Backdoor Roths

[dr.girlfriend]

I swear, our financial advisor tried to explain this to us like three times and I just could not understand it.  I have had the same job for almost 20 years; I contribute to a 403b (like a 401k for nonprofits) for it.  DH has had a variety of jobs, and therefore has a multitude of 401ks and Rollover IRAs that we are trying to consolidate.  He's now sole proprietor of a business, and will be opening a SEP IRA for his retirement contributions going forward.  We make too much for traditional Roth IRAs.

The financial advisor said it *would* make sense for me to do a backdoor Roth.  He said, however, that it *wouldn't* make sense for my husband do to it.  That they would look at his total IRAs, and if they were like, for ease of calculation 100k, and his backdoor Roth was 6k, they would say it's less than 94% of your account and so you would have to pay more in taxes than the contribution is worth.

I just don't get how his situation is different from mine.  I even asked about making backdoor Roth contributions from his 401ks, and the advisor said that would have the same issue.  Can anyone explain this to me in a way I can understand?

[RockNVoll]

Google "backdoor Roth pro rata rule" and see if that helps. This is one link that came up that I thought had a decent explanation in the "What is the pro rata rule" section.

advancedretirementstrategies.com/what-the-pro-rata-rule-means-for-your-backdoor-roth-ira/

[dr.girlfriend]

Dec 13, 2021 23:37:47 GMT -5 RockNVoll said:

Google "backdoor Roth pro rata rule" and see if that helps. This is one link that came up that I thought had a decent explanation in the "What is the pro rata rule" section.

advancedretirementstrategies.com/what-the-pro-rata-rule-means-for-your-backdoor-roth-ira/

I kind of follow this part:

Here’s where things get confusing: some of the retirement accounts that you are converting may contain pre-tax dollars, others may contain after-tax dollars, and some may contain a combination of both pre-tax and after-tax dollars. The pro rata rule governs how these mixtures of funds should be treated at the time of conversion in terms of taxes.

What is the Backdoor Roth IRA Pro Rata Rule?
When the IRS determines your backdoor Roth IRA conversion taxes, they will regard all of your current IRA accounts as one entity. This is known as the aggregation rule – no IRA stands alone; instead IRAs are regarded in the aggregate.

But is it not an issue for me because my 403b is not considered an "IRA"?  Is he a bad candidate because he has funds in Rollover IRAs?  The difference between a 401k/403b and a previously-401k-that-has-been-rolled-over-into-an-IRA seems so negligible to me, but I guess maybe they are considered to be dramatically different somehow?

[Poppy]

Dec 14, 2021 0:16:03 GMT -5 dr.girlfriend said:

Dec 13, 2021 23:37:47 GMT -5 RockNVoll said:

Google "backdoor Roth pro rata rule" and see if that helps. This is one link that came up that I thought had a decent explanation in the "What is the pro rata rule" section.

advancedretirementstrategies.com/what-the-pro-rata-rule-means-for-your-backdoor-roth-ira/

I kind of follow this part:

Here’s where things get confusing: some of the retirement accounts that you are converting may contain pre-tax dollars, others may contain after-tax dollars, and some may contain a combination of both pre-tax and after-tax dollars. The pro rata rule governs how these mixtures of funds should be treated at the time of conversion in terms of taxes.

What is the Backdoor Roth IRA Pro Rata Rule?
When the IRS determines your backdoor Roth IRA conversion taxes, they will regard all of your current IRA accounts as one entity. This is known as the aggregation rule – no IRA stands alone; instead IRAs are regarded in the aggregate.

But is it not an issue for me because my 403b is not considered an "IRA"?  Is he a bad candidate because he has funds in Rollover IRAs?  The difference between a 401k/403b and a previously-401k-that-has-been-rolled-over-into-an-IRA seems so negligible to me, but I guess maybe they are considered to be dramatically different somehow?

Yes, you are correct.

The first thing to know is that your retirement accounts and your H's retirement accounts are treated totally separately for the purposes of Roth conversions. I know it's counter intuitive if you are married filing jointly since most everything else is shared.

The second is that the pro rata rule for calculating taxes owed applies to [non-Roth] IRA accounts only (and applies to ALL of them that the person owns). The rule does differentiate IRAs from 401k/403b accounts and treats them differently.

So that is why it makes sense for you to do the backdoor Roth but not your H.

[dragon's breath]

Yes, it's the fact that there is pre-tax money in his traditional IRA that makes the backdoor Roth less ideal for him. If he has an old 401k he could roll all the pre-tax money into, that would get him around the pro-rata rules.

Not sure if your advisor mentioned it, but the Build Back Better bill would eliminate the ability to do a backdoor Roth after this year. There is still a chance it won't pass as it is written, but I'd do this quickly, just in case.

[Susie]

I think we're basically in the same situation as you, but reversed.  I have a significant chunk of my retirement assets in IRAs because we only fairly recently switched from offering a SIMPLE IRA to a 401k at my firm.  I have an old traditional IRA, a Roth IRA (that I haven't contributed to in years because we're above the limits), and a rollover IRA that contains my old SIMPLE IRA contributions from roughly 2007-2017.  Then I have a 401k that contains what I've saved in an employer sponsored plan from 2017-present.  I've worked for the same firm the whole time, but we switched from offering a SIMPLE IRA to a 401k in about 2017.  A backdoor Roth doesn't make sense for me because of the relatively large amount that I have specifically in IRAs.  

However, MH has all of his employer sponsored plan retirement savings in 457b's.  He has a small old traditional IRA, a modest Roth IRA (also haven't contributed in years), and nothing else in IRAs specifically.  For him it would probably make sense.

I can't make the distinction make sense, because I don't get why it matters, IRA vs. 401k.  But I am pretty sure that's what it turns on.

[RockNVoll]

Dec 14, 2021 11:04:59 GMT -5 Poppy said:

Dec 14, 2021 0:16:03 GMT -5 dr.girlfriend said:

I kind of follow this part:

Here’s where things get confusing: some of the retirement accounts that you are converting may contain pre-tax dollars, others may contain after-tax dollars, and some may contain a combination of both pre-tax and after-tax dollars. The pro rata rule governs how these mixtures of funds should be treated at the time of conversion in terms of taxes.

What is the Backdoor Roth IRA Pro Rata Rule?
When the IRS determines your backdoor Roth IRA conversion taxes, they will regard all of your current IRA accounts as one entity. This is known as the aggregation rule – no IRA stands alone; instead IRAs are regarded in the aggregate.

But is it not an issue for me because my 403b is not considered an "IRA"?  Is he a bad candidate because he has funds in Rollover IRAs?  The difference between a 401k/403b and a previously-401k-that-has-been-rolled-over-into-an-IRA seems so negligible to me, but I guess maybe they are considered to be dramatically different somehow?

Yes, you are correct.

The first thing to know is that your retirement accounts and your H's retirement accounts are treated totally separately for the purposes of Roth conversions. I know it's counter intuitive if you are married filing jointly since most everything else is shared.

The second is that the pro rata rule for calculating taxes owed applies to [non-Roth] IRA accounts only (and applies to ALL of them that the person owns). The rule does differentiate IRAs from 401k/403b accounts and treats them differently.

So that is why it makes sense for you to do the backdoor Roth but not your H.

It's possible to have post-tax traditional IRA contributions, too, though this is admittedly uncommon.  For the sake of accuracy, though, the pro-rata rule applies to pre-tax IRA contributions into a traditional IRA.

dr.girlfriend, you are correct that employer-sponsored plans like 403(b)s and 401(k)s are not the same as IRAs.  Because you don't have any existing pre-tax IRAs, if you pursue a backdoor Roth the math is simply paying income tax on the amount you're putting into the account.  For your husband, however, let's say he has $10,000 in pre-tax IRAs and wants to convert $1,000 of that to a backdoor Roth.  The way the tax math should work (and you can Google for more examples) is that the pro rata amount would be tax-free, so $1k/$10k = 10%, but the other 90% is taxable and he would have to pay income tax on $900 of the conversion.

I don't think it's necessarily true that it's not worth it for him to do the backdoor Roth.  You have to pay the tax sometime, it's just a question of when and what your tax bracket is at the time vs. what you think it will be in the future.  I don't do them because I'm in a pretty high tax bracket and I can only go down from here in retirement (well, barring massive tax hikes), plus I have the option of contributing to a Roth 401(k) if I really want to diversify my options, which is way easier than dealing with a backdoor conversion.  And (to close the loop on that train of thought), the only reason I'd do the Roth 401(k) is because Roths do have the benefit of no RMDs when I get to that age and the money can keep growing longer tax-free.

[Poppy]

Dec 14, 2021 20:04:08 GMT -5 RockNVoll said:

Dec 14, 2021 11:04:59 GMT -5 Poppy said:

Yes, you are correct.

The first thing to know is that your retirement accounts and your H's retirement accounts are treated totally separately for the purposes of Roth conversions. I know it's counter intuitive if you are married filing jointly since most everything else is shared.

The second is that the pro rata rule for calculating taxes owed applies to [non-Roth] IRA accounts only (and applies to ALL of them that the person owns). The rule does differentiate IRAs from 401k/403b accounts and treats them differently.

So that is why it makes sense for you to do the backdoor Roth but not your H.

It's possible to have post-tax traditional IRA contributions, too, though this is admittedly uncommon.  For the sake of accuracy, though, the pro-rata rule applies to pre-tax IRA contributions into a traditional IRA.

drgirlfriend, you can ignore this, it's pedantic and intended for RockNVoll.

Yes, of course. Post-tax contributions to a traditional IRA are step 1 of a backdoor Roth...

I said "non-Roth IRA," meaning traditional IRA (but people also often refer to their IRAs in other ways like Rollover IRA or SEP or whatever so I thought non-Roth was clearer).

[mokes]

Basically, the IRS looks at the total of your IRA funds when determining how much you owe. Even if you have 10 different accounts, for tax purposes, they consider them as one.

Let's say you have:
$10000 in rollover IRAs (pre-tax)
$5000 you want to deposit in a nondeductible IRA and then convert to a Roth (post-tax)

You can't just say, "IRS, I'm using my post-tax $5k for a Roth, I paid the tax already, so I owe you $0."

In this example, the total IRA holdings are ~67% taxable, so you'd owe tax on that same percentage (~$3350) of the $5k.

Since you have no existing pre-tax IRAs (and assuming your income is too high to qualify to deduct traditional IRA contributions), anything you contribute will be post-tax already, so your tax liability on the conversion is $0.

Since your husband has existing pre-tax IRA funds, the total of his IRAs will be taxed into account to calculate the tax. As someone mentioned, if he were to roll all over those pre-tax funds into an employer-sponsored retirement account, he could get around that.

He could still contribute to a nondeductible IRA for the year -- which has the benefit of tax deferral on gains.

[Poppy]

Dec 15, 2021 15:38:19 GMT -5 mokes said:

Since your husband has existing pre-tax IRA funds, the total of his IRAs will be taxed into account to calculate the tax. As someone mentioned, if he were to roll all over those pre-tax funds into an employer-sponsored retirement account, he could get around that.

He could still contribute to a nondeductible IRA for the year -- which has the benefit of tax deferral on gains.

If the backdoor Roth prohibition does not become law, it might be worth looking into whether he can roll his traditional IRAs into an old employer 401k, assuming he still has one. But the old account I have does not allow this for people who are no longer employed with the company, only for current employees (401k is through Fidelity, although I don't know if it's their rule or my former employer's). Worth the phone call to check, though.

wrt the second part, that's probably not worth doing over a regular taxable account, but you can double check with your financial advisor.