Backdoor Roth IRA contributions still allowed in 2012, right?

[soupcxan]

DW and I make too made money (filthy lucre!) to qualify for contributing to our Roth IRAs in 2011. So we each funded a Traditional IRA and then converted those accounts to Roths since the income limits on conversions was lifted in 2010. Hence the "backdoor" Roth contribution.

This is still allowed for 2012, right? I am planning to make the contribution and convert it in January. I just want to make sure the rules are the same as they were for 2011.

 

[GrayHare]

Yes, though I wonder how much longer until the conversion option is either stopped or simplified to remove the silly extra step.

 

[meekie]

Wow. I did not know about this. We haven't been able to fund the Roth either.

From what I've just read, the conversions can be withdrawn penalty free after 5 years? even if we're under 59 or whatever?

Mieko

 

[soupcxan]

meekie, If you make the contribution and conversion before you file your 2011 taxes, you can make do $5k each for 2011 and 2012, per person (so $20k total if you're married). But be careful - if you have other non-taxable IRAs (e.g. a 401k that you rolled-over into a pre-tax IRA) then the conversion will subject those pre-tax funds to taxation in the current year on a pro-rata basis to your post-tax funds from the traditional IRA.

 

[kaneohe]

the non-taxable part of the conversion can be withdrawn penalty free after 5 yrs. The taxable part (if any) of the conversion is still subject to the penalty
if you are < 59.5 y.o.

 

[Ed_The_Gypsy]

meekie, If you make the contribution and conversion before you file your 2011 taxes, you can make do $5k each for 2011 and 2012, per person (so $20k total if you're married). But be careful - if you have other non-taxable IRAs (e.g. a 401k that you rolled-over into a pre-tax IRA) then the conversion will subject those pre-tax funds to taxation in the current year on a pro-rata basis to your post-tax funds from the traditional IRA.

Is'nt this the same thing as paying normal income tax on the money?
That would be expected. You just want to get around thehigh income restriction on Roth contributuons, not dodge income taxes at time of contribution.

 

[Ed_The_Gypsy]

Or are you warning that a separate IRA, without earlier contributions, be used for this?

 

[gauss]

If you like this strategy, then you may be intersted in the one that I am using that allows up to $49,000 of after tax money to be transferred to a Roth each year.

The catch is that you need to have access to a 401(k) with the following features:

- accepts "after-tax" contributions up to some limit
(IRS max is $49,000 in 2011)

- allows for "in-service" withdrawls
(at least of your after-tax contributions)

If you are concerned about reduced current cash flow after you crank up your 401(k) deductions, remember that you can always use any existing after tax savings to offset needs for current spending.

There were many discussions of this at fairmark.com leading up to 2010 when the income limits for Roth conversions rules were removed. I think that this was also discussed here also.

 

[soupcxan]

Or are you warning that a separate IRA, without earlier contributions, be used for this?

My warning is that the "backdoor" Roth IRA contribution can result in a current tax bill if you have a mix of pre-tax and post-tax IRAs, even if the traditional IRA you convert to a Roth is 100% post-tax.

For example: I had a 401k at my last job. When I left, I rolled it over into an IRA. The money in that account was deducted from my paycheck while I was working and I have never paid tax on it. So that's a pre-tax IRA. Let's say that today I fund a Traditional IRA with $5k post-tax dollars (aka a non-deductible IRA). The tax problem comes when I convert that to a Roth IRA. The IRS says that even though that particular $5k that I converted was post-tax, you have to treat it as if you converted a proportionate share of all your IRAs, including my pre-tax IRA. Since I have a large balance in my pre-tax IRA, I would owe income tax on a large percentage of that $5k. It is as if you took a taxable distribution from your pre-tax IRA to fund the Roth IRA.

So in my particular case, I am funding the Traditional IRA but not converting it to a Roth because that would create a current tax liability (our combined income is high right now, so is our tax rate, but this could change in the future, at which time I would make the conversion). My wife, who does not have a pre-tax IRA, is able to fund the Trad IRA and convert to a Roth with no problem.

This is just a potential pitfall that people should be aware of before attempting the backdoor Roth IRA contribution.

 

[Ed_The_Gypsy]

Thanks, soupcxan,

Strange rules.

If you have to income tax on a proportionate share of your pre-tax IRA, does that mean that you can put that proportionate share in your Roth, too? I could live with that.

 

[soupcxan]

Ed, I 'm not sure I follow your question, but I am no expert on all this...I just know enough (barely) to stay out of trouble.

 

[Ed_The_Gypsy]

Let me try again. See if I understand.

My warning is that the "backdoor" Roth IRA contribution can result in a current tax bill if you have a mix of pre-tax and post-tax IRAs, even if the traditional IRA you convert to a Roth is 100% post-tax.

For example: I had a 401k at my last job. When I left, I rolled it over into an IRA. The money in that account was deducted from my paycheck while I was working and I have never paid tax on it. So that's a pre-tax IRA. Let's say that today I fund a Traditional IRA with $5k post-tax dollars (aka a non-deductible IRA). The tax problem comes when I convert that to a Roth IRA. The IRS says that even though that particular $5k that I converted was post-tax, you have to treat it as if you converted a proportionate share of all your IRAs, including my pre-tax IRA. Since I have a large balance in my pre-tax IRA, I would owe income tax on a large percentage of that $5k. It is as if you took a taxable distribution from your pre-tax IRA to fund the Roth IRA.

Say you have 500k in your pre-tax roll-over IRA and have 5K in a trad IRA. You convert the 5k trad IRA to a Roth and pay, say, 25% income tax on it, or $1250 (and in the end, you have $5k in a new Roth, having paid the taxes out of pocket, in after-tax money).

If I understand correctly, you will be required to pay 25% (say) on 1% of you pre-tax rollover IRA (in the proportion of 5k/500k), or another $1250.

If you do this, it strikes me that you have paid income tax on another 5k which ought to be able to be moved into the Roth as well, being now after-tax. If I have this right, you wind up paying tax on two pots of money, both of which you should be able to put into your Roth.

Is this right? I will look it up anyway. Interesting.

 

[soupcxan]

Ed, I don't think the second $1250 of tax in your example is correct. Before you did the conversion, $500k (100%) of the money in your rollover IRA was pre-tax. After the conversion, only ~$495k is pre-tax because you paid the tax on ~$5k of it when you did the conversion. So later on, when you eventually withdraw the $500k, only ~$495k of it is taxable income. You need to remember that your basis in the rollover IRA has changed.

To put it another way, this scenario only changes the timing of when a portion of the pre-tax IRA is recognized as income, not the amount of income (obviously different tax rates and the time value of money will change the net tax expense you incur).

 

[kaneohe]

I'm not sure I understand what you guys are thinking but that's no reason to hesitate to muddy the waters more :

Start w/ 500K in a pretax rollover IRA from a corporate plan. Add a 5K
non-deductible contributory TIRA. Because the contributory TIRA is non-deductible, you have to pay taxes on that income =25% of 5k = $1250.
Later (make it a yr later just to separate the concepts), you decide to convert 5K to a Roth. Even tho you "physically" convert the contributory TIRA, the IRS doesn't care that you already paid taxes on those $$$$. It considers both assets as one big uniformly mixed IRA (like cream in coffee).
5K of the 505K is basis .....previously taxed(1/101 of the mix; slightly less than 1%).

When you convert 5K to Roth, 1/101 of that or slightly less than 50 is considered basis and is not taxed. Slightly more than $4950 is taxed at
25% or about $1238 is taxed. You end up with 5K in Roth and 500K in
TIRA with about 4950 in basis that won't be taxed upon withdrawal.

It may seem that you are "double" taxed if you insist on thinking about converting the "non-deductible " TIRA but that is the wrong way (but perhaps natural way) to think about it. Think about the cream in coffee concept and you will see that it all ends up correct in the end.
Bottom line.....I'm more agreeing w/ soupcxan.

btw.....there is a way to make things better. If you had a current employer plan that would accept your previous employer's plan, you could move the 500K rollover IRA there, leaving the 5K non-deductible IRA.
Then when you converted that 5K to Roth, no taxes since it is all basis
(perhaps some small earnings component would be taxable).

 

[Ed_The_Gypsy]

Thanks both. I think I am getting a consistent picture now.

Still, one thing puzzles me. kaneohe, that $4950 that won't be taxed upon withdrawal, is it possible to pull it out of the TIRA and put it into the Roth? First, I thought that before-tax and after-tax IRAs could not be co-mingled. Second, if the monies stay co-mingled, at some point in time the taxable/non-taxable distributions have to be distinguished, which gets difficult because how do you separate the untaxable dividends from the taxable dividends? Simple proportions? It strikes me that it would be so much simpler to move the tax-paid assets out of the TIRA into a Roth.

With a separate already-taxed Roth and a TIRA, I can select which one I am taking distributions from. If the IRA has taxed and un-taxed components all in the same box, I can't distinguish between the two upon withdrawal.

It makes too much sense. Therefore, I expect that it is not allowed.

I wouldn't try any of this until I understood it better.

 

[kaneohe]

Ed........the best advice I got about this subject is the coffee and cream analogy. It is true you can't distinguish the components since they're mixed together. The other best advice came from Nords.....you can't distinguish the components but you can know how much of each is left via Form 8606 which does the calculation. In the beginning, just follow the step by step instructions which track basis (the already taxed part) and you won't get a headache thinking about it. If you want to get a headache, though, go ahead and think away all you want.

To your question......yes you can convert the $4950 left that was already taxed......you just can't do it by itself..........you have to convert the other stuff along with it proportionally. What? You forgot the coffee and cream lesson 1 already? You can only convert that $4950 if you convert everything.
.......unless you use the other strategy of separating the rollover IRA back into another 401K .

 

[Ed_The_Gypsy]

kaneohe, I think I will leave this to the brave and the rocket scientists.

 

[kaneohe]

Ed.....it's headache to think about but the basics are basic . Ever change coolant in a car by just draining it, refilling w/ water, running to mix it, then draining again? Say you want to know how many times you need to do this to get rid of most of the old antifreeze.
Suppose the cooling system contains 10units of coolant of which 50% is antifreeze.
You drain it but only 5 units comes out. 5 units of coolant remain in the system. Of that, 50% or 2.5 units is antifreeze. You fill it with water, mix it up by running the engine, then drain it again. You removed half of the fluid so now 1.25 units of antifreeze are left. You can think of the antifreeze as the basis so by keeping track of that and the total amount, you will always have what you need to know to trackl
things. The math can get kind of messy but as Nords pointed out, you just follow the steps in the form. Not worth getting a headache over , though, unless you like headaches.

 

[soupcxan]

If this makes your head hurt, another option is just to fund the non-deductible IRA now and hold off on the conversion to Roth...then you never get into the pre-tax/post-tax prorationing. That is what I am doing.

 

[youbet]

kaneohe.....

You've done a nice job explaining. Thanks.

I have a TIRA which is a blend of pre and post tax contributions (all quantified and documented on form 8606 of course.) I've begun doing some converting and, yes, you do a blend. Identifying the post tax dollars and converting those is not allowed. In my case, I'm in the neighborhood of 50/50 so when I converted $30k, about $15k added to my income as taxable.

I'm fortunate that my prior employer's 401k is good (low cost index funds with zero admin charges) and therefore I've been able to leave those dollars there while doing the Roth coversions from my TIRA. Otherwise, the ratio would be more like 90% pre-tax and 10% post tax.

Thanks again for your well presented explanation.

 

[ERD50]

kaneohe.....

You've done a nice job explaining. Thanks.

I have a TIRA which is a blend of pre and post tax contributions (all quantified and documented on form 8606 of course.) I've begun doing some converting and, yes, you do a blend. Identifying the post tax dollars and converting those is not allowed. In my case, I'm in the neighborhood of 50/50 so when I converted $30k, about $15k added to my income as taxable. ...

And IIRC, the blend is based on ALL your IRA $ that are of the same type you are withdrawing from, not just that one account (moot if you only have one account).

I had a small post-tax contribution in my 401K, and when I rolled it over to a Trad IRA, the broker would only accept the pre-tax portion, no blending (this may be by law). It was only a few thousand in the post tax portion, they just sent me a check. Since this was already taxed, nothing to report (unless I did it wrong, or my memory is failing on this issue; both are possible, maybe even probable).

-ERD50

 

[youbet]

And IIRC, the blend is based on ALL your IRA $ that are of the same type you are withdrawing from, not just that one account (moot if you only have one account).


-ERD50

Correct. I have only my TIRA and my Roth so when converting to the Roth from the TIRA, the dollars I convert are taxed in the same proportion as the pre and post tax dollars in the TIRA. If I had a rollover IRA, those dollars would be added to the TIRA and the calculation would be done on the combination.

I'm delaying rolling over my 401k so that that large slug of pre-tax dollars are not in the calculation as they would be if I converted it to a rollover IRA now. As mentioned earlier, I'm fortunate that MegaCorp's 401k has low cost index funds available. DW's 403B was horrible and we rolled that over immediately upon her retirement to get away from the lousy choices and sky high fees. So...... no Roth conversions for her.


Like form 8606, it looks complicated when you start figuring it out but isn't really.

 

[kaneohe]

I had a small post-tax contribution in my 401K, and when I rolled it over to a Trad IRA, the broker would only accept the pre-tax portion, no blending (this may be by law). It was only a few thousand in the post tax portion, they just sent me a check. Since this was already taxed, nothing to report (unless I did it wrong, or my memory is failing on this issue; both are possible, maybe even probable).

-ERD50

ERD50.....I have no knowledge about this but I would have thought that somehow the post tax part could have been converted to a Roth....maybe it would have to be done separately?

 

[BigE]

DW and I make too made money (filthy lucre!) to qualify for contributing to our Roth IRAs in 2011. So we each funded a Traditional IRA and then converted those accounts to Roths since the income limits on conversions was lifted in 2010. Hence the "backdoor" Roth contribution.

This is still allowed for 2012, right? I am planning to make the contribution and convert it in January. I just want to make sure the rules are the same as they were for 2011.

I did the backdoor conversion for 2011 and will do it again for 2012 (and will keep doing it until they close this option. We are also boxed out of ROTH via income limits. I knew the IRS change lifting income limits were on the horizon and therefore my wife and I contribute to nondeductible TIRA's for years leading up to 2010 and was a little miffed that you had to convert ALL previous IRA's or do some complicated accounting computations if you didn't want to convert all. I unfortunately, had rolled over a 401k to an IRA for my wife, so we did no conversions for her but I proceeded to convert all my older deductible TIRAs and more recent nondeductible TIRAs and pay taxes in 2010. So now I have a "clean slate" with only Roth IRA's and I convert each year. My strategy from advice obtained from this forum is to have as many options in retirement as possible. Of interest, my accountant thinks this is in the "grey zone" and as I have discovered repeatedly, I usually know more than my accountant (and I'm not very bright).

 

[Ed_The_Gypsy]

Of interest, my accountant thinks this is in the "grey zone" and as I have discovered repeatedly, I usually know more than my accountant (and I'm not very bright).

I have had the same experience. It gives me the willies. The only reason I keep him is that I need someone to talk to the IRS when they call.