Question on Back Door Roth IRA Conversions

[Ready]

I've generally ignored the articles over the years on the benefits of the Roth IRA because I have always exceeded the income limit since the Roth IRA was introduced. I understand there is now an opportunity to do a "backdoor" conversion from a standard IRA to a Roth IRA, and I have been reading a number of articles which encourage me to do so. I'm not following how this might benefit me, but I thought I would seek feedback to see if I'm missing something.

I currently am generating enough income to where I am not able to contribute to a Roth IRA directly, nor can I contribute pre tax dollars to a standard IRA. My tax bracket for this year is 33%, and next year will be 28%. If I convert my funds from a traditional IRA to a Roth IRA next year, my understanding is that I would have to pay taxes on the conversion. What I'm not clear on is what the taxes would be. Is it a capital gains tax on the profits, or a tax on the entire amount in the fund...or both? And would it be at 15% or 28%?

And, more importantly, if I wait until I stop generating income (full retirement), and then do a Roth conversion, wouldn't I be in a much lower tax bracket and thus pay a much lower tax on the conversion? My hope is that when I'm fully retired I will be generating no earned income, so my only income would be from capital gains and dividends, and likely less than 35K per year, so I would be in the 0% tax bracket

In general I don't follow the logic in why people expect to be in a higher tax bracket later. Once people retire, aren't they generally in a much lower tax bracket than when they were working?

 

[Rustward]

<snip>

In general I don't follow the logic in why people expect to be in a higher tax bracket later. Once people retire, aren't they generally in a much lower tax bracket than when they were working?

Unless there is some kind of long-term major market meltdown, RMD's (Required Minimum Distributions) from our IRAs + a modest pension + Social Security benefits will push us to a higher tax bracket, and there is little we can do to avoid it.

We are realizing some long term capital gains while we are in the 15% bracket. LTCG's are currently taxed at 0% in the 10 and 15% brackets. It will take us four or five years to realize these gains; most are from investments made 20+ years ago. After we have realized most of the 0% gains, or if the 0% tax on LTCG's goes away, we plan to then evaluate Roth Conversions.

 

[GrayHare]

If you've never made non-deductible contributions to your tIRA, then upon conversion to Roth 100% of the converted amount of tIRA is taxable as ordinary income.

If you have made non-deductible contributions to your tIRA, they are non-taxable in proportion to the total value of all your tIRAs. For example, if your tIRA is worth $10000, and $1000 of that is from non-deductible contribs, 10% of the tIRA is not taxable. That leaves $9000, or 90%, that is taxable upon conversion. If you convert only part of your tIRA to Roth, you use that same 90% to figure what portion of the conversion is taxable.

Once you convert all tIRA dollars to Roth, all subsequent non-deductible tIRA contributions can be immediately converted to Roth without tax, AKA the back door. If you wait to convert, whatever gains accrue on the tIRA will be taxable though.

 

[kaneohe]

Ready...........you have it exactly right. The Roth decision is based on the tax rate you pay to convert vs the tax rate you would have to pay later if you didn't convert. As you mentioned there are various stages of life: 1) stage A when you are working with wage income, 2)stage B when you are retired with no wage income and perhaps no SS/pension yet , stage C with SS & pensions , and then stage D adding RMDs. The tax rate for "now" depends on which stage you are in so perhaps/probably the Roth conversion doesn't make sense while you are working. However as you will find here, many ERs take the opportunity in stage B to do Roth conversions up to the top of the 15% bracket and deliberately postpone SS to widen the time window for doing those.

If you don't convert at all or start too late, you may find that the RMDs from TIRAs and 401Ks can put you in tax brackets approaching those while you were working and also increase your Medicare premiums.

 

[Ready]

Thanks for the replies folks. If I'm understanding this correctly, it would appear there is no benefit for me to convert my TIRA to a Roth given that I'm 47 years old, still generating income, and 23 years away from RMDs. I'm assuming that at some point I will no longer be working part time, and will not be collecting Social Security for 20+ years. During those years where I'm generating no earned income nor SS income, I'm assuming my tax bracket will be very low, and I will be able to slowly convert the funds in my TIRA to a Roth while staying within the 15% Federal Tax bracket and 0% CG bracket.

Did I get this right?

 

[Ed_The_Gypsy]

Ready...........you have it exactly right. The Roth decision is based on the tax rate you pay to convert vs the tax rate you would have to pay later if you didn't convert. As you mentioned there are various stages of life: 1) stage A when you are working with wage income, 2)stage B when you are retired with no wage income and perhaps no SS/pension yet , stage C with SS & pensions , and then stage D adding RMDs. The tax rate for "now" depends on which stage you are in so perhaps/probably the Roth conversion doesn't make sense while you are working. However as you will find here, many ERs take the opportunity in stage B to do Roth conversions up to the top of the 15% bracket and deliberately postpone SS to widen the time window for doing those.

If you don't convert at all or start too late, you may find that the RMDs from TIRAs and 401Ks can put you in tax brackets approaching those while you were working and also increase your Medicare premiums.

True.

But it gets worse. If one spouse dies, the loss of the standard deduction increases taxes dramatically, from what I can tell so far, due to the Tax Torpedo.

Deductible IRAs or 401ks appear to be a trap if one does not retire early.

 

[Ed_The_Gypsy]

Thanks for the replies folks. If I'm understanding this correctly, it would appear there is no benefit for me to convert my TIRA to a Roth given that I'm 47 years old, still generating income, and 23 years away from RMDs. I'm assuming that at some point I will no longer be working part time, and will not be collecting Social Security for 20+ years. During those years where I'm generating no earned income nor SS income, I'm assuming my tax bracket will be very low, and I will be able to slowly convert the funds in my TIRA to a Roth while staying within the 15% Federal Tax bracket and 0% CG bracket.

Did I get this right?

Yes.

Convert before SS and before MRDs.

 

[Act2]

A big factor is how much your nondeductible TIRA has gained/lost over total contributions. If total gains are significant (and I hope that is your situation) you have a different situation than if they are not. Since you are only paying tax on the amount of gain, when you have a significant loss in your TIRA balance you have a good opportunity to convert at least part of the TIRA to Roth. Not that I'm hoping for another downturn.

 

[kaneohe]

If you have a 401K that will accept the taxable gains in your IRA, you can roll those gains into the 401K thus isolating the non-deductible basis that you can then convert tax-free.
That assumes you don't have any other TIRAs with gains or pre-tax contributions.