Sold $100,000 stock can I place in IRA and do Roth Conversion

[Ethan Tax Question]

I sold 100,000 of stock and make 80,000 a year so I am over the maximum Wage to submit to Roth IRA. Two questions, I wanted to place money in a roth so can I first place in a traditional IRA and then do a Roth Conversion. It may not make sense because my tax rate will be higher then it normally is because of the sale. Are there other ways to reduce my tax rate? I do own a home and have a loan if that helps.

[macuser_22 · Accepted solution]

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@Ethan Tax Question wrote:

I sold 100,000 of stock and make 80,000 a year so I am over the maximum Wage to submit to Roth IRA. Two questions, I wanted to place money in a roth so can I first place in a traditional IRA and then do a Roth Conversion. It may not make sense because my tax rate will be higher then it normally is because of the sale. Are there other ways to reduce my tax rate? I do own a home and have a loan if that helps.

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The maximum IRA contributions  is $6,000, or $7,000 if you’re age 50 or older by the end of the year; or your taxable compensation for the year which ever is less.

(Taxable compensation is generally wages that you worked for - W-2 or net self-employed income minus the deducible part of the SE tax, but can include commissions, certain alimony and separate maintenance, and nontaxable combat pay ).

See IRS Pub 590A "What is compensation" for details:
https://www.irs.gov/publications/p590a#en_US_2018_publink1000230355

See this IRS link for Traditional IRA deduction limits when covered by a retirement plan at work.

https://www.irs.gov/Retirement-Plans/IRA-Deduction-Limits

[fanfare]

the only way to reduce tax is to sell other stock on which you have a loss.

After 31 days have passed, you can buy that other stock back.

[fanfare]

A backdoor Roth will be a non-event tax-wise as long as you currently have no Traditional IRA.

[Carl]

I could be wrong (but I doubt it) but your gain on sale of stock does not count for anything for contributions to any type of IRA - be it ROTH or Traditional. Contributions to an IRA are based on earned income, and gains on stock sales are not *earned* income.

If I'm wrong on this, someone please let me know.

[TomD8]

"I wanted to place money in a roth so can I first place in a traditional IRA and then do a Roth Conversion."

Yes, you can do that.  What you're proposing is called a "Backdoor Roth IRA."  It's a strategy often used by people who want to open a Roth IRA, but whose income is in excess of the allowable amount for making Roth IRA contributions.  That "allowable amount" is based on your modified AGI.  These limits are well explained on this IRS web page:

https://www.irs.gov/retirement-plans/plan-participant-employee/amount-of-roth-ira-contributions-that...

A Backdoor Roth IRA is perfectly legal and fully acceptable to the IRS.   Also, the $6000 limit that others have referred to does not apply to backdoor conversions.  It applies to annual contributions.

Setting up a Backdoor Roth is a bit tricky, and there can be significant tax consequences.  I strongly urge that you contact the bank or broker that you want to be the trustee for your planned IRA (or your own financial adviser, if you have one), and tell them that you want to open a Backdoor Roth IRA.  They should be happy to assist you and to walk you through the process.  Be sure the person you talk to has expertise about Backdoor Roth's.  

[macuser_22]

The "Backdoor Roth" does not exist in tax law. It is a procedure used by some to take advantage of a quirk in tax law that allows making a non-deductible contribution to a Traditional IRA when one cannot contribute to a Roth IRA, and the immediately converting the Traditional IRA to a Roth IRA, thereby getting the money into the Roth via "backdoor".

That "procedure" can only work of all these requirements are met:
1) No Traditional IRA account whatsoever can exist (that includes any SEP or SIMPLE IRA accounts) at the start.
2) The Tradition IRA contributions must be reported on a 8606 form as non-deductible.
3) The conversion to a ROTH must be shortly after the contribution to avoid taxable gains.
4) The entire Traditional IRA value must be zero that the end of the year of conversion.

Otherwise the conversion will be partly taxable.

[TomD8]

Just to clarify, @macuser_22 's 4 requirements are not requirements to open a Backdoor Roth, they're requirements to do so with little or no tax consequences.

Again, I strongly suggest you seek professional guidance if you want to do this.  A Backdoor Roth can be a very good retirement savings strategy, as a professional should explain.

[macuser_22]

Then it is simply a Roth conversion that.   The whole concept of a "Backdoor Roth" is to make a non-deductible Traditional IRA contribution and then convert that contribution to a Roth so that the non-deductible contribution "basis" exactally offsets the tax so there is no tax at all and it behaves the same as if the contribution has been to the Roth in the first place.

If the conditions I posted are not met, then it is simply a conversion of an IRA that has a basis that will only offset part of the tax depending on those factors.

[Opus 17]

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@TomD8 wrote:

"I wanted to place money in a roth so can I first place in a traditional IRA and then do a Roth Conversion."

Yes, you can do that.  What you're proposing is called a "Backdoor Roth IRA."  It's a strategy often used by people who want to open a Roth IRA, but whose income is in excess of the allowable amount for making Roth IRA contributions.  That "allowable amount" is based on your modified AGI.  These limits are well explained on this IRS web page:

https://www.irs.gov/retirement-plans/plan-participant-employee/amount-of-roth-ira-contributions-that...

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But this taxpayer has $100,000 sitting in the bank, and you can still only do the backdoor at $6000 or $7000 per year, correct?

@Ethan Tax Question , the first thing you need to process is that the entire stock proceeds aren't taxable income, only the capital gains.  The gain is the difference between the sales price and your cost basis.  Your cost basis is what you paid for the stock originally.  (If the stock was a gift, your basis is what the giver paid, and you could have a real problem on your hands.  If the stock was an inheritance, your basis is the value on the date the previous owner died.)

I doubt the entire $100,000 is taxable gain.  

Second, remember that long term capital gains (held more than 1 year) are already taxed at a lower rate than most other income.

Third, realize that even if you do a backdoor Roth for whatever amount, it won't change the tax you owe on the capital gains from the sale of the stock.  You're stuck with that bill.  A backdoor Roth can be used to avoid future taxes, as long as you are prepared to put the money away until you retire.

(Take two scenarios.

a. You keep the $100,000 and invest it in a regular broker account.  You will pay some tax every year on interest and dividends, and you will pay long term capital gains tax on the gains only, when you sell.  You can sell at any time for any financial need, such as a house or other large purchase, vacation, unemployment, etc.

b. You put the $100,000 in a broker account, and every year you do a $6000 backdoor Roth conversion, gradually depleting the broker account.  If you wait until retirement, you won't pay any tax on withdrawals from the Roth IRA.  But if you need the money early, you could pay 34% tax on the gains you withdraw (regular income tax plus penalty) instead of 15% long term capital gains tax.)

You should probably consult with a financial advisor.

[TomD8]

@Opus 17 

<<"But this taxpayer has $100,000 sitting in the bank, and you can still only do the backdoor at $6000 or $7000 per year, correct?">>

That is correct, a taxpayer's new contributions to a Roth or Traditional IRA are limited to $6000  per annum ($7000 if over 50).  So the OP can only move his $100,000 into an IRA  at a rate of $6000 (or $7000) per annum.

But there is no income or contribution limit on the amount of money a taxpayer can convert from a Traditional to a Roth IRA, which is how a Backdoor Roth is done.  The curve ball is that there will be a tax bill on any pre-tax money sitting in any or all  of the taxpayer's existing traditional IRA's, thanks to the IRS's pro-rata rule.  The pro-rata rule can be a bit confusing.  Scroll down to The pro-rata rule in this web reference to see an explanation:

https://www.nerdwallet.com/blog/investing/backdoor-roth-ira-high-income-how-to-guide

Of course the pro-rata rule only becomes a problem if the taxpayer already has money in Traditional IRA's.

[Opus 17]

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@TomD8 wrote:

@Opus 17 

<<"But this taxpayer has $100,000 sitting in the bank, and you can still only do the backdoor at $6000 or $7000 per year, correct?">>

That is correct, a taxpayer's new contributions to a Roth or Traditional IRA are limited to $6000  per annum ($7000 if over 50).  So the OP can only move his $100,000 into an IRA  at a rate of $6000 (or $7000) per annum.

But there is no income or contribution limit on the amount of money a taxpayer can convert from a Traditional to a Roth IRA, which is how a Backdoor Roth is done.  The curve ball is that there will be a tax bill on any pre-tax money sitting in any or all  of the taxpayer's existing traditional IRA's, thanks to the IRS's pro-rata rule.  The pro-rata rule can be a bit confusing.  Scroll down to The pro-rata rule in this web reference to see an explanation:

https://www.nerdwallet.com/blog/investing/backdoor-roth-ira-high-income-how-to-guide

Of course the pro-rata rule only becomes a problem if the taxpayer already has money in Traditional IRA's.

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Right, so assuming the taxpayer does not already have an IRA, they can convert $6000 or $7000 per year into a Roth via the backdoor, if they aren't eligible for straightforward contributions. 

If the taxpayer already has a traditional IRA, the simplest thing to do is to convert the entire amount to a Roth IRA and use the lump sum of stock income to pay the income tax on the conversion, then if there is any money left, they can convert a further $6000 per year.

And this is all assuming that the taxpayer is OK with the tradeoff of not being able to touch the new growth until retirement age.  

 (We should probably also add that if the taxpayer is married, they can probably convert another $6000 or $7000 per year into a Roth in their spouse's name.)