Author Topic: Specific Questions on Mega Backdoor Roth  (Read 1029 times)

Milkshake

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Specific Questions on Mega Backdoor Roth
« on: January 03, 2020, 11:59:59 AM »
Hi everyone. I've been reading the posts here and on bogleheads about the Mega Backdoor Roth mechanics and tax consequences, and I understand the basic principles but some specifics are still eluding me. I am hoping that some of you brilliant folks can show me the light.

Some background:
So last year our company was purchased by a MegaCorp, and they changed our 401k plan to allow contributions after-tax, non-Roth. They also allow after tax withdraws at any time (To quote: "You may withdraw all or part of your after tax account at any time without incurring a suspension from participating in the Plan.")

I didn't touch my percentage contributions to my 401k, so with merit increases I filled up the pre-tax 401k space and put a little bit over into the after-tax bucket. Once I realized what was going on, I noticed that I was probably now able to execute this Mega BDR. (I was expecting just a bigger paycheck at the end of the year).

Notes:
-Currently we max 2 Roth IRAs, an HSA and 2 401ks, and put some in a taxable account.
-DW is not eligible for any of this Mega BDR stuff, so not worried about that.
-I do not have a tIRA at all.
-Also, my company matches with each paycheck (no lump sum), and they match in after-tax or pre-tax, they don't care.

So here are my questions (mechanics and taxes):

MECHANICS
-How often should I convert to the Roth IRA? Every paycheck? Once per year?
-The plan does not state that there is a limit on number of conversions. Should I ask for confirmation?
-Is there a marinating time (5 years?) for these conversions, the same way that there is for doing a Roth Ladder?
-Will this affect the Roth Ladder plan at all?

TAXES
-How do taxes work with the gains? I know which amounts are gains vs nontaxable, my plan admin shows everything divided out.
-Is a form sent to me? If so, by Vanguard (Roth IRA) or the 401k admin?
-Do I pay taxes immediately upon conversion or at the end of the year?
-Do I need to fill out any special IRS forms?
-Is there automatically a 10% penalty tax applied to the earnings for withdrawing before age 59.5?
     -The plan states that this penalty will be avoided if rolled into an IRA within 60 days. It does not mention Roth IRAs.
-Am I going to need an accountant to do my taxes with all of this? Usually we just use HR Block software, can that handle this slightly more complicated return?

I may have more questions to come, but I really appreciate your help!

seattlecyclone

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Re: Specific Questions on Mega Backdoor Roth
« Reply #1 on: January 03, 2020, 12:38:47 PM »
MECHANICS
-How often should I convert to the Roth IRA? Every paycheck? Once per year?

Any amount your investments grow when it's still in the after-tax 401(k) will be taxed when you convert. The less time you let the money sit in there, the less of this tax you'll pay. Balance this against how difficult it is to do these conversions. If it can be accomplished in just a few clicks online, might as well do it every paycheck. If you need to fill out paper forms and get a medallion signature guarantee and the signature of a notary public, maybe doing it only once a year is a better choice.

Quote
-The plan does not state that there is a limit on number of conversions. Should I ask for confirmation?

Up to you. Worst case if you don't ask, you run into the limit and have to wait until next year to do more.

Quote
-Is there a marinating time (5 years?) for these conversions, the same way that there is for doing a Roth Ladder?

Sort of. The Roth IRA ordering rules break up your balance into three major buckets: your direct contributions (these come out first), your conversions (these come out second), and earnings (these come out last). The conversions bucket is subdivided into smaller buckets by year of conversion (oldest comes out first). Each year's bucket is further subdivided into two smaller buckets: the amount you paid tax on at the time of conversion (this comes out first), and then any post-tax basis you converted (this comes out second).

The 10% early withdrawal tax applies to converted amounts within the past five years that you paid tax on, but not on the post-tax basis.

With the mega backdoor, the overwhelming majority of the amount converted will be post-tax basis. Only any growth that happened while still in the after-tax 401(k) will be taxed when you convert. Convert frequently and this amount will be minuscule, hardly worth considering. If your $1,000 contribution grows by 1% ($10) before you convert it, and you happen to withdraw this amount within five years, you'll pay a whopping $1 tax (10% of $10) on the $1,010 withdrawal.

Do be aware that if you perform some fully taxable conversions these can insert themselves into your conversion ordering by the year you perform the conversion. While the after-tax-to-Roth conversion you make this year can be withdrawn mostly tax-free at any time, remember you can't get at that money until after you first withdraw the taxable conversion you did last year.

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-Will this affect the Roth Ladder plan at all?

See above. If you start Roth conversions of pre-tax amounts before you're done making your mega backdoor contributions, that can affect when your mega backdoor contributions can be withdrawn for free.

However since the mega backdoor contributions can be withdrawn essentially for free at any time, the basis from these contributions may be enough to last your first five years of a Roth ladder and would therefore reduce the amount you might otherwise want to convert prior to retirement to prepare for your post-retirement withdrawals.

TAXES
Quote
-How do taxes work with the gains? I know which amounts are gains vs nontaxable, my plan admin shows everything divided out.

When you make the conversion, the gains are taxable as regular income in the year you convert. At tax time the next year, your 401(k) administrator should send you a 1099-R with two relevant numbers on it: the total amount withdrawn and the taxable portion of that amount. You basically copy these numbers to lines 4c and 4d of your 1040.

Supposing you waited a while before making the conversion and the taxable amount is more than you're willing to pay taxes on at this time, you have the option of splitting your withdrawal so that the basis goes to Roth (untaxed) and the gains go to a traditional IRA (not taxed yet). If the amount of gain is relatively small, I think you should just pay the tax now to make your life easier.

Quote
-Is a form sent to me? If so, by Vanguard (Roth IRA) or the 401k admin?

The 401(k) administrator should send you a 1099-R at the end of the year.

Quote
-Do I pay taxes immediately upon conversion or at the end of the year?

Any taxes due upon the conversion will be added to your overall tax bill for the year. As with tax from your work income or any other income, you're generally supposed to pay your tax as you go through a combination of withholding and/or quarterly estimated payments. Double-check your paycheck withholding to make sure you'll cover your overall tax liability (or at least meet one of the safe harbors), and you should be good.

Quote
-Do I need to fill out any special IRS forms?

Not yet. For now this transaction is just reported on your 1040 lines 4c and 4d (labeled "pensions and annuities"). When it comes time to withdraw from your Roth IRA in the future you'll need to fill out Part III of Form 8606 to track your Roth basis and determine how much of the withdrawal (if any) is taxable. To do this you'll need to keep records of what your basis is. Keep your 1099-Rs and any other statements and forms that track when money goes into your Roth IRA and from where. You'll need them later.

Quote
-Is there automatically a 10% penalty tax applied to the earnings for withdrawing before age 59.5?

The earnings within the Roth IRA are charged federal income tax at your standard rate plus a 10% early withdrawal tax if withdrawn early. Try to avoid needing to dip that far down into your Roth IRA before then.

Quote
-The plan states that this penalty will be avoided if rolled into an IRA within 60 days. It does not mention Roth IRAs.

I think either type of IRA is fine for a 60-day rollover. Don't do a 60-day rollover. These are limited to one per year. Your 401(k) administrator should be able to either do a direct transfer to your IRA, or make out a check to "<your IRA custodian> FBO (for the benefit of) <your name>". Either one of these methods is not considered a 60-day rollover because you never actually take possession of the funds, and therefore is not subject to the limitations on those.

Quote
-Am I going to need an accountant to do my taxes with all of this? Usually we just use HR Block software, can that handle this slightly more complicated return?

Probably not. Just make sure to enter the 1099-R into your software, make sure to mention that it's a rollover, and check that the numbers transfer to the correct lines on your 1040.

Milkshake

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Re: Specific Questions on Mega Backdoor Roth
« Reply #2 on: January 03, 2020, 01:41:13 PM »
Excellent breakdown @seattlecyclone! Thank you very much for taking the time to answer those questions, I really appreciate it.

I'll do a conversion this month for the after tax money that was put in at the end of last year, to get a feel for how difficult it is. It sounds like it will be paper checks, not electronic, but should be straightforward otherwise. I'll probably do it each year at the end of Q3 and Q4.

Assuming it goes well, this year I'll bump up my 401k percentage so it fills up as much as I can afford into my 401k. I should be ok with my Roth ladder, as I plan to have enough in Roth contributions and taxable accounts to cover my 5 years of waiting time for the first rung of the ladder to be ready.

So step-by-step:
1) Fill up 401k
2) End of Q3 (or whenever makes sense) request a check for the full, after tax amount made out to "Vanguard FBO <my name>"
3) Mail the check to Vanguard with a letter stating that I would like the full amount converted into my Roth IRA <account number>
4) Repeat at end of Q4 (or whenever makes sense)
5) At tax time, use the 1099-R provided by my 401k admin to fill out section 4c and 4d of my 1040
6) Repeat next year

And things I need to confirm still:
1) Find out if there is a limit on number of times I can withdraw the after-tax money
2) Find out what wording Vanguard wants on the letter that goes with the check

trc4897

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Re: Specific Questions on Mega Backdoor Roth
« Reply #3 on: January 13, 2020, 10:50:18 AM »
I was just about to post the same questions on here, looks like you beat me to it! And I'm glad because I was having a hard time coming up with the right questions haha.

We are planning to do the MBR this year for the first time (my wife's employer allows it). Her employer only allows 2 conversions per year though, so i think we will also do Q3 and Q4 conversions like you plan to.

Are you planning to invest in bond funds to make sure the gains are small before you make the conversions? Or just investing in the same funds you put in your 401k?

Milkshake

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Re: Specific Questions on Mega Backdoor Roth
« Reply #4 on: January 13, 2020, 12:21:29 PM »
I've just kept everything in my S&P index fund, as I don't plan to have a lot of gains between each conversion. I've finally gotten confirmation that my plan allows unlimited conversions of after-tax money. So once I confirm with Vanguard how they want things done, I will execute this first one and see how it goes. It also looks like I can complete the request online, but they will mail me a "FBO" check. If it goes smoothly (easy online, easy send to VG, no complications) then I will probably do this every month that I have after-tax contributions (roughly 5-6 times each year).

I'll update here when it goes through, or if I run into complications along the way.

*Edit to add: deep in the bowels of my 401k's terms and conditions, it says the rollover to an IRA must be more than $1000 or else it will be distributed to me rather than the financial institution. I would still be eligible to move that via the 1x per year 60 day rollover, but that's not ideal. Not a big deal, I will always make sure I rollover more than $1000 to my Roth IRA each time.
« Last Edit: January 13, 2020, 01:49:24 PM by Milkshake »

trc4897

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Re: Specific Questions on Mega Backdoor Roth
« Reply #5 on: January 13, 2020, 01:28:49 PM »
Awesome thanks! Hope it goes smoothly for you

Milkshake

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Re: Specific Questions on Mega Backdoor Roth
« Reply #6 on: January 14, 2020, 07:49:05 AM »
So to update this with my experience so far:

It took about 10 minutes on Vanguard (online) to "prepare" them for the incoming rollover.
It took another 10 minutes or so on my 401k admin website to initiate the rollover. There is a $5 dollar processing fee for every rollover I do, something I'll have to do the math on and hit the sweet spot between $5 fee and $5 or more in taxes on the gains.

My admin can send the check directly to Vanguard, but the added Vanguard account has to have been linked for 7 days before I can execute the rollover. So VG is awaiting the check, and I have to wait 7 more days. I'll update once I can submit the rollover.