H and I have gotten conflicting advice from our financial planner and accountant, so logically we are turning to MM to help us think through the disagreement!
Financial planner recommends we both put 5k each into an IRA each year, and convert it to a Roth immediately. Problem is, we make too much to do that tax-free so we get hit with taxes twice essentially, if I am understanding the process correctly. FP rationale is then we get taxes out of the way and that account grows tax free.
Accountant says that we should keep doing as we are, putting $$ into our 401ks (max) and supplementing that with non-retirement account investing and saving (we currently invest much more than 5k each per year). Accountants rationale is why pay taxes on money again to convert, when you can let that money grow on your behalf instead of giving to Uncle Sam.
H is team Accountant, I am leaning towards team Accountant but feel ilke everyone else has an IRA and are we missing something here!?
I did the math with a pretend 10k and will post how the calculations worked out immediately below, but that further pushed me to team Accountant - we make too much for the IRAs to give us tax advantages (thank you very much Uncle Sam), so ignore the IRA fever and keep doing what we are doing.
Assuming we had 10k (5k each) to invest now, it would be post-tax income that Uncle Sam already took a bite out of.
if we had to pay ordinary income on that, when we pit it in an IRA and then convert to a Roth, assuming 40%, we would end up investing around 6k, because that money would have to come from somewhere, which means it would reduce the amount of money we were investing overall. After 10 years at 5% rate of return, we make 9,800. Less than the 10k we had in the first place.
Now, if we just invested the full 10k, same rate of return and time period, we have 16,400. What am I missing?! How is the Roth a good idea??
The FPs were positioning it as a hedge against the future - if one believes rates will rise, etc. They get paid hourly, so do not make any commission from what we decide to do.
The accountant said that most FPs say that "because they like the idea of tax free growth in the future."
Eager to hear the feedback, sorry this was a long one.
If you're above the income limits for a deductible IRA, you're putting in post-tax money to a nondeductible IRA. You don't have to pay taxes again. You just don't get the tax break when you file -- it just doesn't reduce your taxable income.
You then convert it to a Roth to gain the advantages of tax-free growth. According to current rules, whatever you withdraw later -- your original investments as well as earnings -- aren't taxed.
DId you subtract the taxes on the capiatal gains for that 16400? After initial income taxes on the money used for a ROTH - there are no more taxes on the earnings or at withdral in retirement - it helps to offset the 401k taxes on withdrawal.
At your income level, it's all about whether you pay taxes on growth at today's rate vs the future rate. Today is a known level and that is why FPs recommend it. Plus, they get to add that balance to their assets under management number. Accountant is betting that capital gains tax rate will not be that high in the future and it's worth risking.
Personally, I'm team Accountant since I don't believe capital gains tax will go that high in the future also.
DId you subtract the taxes on the capiatal gains for that 16400? After initial income taxes on the money used for a ROTH - there are no more taxes on the earnings or at withdral in retirement - it helps to offset the 401k taxes on withdrawal.
I thought I had to pay taxes again when I convert to a Roth, is that totally incorrect? I don't know why these stupid IRAs have me so confused, for whatever reason I am having trouble wrapping my head around the rules here!
At your income level, it's all about whether you pay taxes on growth at today's rate vs the future rate. Today is a known level and that is why FPs recommend it. Plus, they get to add that balance to their assets under management number. Accountant is betting that capital gains tax rate will not be that high in the future and it's worth risking.
Personally, I'm team Accountant since I don't believe capital gains tax will go that high in the future also.
The last sentence is where we are definitely leaning.
Our FPs are hourly, not paid by assets under mgt, so they do not have an incentive to increase our investing levels, but I can see the logic here.
I am angry that I didn't learn about IRAs until college, and then angry at myself that I didn't prioritize them until it was too late, and I was over the income limit by the time I was a few years into my career. If we were on the kid track, I would ensure they started IRAs as soon as they had earned income.
I thought I had to pay taxes again when I convert to a Roth, is that totally incorrect? I don't know why these stupid IRAs have me so confused, for whatever reason I am having trouble wrapping my head around the rules here!
You only pay tax on the gains when you covert. If you convert right away, the gains will be minimal or even zero.
If we were currently in school or something, I would feel differently, but our tax rate now is way too high for me to want to take the tax hit. Particularly because I'm not sure it will help us all that much in the long run.
I thought I had to pay taxes again when I convert to a Roth, is that totally incorrect? I don't know why these stupid IRAs have me so confused, for whatever reason I am having trouble wrapping my head around the rules here!
You only pay tax on the gains when you covert. If you convert right away, the gains will be minimal or even zero.
This is important to note.
You pay tax on any pre-tax IRA money that you convert to a Roth IRA. Examples include:
-rollovers from pre-tax employer plans that ended up in an IRA -contributions to the IRA that were deducted from your return (if they were made in a year when you qualified to take such a deduction) -gains on the contributions
You do not pay tax on contributions in your situation if you immediately contribute and convert.
I hear a lot of accountants recommend the contribute/method so I am a little surprised to hear his argument.
Also if you currently invest much more than $5K why not do both? Do the IRA conversion but continue to invest heavily on the side. This will give you both pre and post-tax money for retirement and you can wait to draw down the Roth pool since there are not required distributions.
If we were currently in school or something, I would feel differently, but our tax rate now is way too high for me to want to take the tax hit. Particularly because I'm not sure it will help us all that much in the long run.
But this argument is talking about a situation in which you're contributing to a deductible vehicle. (I skimmed, so please tell me if I'm missing something.)
In OP's situation, because she's over the income limits, she is already contributing post-tax money to her IRA. She has to take the tax hit either way. So I don't see why you wouldn't backdoor into a Roth.
Your math on the conversion isn't correct. If you put in $10k today to a traditional IRA, and convert the same $10k to a Roth tomorrow, you aren't paying taxes on $10k. You are paying taxes on any gain you made between today and tomorrow. So if you gain $100 in that day, you pay taxes on $100. So, at your 40% hypothetical, you would owe $40 upon conversion. The balance would grow in your Roth tax free until you begin withdrawals in retirement.
That article is interesting but there are differences between the decision to do a Roth 401K and the decision to contribute to an IRA and immediately convert to a Roth. Two separate (but of course somewhat related) issues.
If we were currently in school or something, I would feel differently, but our tax rate now is way too high for me to want to take the tax hit. Particularly because I'm not sure it will help us all that much in the long run.
But this argument is talking about a situation in which you're contributing to a deductible vehicle. (I skimmed, so please tell me if I'm missing something.)
In OP's situation, because she's over the income limits, she is already contributing post-tax money to her IRA. She has to take the tax hit either way. So I don't see why you wouldn't backdoor into a Roth.
I would like to hear more about this, because the way I am reading it, this makes sense only up to the max amount you can contribute to a traditional 401(k) pretax and use it to reduce taxable income. After that point, it doesn't seem to make sense not to contribute to a traditional IRA and then convert to Roth.
Post by LoveTrains on Dec 22, 2012 10:49:54 GMT -5
Maybe I am missing something, but if I made too much money to do a Roth, I would open up a new IRA with $5000 and then immediately convert it the next day to a Roth. That way I would only have to pay taxes on the gains for something like a day or two.
Then, the money in the Roth will grow tax free forever. I will never have to pay cap gains taxes on the gains. That seems like a huge savings.
But this argument is talking about a situation in which you're contributing to a deductible vehicle. (I skimmed, so please tell me if I'm missing something.)
In OP's situation, because she's over the income limits, she is already contributing post-tax money to her IRA. She has to take the tax hit either way. So I don't see why you wouldn't backdoor into a Roth.
Two reasons I can think of:
1. Because you're in a very high tax bracket now (and maybe also live in a state/city with high income taxes) and think that you'll be paying a lot less in taxes in the future But she has to pay the taxes now either way. If she contributes to a nondeductible IRA, it's post-tax money. She's not taking any additional tax hit by converting.
2. Because aren't there weird conversion rules that you have to convert a certain percentage of your overall account? If I could convert just my $5000 from this year, I'd think about it (even though it would cost us over $2000 in taxes if I'm doing the math right -- and that's $2000 that I could invest instead and maybe would be worth a hell of a lot more when I retire), but from what I understand, I can't just convert this year's contribution so we'd have a much, much bigger tax hit than $2000 if we converted.
Yes, if you have pre-tax funds comingled with post-tax funds, you pay tax on the percentage you're converting that's pre-tax. That's why I roll over pre-tax funds into my 401(k) and my IRA accounts are only post-tax money. You could roll over your traditional IRA into an employer plan and in the future do the contribute/convert approach (as long as the loophole exists.)
No. You don't have to convert a certain percentage of your IRA.
You could convert $1, $5,000, or $250,000.
But you have to pay taxes on a proportional basis. If pre-tax money is overall 25% of your IRA pool, you have to pay tax on 25% of your conversion. If your entire IRA is post-tax there is only tax on the gains when converting.
Hence why to immediately contribute and convert has very little tax liability.
There was a good post a few weeks ago where we went through the math (was it yours v?) but I'm on my phone and can't find it.
Maybe I am missing something, but if I made too much money to do a Roth, I would open up a new IRA with $5000 and then immediately convert it the next day to a Roth. That way I would only have to pay taxes on the gains for something like a day or two.
Then, the money in the Roth will grow tax free forever. I will never have to pay cap gains taxes on the gains. That seems like a huge savings.
Am I missing something?!
This is what I am wondering now too. If I phase out of a Roth and max the pretax 401(k) to the allowable limit, any money contributed further to any type of account would be with post-tax funds. I am probably being dense, but I am having trouble figuring out why I wouldn't contribute the next $5k to a traditional IRA and convert immediately to a Roth.
But this argument is talking about a situation in which you're contributing to a deductible vehicle. (I skimmed, so please tell me if I'm missing something.)
In OP's situation, because she's over the income limits, she is already contributing post-tax money to her IRA. She has to take the tax hit either way. So I don't see why you wouldn't backdoor into a Roth.
I would like to hear more about this, because the way I am reading it, this makes sense only up to the max amount you can contribute to a traditional 401(k) pretax and use it to reduce taxable income. After that point, it doesn't seem to make sense not to contribute to a traditional IRA and then convert to Roth.
Correct.
I'll take my situation for instance. We max out 401ks. That's our main option for reducing taxable income.
Our income is too high to get the benefit of a traditional IRA reducing taxable income or contribute to a Roth directly. So I can either (1) contribute to a traditional IRA with post-tax money (called a nondeductible IRA) and leave it there or (2) contribute to the nondeductible IRA and convert it to a Roth.
I'll use OP's original numbers.
If you contribute 10k to your nondeductible IRA, and convert it without any gains, you pay nothing more than what you're already paying. Your money then grows tax-free and you withdraw it tax-free (according to today's rules). After 10 years at 5%, you'll have 16,288.95 free and clear.
If you contribute 10k to your nondeductible IRA, and do not convert, you'll still have the advantage of tax-free growth while it's in there. Once you withdraw it, however, the earnings are taxed as ordinary income (you already paid taxes on the initial investment). It doesn't matter what the tax rate is (unless it's 0) -- what you end up with is 16,288.95 minus whatever the taxes on the earnings (in this case 6288.95) are.
Where it becomes more complicated, as sarajoy points out, is if you have pre-tax funds in your IRAs already.
No. You don't have to convert a certain percentage of your IRA.
You could convert $1, $5,000, or $250,000.
But you have to pay taxes on a proportional basis. If pre-tax money is overall 25% of your IRA pool, you have to pay tax on 25% of your conversion. If your entire IRA is post-tax there is only tax on the gains when converting.
Hence why to immediately contribute and convert has very little tax liability.
There was a good post a few weeks ago where we went through the math (was it yours v?) but I'm on my phone and can't find it.
Yup, I think you're thinking of me. My old 401(k) is rolled over into an IRA that I think is 2/3 pre-tax and 1/3 post-tax? I definitely asked the questions a few months ago and then wanted to :-( at the answer (not because the numbers were sobering or anything like that, just because it is ridiculously complicated).
But maybe I didn't understand then? If 2/3 of my IRA is pre-tax, can I immediately convert only the $5500 from next year (for instance), in which case I'd have to pay income tax on 2/3 of that $5500?
So the solution is to put $5k at once into a new traditional Ira opened for this purpose and immediately convert, rather than continuing to fund an existing Ira?
So the solution is to put $5k at once into a new traditional Ira opened for this purpose and immediately convert, rather than continuing to fund an existing Ira?
So confusing.
If you want to join me in crying about how confusing it is, I recommend perusing this article:
So the solution is to put $5k at once into a new traditional Ira opened for this purpose and immediately convert, rather than continuing to fund an existing Ira?
YES.
Take your $5,000 for this year, put in a new non-deductible traditional IRA, and convert it immediately. Now you have a Roth IRA with $5,000 and that $5,000 grows tax free - meaning you don't have to pay taxes on the gains.
It should be pretty easy to do that, most companies allow you to open an IRA with $5,000. You can even just put the $5,000 in a money market or have it sit in cash before you convert it.
The key is to do that EACH year that the tax code allows anyone to convert a traditional IRA into a Roth. It is essentially circumventing the income cap rules for the Roth.
Post by winemaker06 on Dec 22, 2012 12:45:45 GMT -5
For those saying you pay the gains from the time you deposit into the Traditional IRA, to the date your convert - put your money in a Money Market account! Then after the conversion, move it where you want, but at least there won't be any significant investment gains in the meantime.
We avoid all the other annoying calculations by not having any other Traditional IRAs. One small one got rolled into a 401k for simplicity.