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Showing posts with label conversion. Show all posts
Showing posts with label conversion. Show all posts

Saturday, December 30, 2017

The Backdoor Roth


It has come up often enough that I decided to talk about it.

The backdoor Roth.

What sets up this tax tidbit?

Being able to contribute to a Roth in the first place. More accurately, NOT being able to contribute.

Let’s say that you are single and work somewhere without a retirement plan. No 401(k), SIMPLE, SEP, nothing. You make $135,000.

Can you fund an Roth IRA?

Yep.

Why?

Because you do not have a plan at work.

How much can you fund?

$5,500. That becomes $6,500 if you are age 50 or over.

Let’s say you have a plan at work.

How much can you fund?

Nada.

Why?

Because you have a plan at work and you make too much money.

What is too much?

For a single person, $133,000. I question what fantasyland these tax writers live in where $133 grand is too-much-money, but let’s move on.

A Roth is a flavor of IRA. It is like going to Baskin Robbins and deciding whether you want your chocolate ice cream in a sugar cone or waffle cone. Either way you are getting chocolate ice cream.

Let’s say that someone wants to fund a Roth. Say that someone is a well-maintained, moderately successful, middle-aged tax CPA with diminishing dreams of ever playing in the NFL. He is married. His wife works. His back hurts during busy season. His daughter never calls ….

Uhh, back to our discussion.

He has a no plan at work. His wife does.

So we know the income limits will apply, as (at least) one of them is covered by a plan.

For 2017 that limit is $196,000.

Let’s say our tax CPA makes $18,000. His wife makes $180,000.

I see $198,000 combined. He is over the income limit.

Our CPA cannot contribute into a Roth, because a Roth is a flavor of IRA and he has exceeded the income limits for an IRA.

I suppose our CPA can ask his wife to dial it back a notch. Or get divorced.

Or consider a back door.

There are two things to understanding the backdoor:

(1)         We have discussed two types of IRAs: the traditional (that is, deductible) and the Roth. There is a third, although he has moved out of the house and rarely attends family events (at least willingly) anymore.

The third is the nondeductible. He is the wafer cone.

You get no deduction for putting money in. You will pay something when you take money out.

When you pull money out, you calculate a ratio:

 * Nondeductible money you put in/total value of account *

That ratio is not taxable; the balance is.

There is even a tax form for this - Form 8606. You are supposed to use this form every year you make a nondeductible contribution. I understand that there is a penalty for not doing so, but I have never seen that penalty in practice.

And no one would do this if a Roth is available. When you pull money out of a Roth, all of the distribution is nontaxable (if you followed the rules). That result will always beat a nondeductible.

The Roth effectively killed the nondeductible, which perhaps explains why the nondeductible is the unfriendly and distant family member.

But the nondeductible has one trick to its game: there is no income test to a nondeductible. Our tax CPA cannot fund a Roth (went over the limit by a lousy $2 grand), but he can fund that nondeductible. There is no deduction, but there will be no penalty for overfunding an IRA, either.   

(2)         But how to get this nondeductible into a Roth?

Call the broker and have him/her move the money from an account titled “Nondeductible IRA FBO Cincinnati Tax Guy” to one titled “Roth IRA FBO Cincinnati Tax Guy.”

This event is called a “conversion.”

You have to pay tax on a conversion.

Why?

Because you are moving money that has never been taxed to an account that will never be taxed. The government wants its vig, and the conversion is as good a time to tax as any.

How much tax?

Here is the beauty: since our tax CPA did not deduct the thing, tax law considers him to have dollar-for-dollar “basis” in the thing. If he put in $5,500, then his basis is $5,500.

Say he converts it when it is worth $5,501.

Then his income is $5,501 – 5,500 = $1.

Yep, he has to pay tax on $1 to convert the nondeductible to a Roth.

But there is ONE MORE RULE. Too often, tax commentators fail to point this one out, and it is a biggie.

He is probably hosed if he has ANY traditional (that is, deductible) IRAs out there. This triggers the “aggregation” or “pro rata” rule, and the rule is not his friend.

Let’s calculate a ratio.

The numerator is the amount he is converting: $5,500 in our example.

The denominator is ALL the money in ALL his traditional/deductible IRA accounts.

Say our tax CPA had $994,500 in his regular/traditional/free-range IRA before the $5,500 backdoor.

He now has $1 million after the backdoor.

His ratio would be 5,500/1,000,000 = 0.0055.

What does this mean?

It means that the inverse: 100% – 0.55% = 99.445% of every dollar will be taxable.

Counting with fingers and toes, I say that $5,470 is taxable.

The nondeductible saved him tax on all of $30, which appears to meet the definition of “near useless.”

So much for that $1 of conversion income he was hoping for. He got hung on the aggregation rule.

This is an extreme example, but any significant ratio is going to trigger significant taxable income on the conversion.

Is this deliberate by the IRS?

Does Tiger chase little white balls?

Our heroic and stoic tax CPA has other IRAs. The backdoor Roth has become unreachable for him.

Or has it?

Here is a thought: what if our tax CPA rolls ALL of his IRAs into the company 401(k)?
COMMENT: I know I previously said he did not have a plan at work. Work with me here, folks.
He would have to call the 401(k) people and see if they permit that. Federal tax law says he can, but that does not mean that his particular plan has to allow it.

Let’s say he can.

He now has zero/zip/zilch in traditional/deductible/sustainable IRAs.

Seems to me that he is back to converting for $1 in income, per our first example.

And there is your backdoor.




Thursday, September 24, 2015

Do You Earn Too Much For An IRA?



I have received several questions about IRAs recently.  They can roughly be divided into two categories:

(1) Do I qualify?
(2) I converted to a Roth and it is worth less than what I paid tax on.

I wondered whether there is some way to blog about this without our eyes glazing over. IRAs are a thicket of seemingly arbitrary rules.

Let’s give it a try by discussing a couple of situations (names and numbers changed, at least a smidge) that came across my desk this year.     

Our first example:

Matt is single and makes around $200,000 annually. He is over age 50 and maxes-out his 401(k). He heard that he can put away an additional $1,000 in an IRA for being over age 50. He puts $6,500 into a Roth, and then he calls his tax advisor to be sure he was OK.

He is not.

His 401(k) is fine. There generally are no problems with a 401(k), unless you are one of the highly-compensated and the plan administrator sends money back to you because the plan went “top heavy.” 

It is the IRA that is causing headaches.

He has a plan at work (the 401(k)) AND he made an IRA contribution. The tax rules can get wonky with this combination.

You see, having a plan at work can impact his ability to make an IRA contribution. If there is enough impact, He cannot make either a traditional (which means “deductible”) or Roth IRA contribution.

 Is it fair? It’s debatable, but those are the rules.

What is too much?

(1) A single person cannot make a traditional IRA contribution if his/her income exceeds $71,000. 

CONCLUSION: He makes $200,000. He does not qualify for a traditional (that is, deductible) IRA.

(2) A single person cannot make a Roth contribution if his/her income is over $131,000.

CONCLUSION: He makes too much money to make a Roth contribution. 

Did you notice the two different income limits for a regular and Roth IRA? It is an example of the landmines that are scattered in this area.

What should Matt do?

Let’s go through example (2) and come back to that question.

Sam and Diane are married. They are both in their 50s and make approximately $180,000 combined. They did well in the stock market this past year, picking up another $15,000 from capital gains as well as dividends, mostly from their mutual funds. Diane and Sam were a bit surprised about this at tax time.

Diane has a 401(k) at work. Sam does not. Diane contributes $6,500 to her traditional (i.e., deductible) IRA, and Sam contributes $6,500 to his Roth.

There is a problem.

The 401(k) is fine. The 401(k) is almost always fine.

Again it is those IRAs. The income limits this time are different, because we are talking about a married couple and not a single person. The limits are also different because Sam does not have a retirement plan at work.

A reasonable person would think that Sam should be allowed to fully fund an IRA. To require otherwise appears to penalize him as he has no other retirement plan. Many would agree with you, but Congress saw things differently. Congress said that there was a retirement plan at work for one of the two spouses, and that was enough to impose income limits on both spouses. Seems inane to me and more appropriate for the Gilligan’s Island era, but – again – those are the rules.

(1) Since Diane has a plan at work, neither can make a traditional/deductible) IRA contribution if their combined income exceeds $193,000. 

Note that she would have had a deductible IRA (at least partially deductible) except for the dividends and capital gains. Their combined income is $195,000 ($180,000 + $15,000), which is too high. No traditional/deductible IRA for Diane.

(2) Roth contributions are not allowed for marrieds with income over $193,000.

OBSERVATION: Hey, that is the same limit as for a traditional/deductible IRA. Single people had different income limits for a traditional/deductible and Roth IRA. 

Q: Why is that? 

A: Who knows. 

Q: How does a tax person remember this stuff?

A: We look it up.

They went over $193,000. Sam cannot make a Roth contribution. 

Diane and Sam did their tax planning off their salaries of $180,000, which was below the income limit. They did not anticipate the mutual funds. What should Diane and Sam (and Matt) do now?

First, you have to do something, otherwise a penalty will apply for over-funding an IRA. Granted the penalty is only 6%, but it will be 6% every year until you resolve the problem.

Second, you can contact the IRA custodian and have them send the money back to you. They will also send back whatever earnings it made while in the IRA, so there will be a little bit of tax on the earnings. Not a worst case scenario.

Third, you can have the IRA custodian apply the contributions to the following year. Maybe they will, maybe they won’t.  It would be a waste of time, however, if your income situation is expected to remain the same.

Fourth, you can move the money to a nondeductible IRA.

Huh?

Bet you did not realize that there are THREE types of IRAs. We know about the traditional IRA, which means that contributions are deductible. We also know about Roth IRAs, meaning that contributions are not deductible. But there is a third - and much less common – IRA.

The nondeductible IRA. 

You hardly hear about them, as the Roth does a much better job. No one would fund a nondeductible if they also qualified for a Roth. 

There is no deduction for money going into a Roth IRA, but likewise there is no tax on monies distributed from a Roth. Let that money compound for 30 or 35 years, and a Roth is a serious tax-advantaged machine.

There is no deduction for money going into a nondeductible IRA, but monies distributed will be partially taxed. You will get your contributions back tax-free, but the IRS will want tax on the earnings.  The nondeductible IRA requires a schedule to your tax return to keep track of the math. 

The Roth is always better: 0% being taxed is always better than some-% being taxed. 

Until you cannot contribute to a Roth.

You point out that Matt, Diane and Sam are over the income limits. Won’t the nondeductible IRA run into the same wall?

No, it won’t. A nondeductible IRA has no income limit. 

And that gives the tax advisor something to work with when one makes too much money for either a traditional/deductible or Roth IRA.

Let’s advise Matt, Diane and Sam to move their contributions to a nondeductible IRA.  That way, they still make a contribution for the year, and they preserve their ability to make a contribution for the following year. Some retirement contribution is better than no retirement contribution.

BTW, what we have described – moving one “type” of IRA to another “type” – is sometimes called “recharacterization.” More commonly, it refers to moving monies from a Roth IRA to a traditional/deductible IRA. 

For example, if you made a Roth “conversion” (meaning that you transferred from a traditional/deductible IRA to a Roth) in 2014, you might be dismayed to see the stock market tanking in 2015. After all, you paid tax when you moved the money into a Roth, and the account is now worth less. You paid tax on that money!


There is an option: you can “recharacterize” the Roth back to a traditional IRA in 2015. You would then amend your 2014 tax return and get a tax refund. You have to recharacterize by October 15, 2015, however, as that is the extended due date for your 2014 tax return.  Does it matter that you did not extend your 2014 return? No, not for this purpose. The tax Code just assumes that you extended. 

You can recharacterize some or all of the Roth, and there are some rules on when you can move the monies back into a Roth.

The nondeductible IRA is also involved in a technique sometimes called a “backdoor” Roth. This is used when one makes too much money for a Roth contribution but nonetheless really wants to fund a Roth. The idea is to fund a nondeductible IRA and then convert it to a Roth. This works best with an IRA contribution made after December 31st but before the tax return is due.

EXAMPLE:  You make a $5,500 nondeductible IRA contribution on February 21, 2016 for your 2015 tax year. You convert it to a Roth the next day. Think about the dates for a moment. You made a 2015 IRA contribution (albeit in 2016). You converted in 2016. Even though this happened over two days, the two parts of the transaction are reported in different tax years.

BTW, converting to a Roth means that you literally move the money from one account to a different account. It is not enough to just change the name of the account. Formality matters in this area. 

There are rules that make the backdoor all-but-impossible if you have other IRA accounts. It is one of those eye-glazing moments in this area, so we won’t go into the details. Just be aware that there may be an issue if you are thinking about a backdoor Roth.

Saturday, July 7, 2012

Have You Received an IRS Notice About Your Roth?

It came to our attention that the IRS is sending erroneous notices on 2010 Roth conversions. If this is you, you may remember that you were allowed to spread the tax cost of converting your regular IRA to a Roth IRA over two years.  The notice states that you owe tax for 2010, which you would had you not spread the tax over two years.
You do need to respond to the notice. The IRS is aware of the software glitch, however, so we expect these notices to be resolved expeditiously.

Monday, February 6, 2012

The Backdoor Roth IRA


The following question came up recently:
I make too much money to contribute to a Roth. Is there another way to make an additional contribution to my retirement savings?
How much is too much money? If you are single the upper limit is $122,000. If you are married the upper limit is $179,000. We are assuming, by the way, that you are covered by a plan – say a 401(k) - at work.
So what do you do?
Fund a nondeductible IRA. What is this? It is the third “flavor” of an IRA. We all know the regular IRA, where you put away money, deduct it on your tax return and pay tax on the monies down the road when you take the money out. For a Roth, you put away money, take no deduction but pay no tax when you take out the money. Then there is the nondeductible. You get no deduction and the money is (partially) taxable when you take it out.
For example, say that you put away $50,000 in nondeductibles which are worth $250,000 when you start drawing. The withdrawal is 20% nontaxable ($50,000/$250,000). Another way to say this is that 80% will be taxable.
Nondeductibles are the stepchild of IRAs. You want to fund a Roth (if you can) before considering a nondeductible.
Say that you are single, in your 40s and make $200,000 per year. I recommend that you fund a nondeductible IRA for $5,000, because $5,000 is the best you can do. You have to fund your IRA by April 15th under all flavors of IRA. Let April 15th pass and convert the nondeductible to a Roth. How do you do that? It may be as easy as going on the broker’s website and moving the monies between the two IRAs. Think of it as moving monies between a savings and checking account.
It used to be that one could not do this, but the tax rules have been changed to allow it.
What is the downside? There are two, and the second one can be an insurmountable hurdle to some taxpayers.
(1)    First, any income in the nondeductible becomes immediately taxable. In our example, if the $5,000 is now worth $5,450, you will have $450 of taxable income. If you do what I recommend, chances are the income will be negligible as you did not leave the monies in the nondeductible for very long.
(2)    Second, the pro rata rule. If you have monies in other IRAs, you have to use a fraction. The numerator is the amount you have in the nondeductible. The denominator is the total you have in all IRAs. For example, if you have a $5,000 nondeductible and $95,000 in a regular IRA, your ratio will be 5% ($5,000/ ($5,000 + $95,000). If you convert in this scenario, the conversion will be 95% taxable.
How do you handle issue (2)? If you have a retirement plan at work and the plan allows you to roll-in, then you would roll-in your $95,000 regular IRA. At this point the only IRA you have is the $5,000 nondeductible. Your ratio now is $5,000/$5,000, meaning that 0% is taxable.
The nice thing about a nondeductible is that there is no income limit. If you make $1 million per year, you can still contribute to a nondeductible.
How long do you let the money cool before converting? Tax advisors disagree. Some advisors recommend at least six months, whereas others say that you can do so the next day. I would recommend more than a day and not more than December 31st of the year of the conversion.
One more bit of advice. If you fund a nondeductible, put it in its own account, preferably titled “Nondeductible.” Do not commingle your IRAs. This is not Neapolitan ice cream.