Explain ROTH conversion from an IRA

[street]

When I start backdoor form my IRA to a Roth do I just get taxed on the amount I rollover to the ROTH? Do I pay any more taxes because the ROTH is tax free from there going forward, right?

Explain the tax implications and what the ROTH does for me verses just rolling money into the stock/bond funds?

 

[cathy63]

When you move money from your traditional IRA to your Roth IRA, you will pay taxes on it the same as if it were ordinary income that you earned from a job in the year that you move it.

Later on, when you withdraw the money from the Roth IRA, you will pay no taxes on the original money or on any gains it earned while in the account.

edit: oh wait, I just realized you said "backdoor from my IRA to a Roth". A backdoor contribution is when you take after tax money, put it in a traditional IRA, and then immediately move it to a Roth IRA where it will grow tax-free ever after. In that case, it's already treated as earnings in the current year and you'll pay the tax via employer withholding (or schedule C if you're self-employed).

 

[KCGeezer]

My understanding street is it’s basically a ‘pay me now or pay me later’ proposition. Which way is most advantageous for any individual depends on lots of factors that are specific to that individual. There are some common scenarios. I’ll go first since mine is probably simplest.

I rolled a lump sum pension into an ira. I also had a 401k through my employer. So 100% of my income is from tax deferred. For me it’s a question of whether I want to prepay the tax for my kids or let it grow (hopefully) and they have to pay for it.

A secondary question is then how do I maximize (again, hopefully) whatever they end up with. If moving some to a Roth to grow tax free is better or not is a bunch of math that other threads have explored in great depth.

Maybe this thread can be a straightforward guide explaining various common scenarios. 100% tax deferred, some tax deferred some taxable, still working vs not, and intentional income limitations to maximize charity or assistance programs. Hope this helps.


Edit: I missed the ‘backdoor’ reference as well. Carry on.

 

[street]

Thanks for your response's and clarification for me. Yes, I have read some of the detailed threads before about this subject and can be confusing for me.

I am still not sure what I will do and what would be better for me. There is a lot of avenues and angle to take, not sure what I will do.

 

[Animorph]

A "backdoor" Roth conversion is when you make a non-deductible contribution to a traditional IRA (because you are ineligible to make a deductible contribution) and then do a Roth conversion. The Roth conversion is totally normal actually, but the non-deductible contribution changes how it counts towards your income. For the classic backdoor, you have no deductible contributions or rollovers to any traditional IRAs (of the same type I believe) owned by you. In that case the only income the Roth conversion adds is any growth that occurred between the contribution and the conversion.

If you have any deductible tIRA contributions in any other same-type tIRAs to go along with your non-deductible contribution then you have to assume that the Roth contribution is taken proportionally from all deductible and non-deductible balances in all those tIRAs. That can screw up the normal backdoor scheme because you'll owe taxes on the deductible portion of the conversion amount.

A completely normal Roth conversion is from an all-deductible-contributions tIRA. In that case the whole conversion amount adds to your income. As far as the mechanics, you can convert just some or all or your tIRA. You can transfer shares in-kind from tIRA to Roth so that your AA stays the same. You can have taxes withheld, though that reduces or eliminates the benefit of the Roth conversion and should probably be avoided. There are no more conversion recharacterizations, so your Roth conversion is permanent. You must plan for taxes either through equal quarterly estimated tax payments, or other sources of withholding, either via Safe Harbor or getting close to the amount of tax that will be due.

You might consider Roth converting early in the year (letting it grow the rest of the year tax-free in the Roth account), or several times during the year (monthly?), or at the end of the year (when your taxes can be estimated). Ideally you want to convert when your tIRA is at it's lowest value of the year so you maximize the percentage converted for the tax you pay. Of course, good luck with that!

Roth conversions are just a tax minimization. tIRAs have required minimum distributions beginning at 70.5 (currently). Look at the taxes you might pay at that time, considering the RMD as your last dollars of income. Roth accounts don't have RMDs and they reduce the amount in your tIRA, thus reducing your RMDs. That might keep you from jumping to a higher tax bracket later.

There are also the obvious tax timing considerations. If tax rates go higher in the future, it might be better to pay at today's lower rates by Roth converting. If the value of your tIRA falls by 50% in a recession, you can convert with 50% tax savings (sort of) and ride the recovery back to 100% (hopefully) in the Roth tax free. If you have no income for a few years in early retirement you might be able to get some tIRA money out at 0% or 10%, or at least lower than what RMD's will be taxed at.

Even if you will be taxed at the same rate now and for RMDs the Roth can be beneficial. A tIRA holds some of your money and some of the IRS's money. If your tax rate is a simple 15% and always stays the same, the IRS owns 15% of your tIRA. You give them some of their 15% every time you withdraw from the tIRA. With a Roth it's all your money. So $100 in a tIRA is like $85 in a Roth as far as what belongs to you. But when you convert $100 from a tIRA and put it all into a Roth, now you have $100 that's all yours. Since you paid $15 to the IRS for that conversion from your taxable account, it's like adding $15 of your taxable account money into your Roth retirement account, where it is now tax free. So regardless of any other tax timing benefits, you are now avoiding taxes on $15 that used to be taxable. The advantage of that depends on your tax situation, but worst case is that it gains you nothing if you were paying a 0% tax rate for your taxable account.

 

[kaneohe]

Not sure what you are really asking........but you might want to take the backdoor out of this for now since it just complicates understanding.
Assume that you have a "normal" traditional IRA (TIRA) where you made a contribution and took a deduction. It has grown over time and now in retirement , you are thinking of converting it to a Roth or just put it in a
regular taxable account.

Suppose you have a 100K TIRA. You convert a small part of it (10K) to Roth.
You pay taxes on that 10K from cash in your taxable account. Your friend also withdraws 10K but places it in a taxable account for comparison and pays the same taxes from his taxable account.

Both accounts are placed in similar investments and grow at the "same"rate.
N yrs later your account has doubled to 20K. Assuming you meet age and clock conditions on your Roth ownership, you can withdraw 20K tax free.

Your friend's account has grown to 20K-. It will be worth somewhat less than
yours since there were distributions and perhaps taxes were owed on those distributions (or perhaps not if his tax bracket was low enough and the gains were LTCG or QDIV). If your friend now cashed out, he would have a gain
of 10K- and would owe taxes (or not) on those gains. If he had to pay 15% on
those gains or 1.5K,he would be left with18.5K which is less than your 20K.
Or if his income was low enough,he would be 0 taxes and have 20K like you.

In the end, the Roth would always be better or the same as the taxable account so choose Roth over taxable if you can.

You might also want to compare w/ doing nothing.....leaving it TIRA. You also have 2K in a taxable account that was used to pay taxes for the folks Roth converting or putting it in a taxable account. If you are leaving your TIRA alone, the 2K is also still available in taxable. Assume the funds are in the same investments so after N yrs, your TIRA also has doubled to 20K and your taxable account has "doubled" to 4K. If your tax rate has remained at 20%, your TIRA is
now worth after tax 16K and taxable account is worth 4K-
(the - is because you may have paid taxes on the distributions during the N yrs and also after the 4K was sold). Your value of TIRA and side fund after taxes is
20K- so again,the Roth at least the same or greater.
On the other hand if the tax rate is lower than 20% when
you withdraw from TIRA, your after tax TIRA can be larger
than the Roth..............so the basic rule is to compare tax rate when converting to Roth vs tax rate when withdrawing from TIRA.