repeated backdoor Roth taxation?

[GrayHare]

What happens when the Roth IRA backdoor is used multiple years? Example: someone with $5000 pre-tax tIRA in 2010 contribs pre-tax $5000 (yielding $10000 tIRA total) and backdoor-converts only $5000 to a Roth. The IRS says he converted half his $10000 tIRA, and therefore he is taxed on half ($5000) as ordinary income. Come 2011 the person makes another $5000 tIRA contrib (back up to $10000 total) and again backdoor converts half ($5000) to Roth. On what amount does he owe tax for 2011?

[justplainbll]

Quote:

Originally Posted by GrayHare What happens when the Roth IRA backdoor is used multiple years? Example: someone with $5000 pre-tax tIRA in 2010 contribs pre-tax $5000 (yielding $10000 tIRA total) and backdoor-converts only $5000 to a Roth. The IRS says he converted half his $10000 tIRA, and therefore he is taxed on half ($5000) as ordinary income. Come 2011 the person makes another $5000 tIRA contrib (back up to $10000 total) and again backdoor converts half ($5000) to Roth. On what amount does he owe tax for 2011?

$5,000

[pb4uski]

$5,000. The taxable income relates to the "withdrawal" from the tIRA of money that has not been previously taxed rather than where the money goes. since in each of 2010 and 2011 there is a withdrawal from the tIRA of $5,000 then each withdrawal result in $5,000 of taxable income.

If you are under 59.5 and take the withdrawal in cash there is the penalty as well. The rollover into the Roth avoids the penalty in that case.

[GrayHare]

Perhaps I'm wrong, but I've been thinking that since for partial conversions the IRS treats all IRA dollars together, and taxes Roth conversion proportionally, the tax paid will also be treated proportionally.

In the example, the 2010 tax was figured on the full $10000 tIRA, half of which was taxed in the 50% conversion. Therefore of the $5000 left behind in the tIRA after the 2010 conversion, half has now been taxed. Thus for 2011 only $2500 of that remains pre-tax, so when the 2011 contrib is made, the tIRA has $7500 pre-tax dollars, $2500 post-tax dollars. So, if in 2011 again $5000 of that is converted to Roth, only 2/3rds ($5000/$7500) is taxable.

Since I've done Roth conversions in both years but did not convert all my tIRA dollars, I'm in the example situation, but have not yet plugged the numbers into Turbotax to see what it thinks.

[pb4uski]

Ah, I read the initial post as the entire $10k being pre-tax since the $5k withdrawal in 2010 resulted in $5k of taxable income.

If the account has $10k balance and $5k is pre-tax and $5k is post tax and a $5k withdrawal is made, then wouldn't the taxable income on the 2010 withdrawal only be $2,500? $5,000 withdrawal * (50% pre-tax balance prior to withdrawal divided by $10,000 total balance prior to withdrawal)?

And the 2011 withdrawal would result in taxable income of $1,250, or $5,000 * ($2,500 pre-tax balance prior to withdrawal/$10,000 total balance prior to withdrawal)?

[GrayHare]

pb4uski - well, in my example 2010 tIRA dollars are all pre-tax. The question I'm puzzling over is whether a converting a portion of a pre-tax tIRA to Roth results in a portion of the tIRA dollars left behind becoming post-tax.

[justplainbll]

Portion left behind does not become classified as after tax.

[Animorph]

The "backdoor" Roth contribution would normally be from a post-tax traditional IRA, but I guess a pre-tax TIRA would work. Just that many people are not eligible for a pre-tax IRA due to having a retirement plan at work. It seems a little unusual to make a tax-deductible TIRA contribution and then turn around right away and pay taxes on it and transfer it into a Roth, but I suppose that works.

The transfer from either type of TIRA to a Roth IRA is just a normal conversion. And you can transfer more than $5k with a conversion if you want. So you could do the whole $10k any time.

[pb4uski]

Quote:

Originally Posted by Animorph ....Just that many people are not eligible for a pre-tax IRA due to having a retirement plan at work. ....

True, but if you left a job and rolled your 401k from that job into an IRA, it would be a pre-tax IRA. I suspect that there are a bunch of those out there (including me).

[GrayHare]

Thanks for the replies, all. OK, so the pre/post-tax status of what's left behind in the tIRA after a partial conversion does not change. I'm not yet sure I have my head wrapped around all the complexities, so let me ask about a second example that appears to yield a double-tax trap.

In my initial example, the tIRA had $5000 PRE-tax dollars and in 2010 the person added a $5000 NON-taxable contrib. For the second example, let's say instead in 2010 the person adds a $5000 TAXABLE tIRA contrib, making for $10000 total in tIRA, and then he backdoor converts $5000 to Roth. Come the following year's April 15th, he'll owe tax on the $5000 tIRA contrib, which makes half his tIRA pre-tax dollars and half post-tax. Because his tIRA is half pre-tax dollars, half of his $5000 conversion to Roth will be subject to tax. So, not only will he be taxed on the initial $5000 tIRA contrib, he'll be taxed also on 50% of the conversion! If he repeats this in 2011 and later, the same double-tax will occur each year!

Is that correct? It sounds strange, so perhaps I'm misunderstanding some part. If it is indeed correct, then the double-tax can be avoided by converting all tIRA dollars to Roth, in which case the following year's tIRA will be taxed but the backdoor conversion will not.

[justplainbll]

Perhaps you should download Form 8606 and instructions for same from the IRS website?

[GrayHare]

Quote:

Originally Posted by justplainbll Perhaps you should download Form 8606 and instructions for same from the IRS website?

Yes, this is a complex matter, but since many here are doing backdoor conversions, the discussion will likely be helpful to many of our community. Besides, "go look it up yourself" is applicable to most questions here, but such replies make for an unfriendly and rather useless board, no?

[Alan]

Quote:

Originally Posted by justplainbll Perhaps you should download Form 8606 and instructions for same from the IRS website?

Exactly. The 8606 makes it all clear.

In the example of $5k pre-tax and $5k post tax the calculation goes like this.

Year 1 - 50% of the 10k is post tax (cost basis = 5k), and you convert 5k
that means 50% of the conversion is taxed, leaving a tax basis of 2.5k

Year 2 add 5k post tax to make the total back up to 10k. Cost basis is the 2.5k carried forward from previous year + 5k = 7.5k. ie 75% of the 10k is post tax. When you convert 5k, 25% is taxed (1.25k), leaving a cost basis going forward of 3.75k

Year 3 add 5k post tax to make the total back up 10k and cost basis of 8.75k etc, etc

as the years go by adding 5k post tax year each year and converting you are paying taxes on a decreasing percentage of that 5k.

[justplainbll]

IRA contributions with funds on which income tax has been paid are not taxed upon conversion or distribution. This is made obvious by form 8606.

[GrayHare]

Alan - OK, so the pre/post tax status of tIRA dollars left behind *does* indeed change with repeated partial Roth conversions. That seems logical, and helps with planning for 2012, thanks.

[Alan]

Quote:

Originally Posted by GrayHare Alan - OK, so the pre/post tax status of tIRA dollars left behind *does* indeed change with repeated partial Roth conversions. That seems logical, and helps with planning for 2012, thanks.

I assume that you use tax software and that will do the calculations for you. After the first time you do the conversion, take a look at form 8606 and you will see how the tax-free portion is calculated and then subtracted from your cost basis going forward.

If you look at your most recent 8606 you will see your current cost basis, plus the boxes where you would enter the sums to be converted and instructions on the step by step calculations.

[justplainbll]

Quote:

Originally Posted by Alan I assume that you use tax software and that will do the calculations for you. After the first time you do the conversion, take a look at form 8606 and you will see how the tax-free portion is calculated and then subtracted from your cost basis going forward. If you look at your most recent 8606 you will see your current cost basis, plus the boxes where you would enter the sums to be converted and instructions on the step by step calculations.

Some tax software defaults to IRA contributions being made from untaxed income. I've had occasion to have to override this default when wanting to make IRA contributions with tax paid funds.

[brewer12345]

"backdoor" taxation? So they are taxing your ass?

[GrayHare]

there may be a reason Uncle Sam is so often seen with his finger sticking out

[Alan]

Quote:

Originally Posted by brewer12345 "backdoor" taxation? So they are taxing your ass?

...and your mule and donkey also.