I hope all you savvy readers know what a backdoor Roth IRA is? You don’t? It’s really complicated, which is why posts are generally 200000 words or more and have diagrams.. here’s my explanation:
If you earn too much to pay into a Roth (per this chart) then you can instead contribute to a Traditional IRA, and roll it to a Roth. The confusion people have in grasping this concept is that Traditional IRA’s also have salary limits. The answer to this confusion is knowing that the limits for Traditional IRAs are only referring to the limit of salary where you are able to deduct the contribution. IE if you earn too much, you can still contribute to a Traditional, just not deduct it, and then roll it over to a Roth. This is called a.. wait for it.. nondeductible Traditional IRA.
Got it? If not, ask away in the comments and I’ll try my best to help explain.
What’s a Sidedoor Roth then?
Chances are you haven’t heard of this term, because I made it up. It came up when reviewing financial options for 2015, let’s explain in 2000000 words:
Tom (Married, Filing Jointly.. MFJ) earns $60,000 in AGI and has $100K in his current employer 401k plan, his goal is to quit this year to be a full time blogger selling credit cards in exchange for his soul. This year Tom contributed $18K to his 401K. He also has $11,000 in an old Traditional IRA at Fidelity. His wife Jerry does not work, and spends most of the day watching real housewives of New York, and is currently working on a book deal that should net her a solid income for 2016.
Tom, anticipating 2016 and beyond income to increase, decides that this is a good time to rollover some of tax deferred money into Roths, ready for tax free growth.
The $60,000 AGI is reduced by $18,000 to $42,000. As he is MFJ he is in the 15% tax bracket until he reaches $74,900 for 2015. This means he can covert $32,900 of his 401K to a Roth at the 15% rate. To do so, he has to do the following:
Rollover (custodian to custodian is best to avoid messing this up) the 401(k) to a low cost IRA provider, such as Vanguard. It would move into a Traditional IRA at Vanguard (no taxable event for the move). He would then elect to convert $32,900 into a Roth also at Vanguard. The transaction would increase his tax for the year, as the IRS counts the Roth conversion as taxable income, reported on the 1099R.
Where’s the Sidedoor?
Tom has had an interesting year. He has reduced his AGI by contributing to the tax deferred 401(k), and then he has bumped the AGI back up again by shifting money from the 401k to the Roth. And now he is at the top of the 15% bracket, any income above that is going to get hit with a 25% rate, a huge leap. He also has a few predicaments:
- He has most of his old 401(k) money still in the Traditional IRA
- He hasn’t contributed to his Traditional IRA or Roth for the year (nor has Jerry)
- 401(k) reduces by $11K rolled to Roth
- Traditional increases by $11K
So in this case, why not just do a regular Roth contribution rather than mess with the Traditional and rolling the traditional into a roth? Sounds like a lot more hassle for the same net?
Enter the Sidedoor Roth™
Interestingly, if you go straight to Roth vs Traditional (deductible) to Roth you lose out on something, such is the tax code. By stepping through the Traditional on route to the Roth you buy some time to feel out the market, and if it doesn’t perform as you hoped, you can change your mind, and get the tax paid back. Here’s Tom again:
They elect to contribute $11,000 to a Traditional IRA for 2015, and rollover their $11,000 at Fidelity. The events wash out any tax impact.
They then go on to invest the $11,000 at Fidelity into GoPro, because Tom has one and thinks they are super. By spring, GoPro has dropped another 50% and their account now is valued at $5,500.
If they contact Fidelity by October 15th, they can ask to reverse the decision to Roth covert. This doesn’t mean they can reverse the decision to invest in the silly single stock, so the account value is reduced still, but they can file an amended 1040 tax return, called the 1040x before the due date for amended returns. Doing so means that the tax they paid on the conversion ($11,000*15%) or $1650 would be returned to them.
This ability to change your mind on the conversion to a Roth means that if the investment does sour, it is possible to backtrack, and get your tax back. This is unique to a Roth that has been converted, so even when it seems like we had a ‘wash’ between funding a Traditional IRA and a Roth in Toms case, there is actually an edge by creating the Sidedoor Roth IRA™.
Note that this is a complicated procedure, and not for everyone. However, if you have rolled into a Roth and the investment hasn’t performed, you may be able to reverse that decision if you meet the deadlines, and it could mean you get a tax refund.
The post Should you do a Sidedoor Roth IRA? appeared first on Saverocity Finance.
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