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Before we get started on today’s reader case, we just wanted to let you know that we’ll be attending the Travel Summit in Toronto from Oct 28-29, 2022! If want to come, you can use our affiliate code “MILLENNIAL” to get $50 off: https://thetravelsummit.com/#tickets
Now onward to the reader case!
Today’s reader case poses an interesting dilemma that isn’t typical of our usual early retiree questions, so I was immediately intrigued. Check it out, yo!
Hi Firecracker & Wanderer,
I recently left my job and could use your guidance to decide whether to rollover my 401k to an IRA or not. My new job does not have a 401k plan.
My 401k has both Pre-tax and Roth contributions in it. Based on some internet reading, it looks like the main disadvantage of doing the rollover would be that I can no longer do a straight forward Backdoor Roth contribution because of the pro-rata rule.
In order to understand the implications of each side, in millennial-revolution style, I decided to “math shit up”.
Return Rate: 8%
Years to Retirement: 20
Tax Rate: 37%
Rollover Tax: $116,378.48
Roth Total After Rollover: $325,213.11
Value at Retirement: $1,861,764.84
401k Fees: 0.10%
Pre-tax Value at Retirement: $1,439,129.36
Tax on Withdrawal: $532,477.86
Roth Value at Retirement: $581,327.99
Value at Retirement: $1,487,979.49
Assuming that I will continue to be in the highest tax bracket at retirement (wife wants to continue working + passive income sources), it looks like I’d be better off doing the rollover and continuing to take advantage of the Backdoor Roth contributions.
Not doing a rollover seems to be better if my tax bracket at retirement drops to 11%.
Thank you for everything you do. I really enjoy reading your blogs regularly and thought this was a great opportunity for me to say thank you and possibly contribute to the blog and community as I’m fairly sure many others face the same question.
OK this is less of a traditional reader case and more of a tax question. Let’s do a quick recap of the strategy he’s referring to.
Most people are familiar with Roth IRAs as a tax-sheltered way to save for retirement. You can contribute up to $6000 ($7000 if you’re over 50) a year and it grows tax-free forever. Unlike traditional IRAs which force you to withdraw taxable distributions when you hit a certain age, no such forced withdrawals happen with Roth IRAs.
Roths do have a bit of a quirk though. For some reason, the US government restricts the ability to make contributions if you earn too much money.
I’ve always thought that was such a dumb rule. Helping your citizens save for their retirement is always a good thing, since it means they’re less likely to be destitute and come begging to the government for a handout later, yet this rule discourages higher-income families for no good reason. Similar accounts in other countries like Canada’s RRSP or the UK’s ISA don’t have income limits, so in this regard America stands out as an outlier.
Fortunately, there’s a strategy to get around this limitation. You can elect to make a non-deductible contribution to a traditional IRA, which means you can’t deduct it from your taxable income. Normally, you never want to do this since you’re forfeiting the main tax advantage of using a traditional IRA, but if you do this and then transfer the non-deductible contributions over to a Roth IRA, you have effectively bypassed the income limits on the Roth.
This is a strategy known as the Backdoor Roth IRA contribution, and I wrote up a longer and more detailed explanation here.
How Does a 401K Rollover Affect Them?
Our reader is also asking about doing a 401(k) rollover, which is something you can do too when you leave an employer. Basically, you can fill out some paperwork and have your 401(k) balance transferred or “roller over” into a traditional IRA account that you open on your own. This way, you don’t have to leave your retirement savings with your old employer, which simplifies your accounts as well as potentially saves on fees.
However, this may have an effect on the ability to do backdoor Roth IRA conversions going forward.
The reason for this is a super annoying IRS rule called the Pro-Rata rule.
Basically, if your traditional IRA has both pre-tax and post-tax contributions, withdrawals are taxed based on how much of each was in your account before the withdrawal. For example, let’s say your traditional IRA had $50k in it, and $45k of it was from pre-tax deductible contributions and $5k was from post-tax non-deductible contributions.
If you tried to transfer $5k from your traditional IRA to your Roth IRA hoping that the contribution would be untaxed since it was from your post-tax contributions, the IRS would claim that because your IRA had 90% pre-tax and 10% post-tax contributions in it, the 90% of the $5k transfer, or $4,500, would be considered a pre-tax withdrawal, and therefore taxed as regular income.
Your withdrawals are taxed proportionally, or pro-rata, to the pre- and post-tax makeup of your traditional IRA, hence the name.
Why does this need to be so complicated? I have no idea. It’s the IRS!
Regardless, that means that any pre-tax contributions to a traditional IRA “pollute” it and makes future backdoor Roth IRA contributions less tax efficient.
What Should Our Reader Do?
OK so a few things are interesting about our reader’s situation here.
First of all, he’s expecting to be in a high tax bracket in retirement, which is not usually how retirement works. Normally, when you retire your earned income drops to 0, which means that you’re in no danger of hitting the Roth IRA income levels that limit contributions. You can just contribute the max every year.
However, our reader’s wife, apparently, is planning on continuing to work, and on top of that she apparently makes quite a bit because in order for the Roth IRA’s contributions to be eliminated the annual income of the family has to be above $200k. I think this technically makes her a Sugar Mamma. Nice.
So what that means is that he should not rollover his 401(k) into a Traditional IRA. The minute he does that, the IRA becomes polluted with deductible contributions, and if he attempts to do a backdoor Roth contribution later, the dreaded pro-rate rules would kick in since he’d have both pre-tax and post-tax contributions in his IRA.
So if he’s worried about preserving his ability to make Backdoor Roth contributions after retirement, he should leave his 401(k) alone with his old employer.
Another thing that’s interesting is that he’s moving from a job that offers a 401(k) to one that doesn’t. In the US, it’s up to each individual employer to decide whether they want to offer a 401(k) plan, but if your employer doesn’t offer one, you can still open up your own IRA and contribute to it yourself.
However, he shouldn’t do this.
Once again, as soon as he makes a pre-tax contribution to his traditional IRA account, it becomes “polluted” and can no longer do tax-free backdoor Roth contributions in retirement. What he should do instead is only make non-deductible contributions to his Traditional IRA, then convert them each year to his Roth IRA once he starts his new job.
Granted that this means he’s going to miss out on those sweet sweet tax deductions while he’s working, but it’s the only way to keep his IRA account “clean.”
However, that’s not to say he has to leave everything in his 401(k). He has a 401(k) that can hold both both traditional pre-tax and Roth post-tax contributions, and it looks like he’s made both types of contributions over the years.
A Roth 401(k) can also be rolled over, though rather than transferring it to a traditional IRA like a normal 401(k), it would instead go into a Roth IRA account. This wouldn’t affect the pro-rata rule since it only applies to the balance in your Traditional IRA. So this way, he can save at least part of the 401(k) plan’s management fees.
So basically, he should do this…
Doing this should give him the maximum tax benefits while preserving the ability to do tax-free backdoor Roth IRA contributions going forward.
And as always, our reader should consult with a tax professional before implementing anything because I may not have all the relevant information about his personal tax situation.
So what do you think? Is this the most optimal structure for our reader, or is there something else he should do instead? Let’s hear it in the comments below!
Announcement: We’ll be attending the Travel Summit in Toronto from Oct 28-29, 2022!
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