Backdoor IRA and Tax Liability with TIRA

[Davaldez21]

I wanted to educate myself on how a backdoor IRA affects an existing Traditional IRA.

If one has money in a traditional IRA and then some separate money in a non deductible IRA (already taxed based on income limits since not qualifying for TIRA) which one wants to convert to Roth, I read the non deductible IRA may be taxed again based on a ratio of 'already taxed contributions to never been taxed contributions'.

Again this is said to only affected backdoor roths if you have existing TIRA balances.

link: 6 IRA Mistakes to Avoid

How true is this? I mean couldn't I just convert the nondeductible IRA to Roth and leave the rest of the Traditional IRA intact for later?
Thanks!

 

[Senator]

I believe all non-deductible IRAs and tIRAs are considered one account, even if they are at two different institutions. That is what IRS form 8606 tracks.

If you have $50K in a non-deductible IRA and $50K in a tIRA, you pay income tax on 50% of the withdrawal, no matter what account it comes from.

 

[Dash man]

This makes me curious about our recent actions. We each opened a traditional IRA and rolled it into our Roth accounts, but in the next few weeks DW will be rolling her lump sum pension into the tIRA and I'll be rolling 2/3 of my 401k into my tIRA and the rest (Roth 401k and after tax) into my Roth IRA. Even though we did the Roth conversion first, will moving her pension and my 401k into tIRAs in the same tax year trigger a taxable event?

 

[kaneohe]

This makes me curious about our recent actions. We each opened a traditional IRA and rolled it into our Roth accounts, but in the next few weeks DW will be rolling her lump sum pension into the tIRA and I'll be rolling 2/3 of my 401k into my tIRA and the rest (Roth 401k and after tax) into my Roth IRA. Even though we did the Roth conversion first, will moving her pension and my 401k into tIRAs in the same tax year trigger a taxable event?

yes, F8606 looks at your TIRA balance at yr end. Can you wait till Jan to do rollover?

 

[Davaldez21]

So what would be tax liability for 2 examples, both total of 200k:

Scenario 1:
TIRA:50k, NonDeductible IRA:150k

Scenario 2:
TIRA:150k, NonDeductible IRA:50k

Lets say you want to convert part of the total to Roth. Would you pay taxes at time of conversion?
Just trying to understand it better.

thanks.

 

[kaneohe]

So what would be tax liability for 2 examples, both total of 200k:

Scenario 1:
TIRA:50k, NonDeductible IRA:150k

Scenario 2:
TIRA:150k, NonDeductible IRA:50k

Lets say you want to convert part of the total to Roth. Would you pay taxes at time of conversion?
Just trying to understand it better.

thanks.

In S.1., 25% of assets were not yet taxed (either deductible contributions or earnings), so 25% of any conversion would be taxed. In S.2. 75%.
In principle, pay-as-you-go.........so estimated taxes are due in the quarter the conversion happens at the appropriate dates, not necessarily the date of the conversion. If you meet safe harbor guidelines, perhaps nothing would be due until the following Apr 15., or if you withhold,you can do it anytime that yr.

just to clarify.....the above is a simplistic explanation and the real answer comes from filling out F8606. For example, if you convert when 100% is non-deductible, you might think nothing is taxed. However in your example if you later bring in the taxable assets from a 401K rollover, the simplistic method would lead you astray but F8606 would give you the right answer.

 

[panacea]

In S.1., 25% of assets were not yet taxed (either deductible contributions or earnings), so 25% of any conversion would be taxed. In S.2. 75%.
In principle, pay-as-you-go.........so estimated taxes are due in the quarter the conversion happens at the appropriate dates, not necessarily the date of the conversion. If you meet safe harbor guidelines, perhaps nothing would be due until the following Apr 15., or if you withhold,you can do it anytime that yr.

You said this in a round about way but I wanted to stress that the 25% answer assumes there has been no growth in the nondeductible IRA. So for example, if IRA contributions in S.1. totaled $100,000 and the account grew to $150,000 now 50% is taxable instead of 25%.

 

[Dash man]

yes, F8606 looks at your TIRA balance at yr end. Can you wait till Jan to do rollover?

I can for my situation. DW had to take her lump sum in December since they are closing out the pension plan. They'll be mailing us a check, so we'd have to hold onto the check for a month...that's a scary thought.

 

[panacea]

I can for my situation. DW had to take her lump sum in December since they are closing out the pension plan. They'll be mailing us a check, so we'd have to hold onto the check for a month...that's a scary thought.

You could also recharacterize the Roth back to a Traditional if the tax impact is going to be too great.

 

[kaneohe]

You said this in a round about way but I wanted to stress that the 25% answer assumes there has been no growth in the nondeductible IRA. So for example, if IRA contributions in S.1. totaled $100,000 and the account grew to $150,000 now 50% is taxable instead of 25%.

yes, any discussion of this that doesn't use the word "basis" has got to be suspect or loosely worded in the best case
F8606 is the last word.

 

[youbet]

yes, F8606 looks at your TIRA balance at yr end. Can you wait till Jan to do rollover?

Isn't it the end of prior year that counts? Your 12-31-2014 balances for 2015 TIRA taxes?

Edit: Per Alan's suggestion (below), I should say " Your 12-31-2014 balance for the taxes you are doing in 2015, ie., your 2014 taxes.

 

[Alan]

Isn't it the end of prior year that counts? Your 12-31-2014 balances for 2015 TIRA taxes?

I think it is the end of the tax year you are doing taxes for. The link is to 8606 for tax year 2014, which one would complete in 2015 for tax tear 2014. line 6 asks for the value of all IRA accounts on Dec 31st 2014. (This may be what you mean and I've just misunderstood)

https://www.irs.gov/pub/irs-prior/f8606--2014.pdf

 

[gauss]

How true is this? I mean couldn't I just convert the nondeductible IRA to Roth and leave the rest of the Traditional IRA intact for later?
Thanks!

Nope -- all the non-Roth IRA assets are lumped together and you pay tax on a pro-rata percentage of the taxable balance scaled by the amount of your conversion. As mentioned above, Form 8606 walks you through this calculation.

The way that I got around this is as follows: I had access to a current employer 401k that accepted incoming rollovers from traditional IRAs. I was able to roll the taxable IRA balance into the 401k (where it would remain taxable). The remaining assets in the IRA then were close to 100% non-taxable and thus made for easy Roth-Conversions.

The general term that I have seen for this type of maneuver is "isolating the basis" in that you are effectively separating your taxable and non-taxable IRA balances by moving to the 401k (which is accounted for independently).

There was much good discussion of this over at fairmark.com since 2010 when the IRS rules changed which removed income limits for Traditional to Roth IRA conversions. I would highly recommend researching over there to make sure that your situation will work.

I also suggest performing a small test rollover near the end of the year, then confirming early the next year after preparing your tax return that everything worked as you had planned. Better to make a tax error with 1,000 conversion then $100,000.

-gauss

 

[Davaldez21]

so just to clarify. If you pay taxes on an amount of non deductible IRA and want to immediately convert to Roth same year, would that money (or part) be actually double taxed in the same year? Or when do you get the extra tax hit?

 

[youbet]

I think it is the end of the tax year you are doing taxes for. The link is to 8606 for tax year 2014, which one would complete in 2015 for tax tear 2014. line 6 asks for the value of all IRA accounts on Dec 31st 2014. (This may be what you mean and I've just misunderstood)

https://www.irs.gov/pub/irs-prior/f8606--2014.pdf

Thanks Alan. Yes, that's what I had between my ears but failed to express via the keyboard!

 

[gauss]

so just to clarify. If you pay taxes on an amount of non deductible IRA and want to immediately convert to Roth same year, would that money (or part) be actually double taxed in the same year? Or when do you get the extra tax hit?

To make a statement like that you need to specify the total amount of all of your IRAs along with the non-taxable portion (ie your basis , ie that which was already taxed).

There really is no double taxation going on here.

Say you have $100K balance in all of your traditional IRAs and that $25,000 of this was from non-deductible contributions. You would then have a basis of $25,000 (which would be non-taxable) and $75,000 due to deductible contributions and growth.

If you converted 1/2 of the balance, $50,000 to a Roth, then you would have to pay taxes on 0.75 * 50,000 = $35,000.

-gauss

 

[panacea]

so just to clarify. If you pay taxes on an amount of non deductible IRA and want to immediately convert to Roth same year, would that money (or part) be actually double taxed in the same year? Or when do you get the extra tax hit?

There's no double tax. You pay taxes on the earnings before making the contribution and eventually taxes on the growth of the contribution whether it's to convert it or take a distribution. If you have no rollover or deductible IRAs, make a nondeductible IRA contribution and convert it to a Roth the same day, the conversion is "free" and then future growth is tax-free.

 

[panacea]

To make a statement like that you need to specify the total amount of all of your IRAs along with the non-taxable portion (ie your basis , ie that which was already taxed).

There really is no double taxation going on here.

Say you have $100K balance in all of your traditional IRAs and that $25,000 of this was from non-deductible contributions. You would then have a basis of $25,000 (which would be non-taxable) and $75,000 due to deductible contributions and growth.

If you converted 1/2 of the balance, $50,000 to a Roth, then you would have to pay taxes on 0.75 * 50,000 = $35,000.

-gauss

You're a faster draw than me... what he said!

 

[kaneohe]

so just to clarify. If you pay taxes on an amount of non deductible IRA and want to immediately convert to Roth same year, would that money (or part) be actually double taxed in the same year? Or when do you get the extra tax hit?

Not sure what is bothering you but perhaps this?: you contribute 5K to TIRA but can't deduct due to income being too high. You then convert 5K to Roth.
1) You have no other TIRAs. You will pay tax on the 5K income since contribution was not deductible. You will pay no tax on conversion since all is basis. No double tax.
2)You have 45K in other TIRAs that were deductible. You then convert 5K.
10% is basis and not taxed. You pay tax on 90% of the conversion (4.5K).
You are also paying tax on the 5K income which you contributed. It may seem like double taxation because you will be paying taxes on 9.5K even though you contributed only 5K. That is because the rest of the basis (4.5K) is in the TIRA pool and would eventually be untaxed if you converted the rest of the TIRA.
As gauss mentioned, the workaround to avoid this seeming double taxation is to isolate the basis by rolling the deductible contributions and earnings into a 401K that will accept them.

 

[Davaldez21]

thanks for the replies. I do understand most of the points. However, when you convert non deductible funds from a TIRA pool, you cannot convert the non deductible portion to roth tax free, unless you convert the whole amount, since everything is now pro rated, correct? as in above examples

Essentially your non deductible funds are watered down and become part of 'the pool' unless you convert the whole thing? (Unless you utilize a separate T401k account) several users mentioned

 

[kaneohe]

Essentially your non deductible funds are watered down and become part of 'the pool' unless you convert the whole thing? (Unless you utilize a separate T401k account) several users mentioned

This is a very good way of thinking about it. Everything is mixed together in a uniform solution and the only way to benefit completely from the non-deductible basis is to convert the whole thing.............unless ,as you say, you utilize the T401K , in which case the deductible funds magically float on top of the non-deductible basis and you can skim them off to the 401K, leaving the
non-deductible basis behind to be converted separately.

 

[gauss]

There is no significant difference between converting 99% of your balance and all (ie 100%) of the balance, other than perhaps simplified calculations on the tax forms.

It is not as if something changes when you convert it all.

-gauss

 

[kaneohe]

There is no significant difference between converting 99% of your balance and all (ie 100%) of the balance, other than perhaps simplified calculations on the tax forms.

It is not as if something changes when you convert it all.

-gauss

no argument there.......the key word was "completely"......but it is an analog conversion.....convert 50%, get 50% of the benefit; convert 99%, get 99% of the benefit........never meant to imply that you get no benefit if you don't convert it all. Was just trying to say it could get pretty expensive to convert that way as opposed to the isolation of basis that you mentioned previously....that's where the magic is.

 

[gauss]

Agreed!

Thanks
gauss