@Laura33: Many thanks for your great explanation! I have all my accounts in Fidelity and Vanguard and both support IRAs and ROTHs transaction online or via phone. I have a few doubts about your reply:
"Called the fund company that I have my EF with (money market account that had gotten too high)." A bit confused by EF, what does this acronym stands for? So it's a money market account. Would the process be different if instead of a money market account I use my 401K? Asking since that's what I will do when I quit my job and seems that it's one of the most common ways to do the ROTH ladder conversion thing. And do I need to move all the 401K money at once or just the annual amount I need every year? I want to make sure I don't mess up in the "moving money" part.
Last question to Laura: I never paid taxes for 401K, I thought once you take it out, you paid taxes, but it seems that if it's moved to an IRA it does not apply? I know it's a loophole but man, that is a huge loophole! From your explanation, only capital gains from the day I move the money to IRA to day I move to ROTH IRA will be taxes which will probably be close to 0.
Yeah, sorry, emergency fund.
I think MDM has pretty much covered it, but in case: I would roll your entire 401(k) over to a tIRA at once. This is NOT a taxable event. This allows you to put your money in whatever low-expense funds you want, vs. being stuck in your 401(k)'s fund choices (which likely have higher expenses).*
Then every year you convert a part of that tIRA to a Roth. Because you have not been taxed on the money you put into your 401(k), the
entire amount you convert is treated as taxable income. This is why people usually split the conversions across multiple years (because if your 401(k) rollover gives you a $1M tIRA, and you convert the whole thing to a Roth in one year, Uncle Sam will treat you as if you made $1M that year. And that means you will pay far, far more taxes on that money than if you converted, say, $40K/yr).
The reason the article says not to roll over from your 401(k) to an IRA in the same year you do a conversion is because they are talking about minimizing taxes associated with doing a
Backdoor Roth every year. That is not what you are doing.
-- Backdoor Roth: You do this when you are in the "amassing assets" mode; the goals are (a) to give yourself a way to put new savings into a tax-sheltered investment that you cannot contribute to directly, and (b) to minimize the taxes you pay in getting your money into that vehicle. Every year, you set up nondeductible tIRA**, then convert it to a Roth. Because you have already paid taxes on the money you used to fund the tIRA, when you convert it to a Roth, you pay taxes only on the gains in the account since you first opened it.
But the big caveat here is that the IRS looks at all of your tIRAs as one big pot, no matter how many individual accounts you have. And if you have a deductible tIRA out there, and you convert it to a Roth, you have to pay taxes on the entire amount of money you convert (because you never paid taxes on that money when you set it up). So if you have say $95K in an existing deductible tIRA, and you start a new nondeductible tIRA with $5K, and then convert $5K of your tIRA money into a Roth, the government will assume that you took 95% of that money from your deductible account and 5% from your nondeductible account -- meaning that you will pay taxes on 95% of the amount you convert! Look at step 1 of the article again: the first thing they want you to do is "hide" all of your other deductible tIRAs (by, say, rolling them into your 401(k)), so every year when you open a nondeductible tIRA, that is the
only tIRA you have (i.e., you don't have any other deductible tIRAs hanging around)***, and so all of the money you are converting into the Roth comes from the nondeductible tIRA, which means you pay taxes only on the gains between when you started that account and when you converted it (which should be minimal).
-- 401(k) rollover to tIRA: The 401(k) rollover, OTOH, is typically what you do at the end of your working career -- now, instead of putting more money into tax-sheltered accounts, you are figuring out how to withdraw that money (a) at an earlier age than allowed for a direct withdrawal from an IRA/401(k), and (b) in a way that minimizes the taxes you owe. So here, you roll over your 401(k) into a tIRA, and you then convert that tIRA over time into a Roth (because a Roth lets you withdraw the money you put into it after 5 years, even if you're not 59.5). In this case, all of the $ you are rolling over is pretax $$, and so you are going to have to pay taxes on 100% of what you convert to a Roth -- the conversion from a rollover IRA to a Roth is treated exactly the same for tax purposes as the conversion from a deductible tIRA to a Roth (because your new IRA "inherits" the deduction you got when you initially made the contributions to the 401(k)). In this case, what you are doing is stringing out the conversion from the rollover tIRA to the Roth so you pay a lower tax rate than if you did it all at once (because, per the example above, someone with $40K in taxable income pays a much lower marginal tax rate than someone with $1M in taxable income!).
--
The problem is when you combine those two very different things in the same year. Remember that the first step for the Backdoor Roth (to make it the most "tax-friendly") is to get rid of any existing deductible or rollover tIRAs. But if you are doing the Roth pipeline, the first thing you are doing is creating another rollover tIRA that is going to trigger taxes when you convert it to a Roth! Which is exactly the opposite of what you want to do to take advantage of the Backdoor Roth. So what they are saying is, hey, don't try to do both of these things in the same year, or else you won't get the full tax benefit that you'd get from the standard Backdoor Roth option.
-- But again, if you are in the withdrawal stage, you are very likely
only doing the Roth pipeline -- taking existing tax-sheltered investments and moving them around to be able to withdraw them earlier and with the lowest overall taxes. So you don't have to worry at all about that warning, because you are just moving existing investments around and are going to need to pay taxes on those conversions anyway.
*The exception to this is if you retire between 55-59, most plans allow you to begin taking withdrawals from your 401(k) immediately, without waiting until you are 59.5 So if you wait until 55 to retire completely, you don't even need to worry about the Roth pipeline, since that is primarily useful for accessing 401(k)/IRA funds before you turn 59.5.
**Implementing deductible vs. nondeductible: see the same article: "You do not specify to the custodian whether the IRA is deductible or not; it is just treated as an IRA. Non-deductible simply means that you do not deduct the IRA contribution on your 1040 tax form (the transaction is recorded on form 8606 and submitted with your tax return)."
*** Money from any other nondeductible tIRA is not a problem here -- again, see the article. Just trying to simplify the explanation rather than get caught up in all the caveats.