Traditional IRA with non-deductible contributions versus Roth IRA

[BMcCalpin]

As you know, you can have non-deductible contributions in a traditional IRA. In a Roth IRA, all contributions are non-deductible. Having non-deductible contributions in a traditional IRA creates record-keeping problems - how many times have we seen taxpayers ask what to do because they don't know what their basis is in an IRA? And has the taxpayer remembered to file the 8606 every year that it was required?

Is there any good reason to keep non-deductible contributions in a traditional IRA rather than rolling it over to a Roth IRA, where, by definition, all contributions are non-deductible, so the record keeping burden is less (and future gains will be tax-free)?

Yes, any gains in the traditional IRA "rolled over" would be declared as income, but perhaps this would not be much of a hit if the non-deductible contributions were recent. I guess the possible 10% early distribution penalty on the taxable amount is a consideration.

In the same vein, if you discover that your traditional IRA contribution in the current year is not deductible, is there any reason not to do the backdoor Roth conversion? Wouldn't having only deductible contributions in the traditional IRA make life easier for everyone down the road?

This is not an actual case, but a question for planning purposes for the many TurboTax users who need to decide how to handle current and previous non-deductible IRA contributions.

[TomYoung]

Making a "backdoor" contribution to a Roth IRA by converting a nondeductible contribution to a traditional IRA is a common occurrence.  But this strategy works the best and is the easiest to handle for reporting purposes when you have no traditional IRAs with deductible contributions anywhere in your portfolio. 

That's because for tax purposes all your various traditional IRAs is considered to be one big pool of traditional IRA money.   Money taken out of any one of your traditional IRA for whatever reason is treated as coming out of the "pool" of IRA money, and the money comes out as a mixture of deductible and nondeductible money.  It's not possible to convert only the nondeductible portion of your contributions. 

[BMcCalpin]

Thanks, Tom. That's the sort of thing I was looking for.

But I am puzzled about this sentence: "But this strategy works the best and is the easiest to handle for reporting purposes when you have no traditional IRAs with deductible contributions anywhere in your portfolio. " Are you saying that if you already have traditional IRAs but with no basis in any of them, that in the current year when you discover that you can make only a non-deductible IRA contribution, that you can still make the backdoor conversion without considering all the other IRAs? I am looking at "traditional IRAs with no deductible contributions" and wondering why this would be better in the context of the backdoor strategy, unless I am misreading the intent of your comment.

[TomYoung]

Well the point is that if you have IRAs with deductible contributions in your portfolio then attempting to do a back door conversion for "this year's" nondeductible contribution isn't going to get rid of all that nondeductible contribution from your "pool" of IRAs.  You'll still have to account for the remainder of the nondeductible contribution that's "left behind" and the conversion itself will have a taxable and nontaxable portion. 

Your second paragraph of your original post, ("Is there any good reason to keep non-deductible contributions in a traditional IRA..."), suggests that you can isolate only the nondeductible contribution and convert that to a Roth IRA, but you simply can't do that.

[Critter]

Another reason to not convert is the age of the person and the income tax bracket they are in at the time ... say you are 65 years old and still making income in the 25% tax bracket ... to convert you would pay taxes at the rate of 25% so you have to take into consideration the ability of the ROTH to earn back what is lost in taxes paid ...easier to do when you are 40 but not if you are 65.

[dmertz]

That's not really true.  The taxes on the money in the traditional IRA will have to be paid sooner or later at the tax rate to which the recipient (traditional IRA owner or beneficiary).  So it's important to estimate the tax rate to which taxable amounts in the traditional IRA will be subject.  For someone who will have the same or higher marginal tax rate in the future and pays the taxes with non-retirement money, break-even will be essentially immediate.  One is effectively moving money otherwise subject to taxes on gains outside a retirement account into the Roth IRA where it will experience tax-free growth.  That tax-free growth can even make up for a current marginal tax rate for the conversion that is slightly higher than the marginal tax rate anticipated in the future.  Also consider that many people do not drop to a lower marginal tax rate in retirement due to the effect of taxation of Social Security benefits and taxable distributions from pensions and RMDs from traditional IRAs and employer plans.

[BMcCalpin]

These are all good comments! Thanks Tom, Critter, and dmertz for your thoughts!

At the outset, I was wondering if there was a way to reduce taxpayer record keeping by moving all after-tax contributions in IRA(s) to a Roth account. From your comments, there does not seem to be, unless ALL of the amounts were after-tax...and even then, the gains on the after-tax amounts in the traditional IRA(s) would still be subject to income tax in the year of moving from traditional to Roth (which may or may not be a big deal).

While the discussion of whether or not for any given taxpayer such a movement would be wise is a good one, it is beyond the scope of this more simple question. But, in fact, one of the original purposes of the Community was to encourage such "what-if" questions that go well beyond questions on this or that form, and I would encourage some of you to think about whether people would benefit from you starting a thread on "what are the considerations that should go into deciding on whether or not to move amounts in traditional IRAs to Roth IRAs?" (some of them have already been alluded to here).

Thanks, again, guys...