Backdoor Roth conversion timing question

[The Cosmic Avenger]

OK, so last year our income went a bit over the Roth contribution limits, and we each had to recharacterize about half of our contributions and then convert them back, the typical backdoor Roth maneuver. This year, I'm transferring money to a Traditional IRA every month, leaving it in the core position, then converting it to my Roth IRA. However, I don't think my partner is doing this, and their Roth will have to be done as a backdoor conversion after tax time.

Is there any difference, any reason one way might be better than the other? It feels like the once a year recharacterization and conversion is simpler, but we were warned that we were contributing too much, can we be penalized for overcontributions for too many years in a row? I checked the IRS publications and tax advice websites and couldn't find any information on timing or strategizing the backdoor conversion, just on how to do it.

 

[kaneohe]

just to understand exactly what you are doing:
1) Contributing to TIRA monthly,then converting........when are you converting?
monthly also? or once in a lump sum to include all months?
2) Partner is contributing to Roth IRA; if over MAGI limits, recharacterizes contribution to TIRA; then does backdoor Roth?

You are aware that you can recharacterize a contribution but that you cannot
recharacterize a conversion?

What did you mean when you were warned that you were overcontributing....
to Roth or TIRA......how much were you contributing?

 

[The Cosmic Avenger]

just to understand exactly what you are doing:
1) Contributing to TIRA monthly,then converting........when are you converting?
monthly also? or once in a lump sum to include all months?

Yes, converting monthly, as I don't want to lose out on dollar-cost averaging. Leaving it in cash and converting once a year seems more of a gamble, and if I invest in the TIRA and then convert, I'll have to figure out and pay taxes, a TIRA PITA.

2) Partner is contributing to Roth IRA; if over MAGI limits, recharacterizes contribution to TIRA; then does backdoor Roth?

Well, that's what we did last year, and I did it for my partner since I mostly do the financial planning and investing for both of us. This year, I don't think they are doing what I'm doing, so I'll have to do a backdoor conversion for them again, I think.

What did you mean when you were warned that you were overcontributing....
to Roth or TIRA......how much were you contributing?

We both contribute $5,500 per year, and last year we were told our limit due to MAGI was slightly more than half that, so I did the recharacterization and conversion.

 

[SecondCor521]

Doing the backdoor conversion on a monthly basis has a higher hassle factor - 12 transactions vs. 1 - but it gets the money into the Roth slightly faster, so over long periods of time can be expected to result in slightly better results. So it depends on if you think the hassle is worth slightly more money. (I'm too lazy at the moment to do the math for you, but your annual contribution is in there on average six months sooner.)

If you leave an excess contribution in your IRA, there is a 6% tax on the excess every year that the excess remains in the account. If you remove the excess (plus any earnings) in time, I don't believe there is any penalty. You could do that every year if you wanted to and the IRS wouldn't care. But you're not getting away with anything; any earnings on the excess contribution will have to be removed and will end up as taxable income.

The only other bit of advice I have is that I have read that it is good to minimize the amount of time that the money is sitting in the traditional IRA. So whether you contribute and backdoor convert monthly or annually, try to do the two steps only a day or two apart. Or invest the money inside the traditional IRA in something that doesn't gain anything. The reason for this is that any earnings on the money while inside the traditional IRA is taxable income and subject to a 10% penalty, so you want to minimize that.

Finally, if you have any money inside that traditional IRA (say, from investments earlier on before you started doing the backdoor), you may need to follow the pro-rata rule. Check out the instructions to Form 8606 carefully, Part I and Part II.

 

[kaneohe]

The only other bit of advice I have is that I have read that it is good to minimize the amount of time that the money is sitting in the traditional IRA.
So whether you contribute and backdoor convert monthly or annually,
1)try to do the two steps only a day or two apart.
2)Or invest the money inside the traditional IRA in something that doesn't gain anything.

The reason for this is that any earnings on the money while inside the traditional IRA is taxable income and subject to a 10% penalty, so you want to minimize that.

.................................

I've read the same thing about doing the two steps close in time.
1) I can understand doing that since you would prefer to have the gains happen
in the Roth (non-taxable) vs the TIRA (only tax deferred)
2)I don't understand this no-gain thing. Seems like I would prefer having something grow and pay a part of it in taxes rather than not grow at all
.........and if it grows I pay taxes on the growth for the conversion but there is no penalty for converting if you pay the tax from outside funds..

 

[bingybear]

I've read the same thing about doing the two steps close in time.
1) I can understand doing that since you would prefer to have the gains happen
in the Roth (non-taxable) vs the TIRA (only tax deferred)
2)I don't understand this no-gain thing. Seems like I would prefer having something grow and pay a part of it in taxes rather than not grow at all
.........and if it grows I pay taxes on the growth for the conversion but there is no penalty for converting if you pay the tax from outside funds..

But if you do the roth conversion quickly, then all the gains are done in the roth, not in the TIRA. Why pay more taxes just because you let the TIRA sit there?

 

[The Cosmic Avenger]

But if you do the roth conversion quickly, then all the gains are done in the roth, not in the TIRA. Why pay more taxes just because you let the TIRA sit there?

I think if I let it sit I'd gain a few dollars, and have to calculate taxes in the range of single digit dollars or even less than a dollar, and I would much rather have that time to myself than save a dollar or ten! I mean, I do my taxes myself, so I'm willing to put in the time, and considering my rate, it's probably not a cost-effective use of my time, but I like doing it. But I also prefer to keep things simple when I can, and so this seems like a no-brainer to do it as you suggest.

 

[SecondCor521]

@kaneohe, it's the hassle factor thing. Yes, you may gain a few dollars if you contribute, invest in something, wait a few days, then convert. But then you have to remember to keep track of that, get the tax form from your custodian, put it into your tax program or read the instructions, etc.

If you put it in and leave it in cash but then convert a day or two later, the theoretical loss is negligible anyway and then you don't have to hassle as much come tax time.

 

[bingybear]

I think if I let it sit I'd gain a few dollars, and have to calculate taxes in the range of single digit dollars or even less than a dollar, and I would much rather have that time to myself than save a dollar or ten! I mean, I do my taxes myself, so I'm willing to put in the time, and considering my rate, it's probably not a cost-effective use of my time, but I like doing it. But I also prefer to keep things simple when I can, and so this seems like a no-brainer to do it as you suggest.

I never did backdoors since I had other TIRAs that would odd existing basis. But I would think it would take less time to just to fund the TIRA and quickly do the roth conversion. Don't put much time between each step. I'm not sure if it can be done the same day, but if not, maybe the next day

I agree that letting it sit in a core account will not create significant taxes, but it will take time.

 

[Eastfolk]

I've read the same thing about doing the two steps close in time.
1) I can understand doing that since you would prefer to have the gains happen
in the Roth (non-taxable) vs the TIRA (only tax deferred)
2)I don't understand this no-gain thing. Seems like I would prefer having something grow and pay a part of it in taxes rather than not grow at all
.........and if it grows I pay taxes on the growth for the conversion but there is no penalty for converting if you pay the tax from outside funds..

So I did a bit of reading on the backdoor ira recently and it seems like there’s mixed advice out there about how long to leave your contribution in a TIRA before converting to Roth. On the one end, as you guys mentioned, you should convert in a day or two to maximize gains in the Roth but on the other end I’ve read that you run the risk of the irs claiming the step doctrine. Although unlikely some articles claim that this could be a risk and it would be best to wait a few months or longer before doing the conversion. Any thoughts? I’ve done the backdoor the past two years by converting shortly after the TIRA contribution and had no issues but that’s a small sample size. Wondering if anyone has had this issue before?

 

[SecondCor521]

Personally I wouldn't worry about the step doctrine. The backdoor Roth strategy is well known and the IRS, to my knowledge, hasn't done anything or said anything to stop it. I've also never heard of anyone having their transactions disallowed or penalties applied for doing the backdoor Roth.