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Back Door Roth


Corduroy Frog
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Talk about unnecessary complications in the tax code.

Incomes over a certain level do not qualify for a Roth IRA.  So those in the high income bracket simply open up a conventional IRA, deduct it, and then recharacterize the thing into a Roth in a couple days or so.

So why doesn't the tax code simply allow for a Roth to begin with, regardless of income level?

Does it have anything to do with not allowing the conventional to be deducted at high levels?  Doesn't seem to matter, the taxpayer can designate the whole thing to be non-deductible, and then he (she) will have a basis when recharacterization occurs.

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9 hours ago, Corduroy Frog said:

So those in the high income bracket simply open up a conventional IRA, deduct it, and then recharacterize the thing into a Roth in a couple days or so.

Does it have anything to do with not allowing the conventional to be deducted at high levels?  Doesn't seem to matter, the taxpayer can designate the whole thing to be non-deductible, and then he (she) will have a basis when recharacterization occurs.

For the backdoor Roth, when qualifying to convert, but not to contribute, to a Roth: open up a non-deductible Traditional IRA (works best if you have no other Traditional IRAs), do NOT deduct it, and then CONVERT the thing into a Roth, hopefully before any earnings.

Yes, it is because a Traditional IRA can NOT be deducted at high income levels.

A non-deductible Traditional IRA with basis still DEFERS taxes on the earnings/appreciation. But there WILL be taxes on everything in excess of the basis.

A Roth IRA ELIMINATES taxes on everything if used per the regulations.

You can convert some or all of an existing Traditional IRA to a Roth IRA at any time, but having basis in some of your Traditional IRAs adds more computations.

Someone will jump in to let me know if I should be using the term Roll Over instead of Convert, and explain the whole process better than I can.

But the Back Door Roth has a place in retirement planning for high-income clients. Many want a mix of taxable and not-taxable income when they retire, or are trying for non-taxable Roths due to already expecting taxable pensions and SS, or want a non-taxable account to leave to heirs so their heirs won't have to sell things to pay the taxes or...

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16 hours ago, Corduroy Frog said:

So those in the high income bracket simply open up a conventional IRA, deduct it, and then recharacterize the thing into a Roth in a couple days or so

But there are potential pitfalls that would not occur if a front door roth contribution was made.

For a taxpayer with existing traditional IRAs, the recharacterization can become a significant taxable event due to the pro-rata rule.

Also need to keep in mind the 5 year rule.

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IRS has been unhappy with the back door approach for years but congress won't change it.  Who knows, maybe most of them take advantage of it?  Heed Danrvan's advice if the client already has a traditional IRA.  Say you're over AGI and contribute $6k to your traditional that's nondeductible.  You can't just pull that $6k out and convert it to a Roth.  If your IRA balance was $100k and you convert the $6k, only .06 percent will be treated as basis and the rest will be taxable. Also be aware that before this year, people 70 1/2 or older couldn't contribute to a traditional at all, so the back door was closed.

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17 hours ago, Corduroy Frog said:

Good conversation.  The biggest potential pitfall apparently occurs when a Traditional IRA already exists.  If basis in the Traditional, taxpayer cannot pick and choose when to relinquish the basis.  Basis must be eliminated pro rata.

Correct.  Because there will always be basis in IRA, a calculation should always be done for how much of distribution is taxable for the rest of their lives.  

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  • 4 weeks later...

Completely unrelated but interesting case:

 

https://www.propublica.org/article/lord-of-the-roths-how-tech-mogul-peter-thiel-turned-a-retirement-account-for-the-middle-class-into-a-5-billion-dollar-tax-free-piggy-bank

 

Summary: Guy who founds Paypal (before it went public) is given stock with an ultra low cost basis as part of his salary contract. The cost basis is deemed $1,700 so he puts the shares into his Roth IRA. The company goes public shortly after that and those shares are worth well over $100m. He does this multiple times with different companies and his Roth IRA is now worth $5 Billion which he'll never pay $1 in tax on if he holds off on withdrawing.

Yes it's all strictly prohibited but the IRS never audited him. You would think a $1,700 Roth value going up 9 figures in one year might draw an audit flag. First, he was a principal in the company so that's a violation. Second, he contributed stock and not cash which is prohibited. Third he valued the shares at far below market value and the IPO disclosures of the firm outline they were below market value.

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