,000 assuming a 50 bps differential.  Assuming this your retirement date, you could then roll that money back into an IRA and have it all in Vanguard funds and proceed with your Roth Conversion strategy in the early years of your retirement.

[DMFA]

xrayvsn wrote:

My IRA is currently in Vanguard with essentially no expenses except the fund expenses (all index so typically less than 10 basis points).    I believe if I did a rollover to my employee 401k plan, I think it would add another 40-50 basis points (not 100% on that, might be a little less).

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Any self-employment income?  This is usually the way that people get all pretax money out of IRAs into qualified plans is to establish an individual 401(k) and do a rollover into one.  Once you've done that, you can convert to Roth a sum equal to your non-deductible basis and rollover the remainder (deducted contributions and any gains) to the individual 401(k).  Just be mindful that Vanguard doesn't permit incoming rollovers for individual 401(k) accounts.

[xrayvsn]

My IRA is currently in Vanguard with essentially no expenses except the fund expenses (all index so typically less than 10 basis points).    I believe if I did a rollover to my employee 401k plan, I think it would add another 40-50 basis points (not 100% on that, might be a little less).

[cgossage]

xrayvsn wrote:

Thanks for the reply.   As far as my traditional IRA goes, the balance is currently around $112k or so.   I will have to check with my CPA if this was listed on 8606 form you mentioned.   As for the years of contribution I know for at least the past 4 or 5 years I had been doing it, some break before then and not sure exactly when I started contributing it (I do have all my IRS returns since the beginning so hopefully I can do some detective work there).    When I first learned of doing a backdoor ROTH it was relatively late in the game and I had probably $85k or more that would be subjected to tax (still not 100% on the pro rata rule).   People have mentioned you can do a rollover into a 401k (which my plan does allow) but the plan fees are a lot higher and don’t have as many choices as what’s in my IRA so I was not thrilled to do that.   My hope was when I hopefully retire early, those first few years before RMD kicks in I would do the Roth conversions at that point.

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The pro-rata rule means that if you do a conversion, you are converting a portion of all of your IRA balances.  Since you predominately have pre-tax money in there, it isn't very attractive to convert it at this time.

Do you know the fees that are in your 401k?  The investment options might not be as great as you can get in an IRA, but my guess is that it is still worth it.  Taxes are your biggest enemy in investing, so the benefits from putting additional money into a tax-advantaged account usually outweigh the extra 401k costs, unless the fees are astronomical.

[xrayvsn]

Thanks for the reply.   As far as my traditional IRA goes, the balance is currently around $112k or so.   I will have to check with my CPA if this was listed on 8606 form you mentioned.   As for the years of contribution I know for at least the past 4 or 5 years I had been doing it, some break before then and not sure exactly when I started contributing it (I do have all my IRS returns since the beginning so hopefully I can do some detective work there).    When I first learned of doing a backdoor ROTH it was relatively late in the game and I had probably $85k or more that would be subjected to tax (still not 100% on the pro rata rule).   People have mentioned you can do a rollover into a 401k (which my plan does allow) but the plan fees are a lot higher and don't have as many choices as what's in my IRA so I was not thrilled to do that.   My hope was when I hopefully retire early, those first few years before RMD kicks in I would do the Roth conversions at that point.

 

[cgossage]

The gains on nondeductible IRA contributions are taxed when you withdraw the money, but your contributions are not taxed on withdrawal so there is no double taxation.

My guess is you are better off with a Backdoor Roth, but I will need more information to clarify.  How much money is currently in your IRA and from what years?  The election to treat your contributions is with the IRS.  Have you or your accountant been electing to treat these contributions as nondeductible on form 8606?  Are contributing to an employer retirement account.

 

[xrayvsn]

I recently learned that because of phaseouts etc, due to my high income all my contributions to my IRA are essentially not tax deductible.

My question is what happens to the contribution when I start taking it out in retirement (or when I eventually will try and attempt ROTH conversion)?  Will the original amount be taxed? (which would essentially be a case of double taxation as this is post tax money contribution apparently).

If it is indeed not taxed, am I personally responsible to figure out how much post tax contribution I have made?  (I haven't been really keeping record of this and my Vanguard account doesn't seem to make any distinction, just gives the amount I have contributed for a particular year).

 

Thanks