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Learning, Sharing, and Teaching => Ask a Mustachian => Topic started by: stouset on May 01, 2013, 08:32:00 PM

Title: Roth 401(k) and backdoor conversions vs. traditional 401(k)
Post by: stouset on May 01, 2013, 08:32:00 PM
Long story short, this year my wife and I should begin making more than the amount that would allow us to qualify for Roth IRA contributions. We're faced with, I think, two practical options for maximizing our retirement savings:

The sticking point is that we'd like to retire sometime soon: in 10 years, perhaps. Maybe 15 if we still enjoy working. At that point, it would be better to have more money in a 401(k) since we could then begin to do yearly Roth IRA conversions, keeping our taxable income (and thus taxes) extremely low. On the other hand, this limits the amount that we can save in tax-advantaged accounts to the maximum 401(k) contribution for two people.

On the other hand, if we contribute to a *Roth* 401(k), this allows us to continue contributing to our Roth IRAs through backdoor conversions. This maximizes the *total* amount we save now, but guarantees us an almost worst-case tax rate. If we tried with this strategy while contributing to a traditional 401(k), when we eventually roll the funds into an IRA (for instance, when changing jobs), to keep doing conversions we'd essentially have to convert *all* of the existing IRA funds in order to get tax-free compounding on the new contributions. This is an even worse situation, tax-wise, as it would bump our income even higher for that year.

I support one possible alternative is to try and have the best of both worlds with 401(k) contributions, but *not* rolling them over into IRAs when I change employers. This way, I can keep performing backdoor conversions into a Roth IRA while still keeping some money in pre-tax accounts, so I can convert it nearly tax-free during my retirement years. But it has the possibility of being significantly more complicated, and some employer retirement plans effectively force you into performing a rollover once you've left the company, otherwise sticking you in extremely expense-ratio-heavy, low-return funds until you do.

So, what's the best strategy here? *Is* there a best strategy?
Title: Re: Roth 401(k) and backdoor conversions vs. traditional 401(k)
Post by: Joet on May 01, 2013, 08:43:44 PM
Do you have any dangling iras from prior employers?

Why not put 17.5k + match into 401k and 5.5k into Ira--Roth via back door

You realize you can contribute to a normal no deductible Ira and immediately convert to a Roth now that they've removed income restrictions on conversions right?

I'm in a similar situation as you and I follow this but take it one step further... My 401k allows in-service withdrawals so I contribute 25k in post-tax to my 401k in addition to the pretax 17.5k + match, then, once a year I move that post tax portion into my Roth directly. Magic!

Eg 17.5k 401k + 6.5k match into 401k pretax
25k post-tax into 401k sent to Roth 1x year
5.5k into Ira converted to a Roth directly
For a net of 24k 401k, 30.5k Roth contribs per year

Pretty slick, spouse does the same
Title: Re: Roth 401(k) and backdoor conversions vs. traditional 401(k)
Post by: stouset on May 01, 2013, 09:18:07 PM
First off, no match on the 401(k). And we have a dangling IRA from a previous employer, but I plan to convert the entire amount this year if we do go the conversion route.

My wife and I *can* put 17.5k (each) into a traditional 401(k) and 5.5k into the Roth via the backdoor. But then, if (and likely when) we switch jobs, we're in a new dilemma.

If we roll over the 401(k) contributions into an IRA, to use the backdoor we'd have to convert tax-advantaged 401(k) funds as well (in direct proportion... so if I had, say, $17,500 from a 401(k) in a rollover IRA, and put a $500 monthly contribution into a non-deductible traditional IRA, $500 converted into the Roth would consist 97% of rollover IRA funds and 3% traditional IRA funds. To convert all the non-deductible funds we'd have to convert all of the former 401(k) funds as well; this would then count as income, raising our tax level even further!

If we *don't* roll the funds into an IRA and choose to keep them at the employer, we could likely be stuck with very poor choices of funds. But thinking about this further, even if this is the case, our hopeful retirement horizon is close enough that the fees plus loss of compound interest won't matter as much as maximizing our savings *rate* and minimizing our tax burden. So I think this is probably the way to go, even if it also means adding the complication of tracking funds across potentially several 401(k)s from old employers.
Title: Re: Roth 401(k) and backdoor conversions vs. traditional 401(k)
Post by: stouset on May 01, 2013, 11:36:58 PM
Wow, I think I missed an aspect of your earlier post. You contribute *over* the maximum into your 401(k) and it's post-tax money. This can be rolled over directly into a Roth IRA (assuming one's plan supports in-service withdrawals, which yours does).

What limits that to 25k? Or is it only limited to the maximum 401(k) contribution of 80% of your salary?
Title: Re: Roth 401(k) and backdoor conversions vs. traditional 401(k)
Post by: the fixer on May 02, 2013, 07:37:17 AM
Another option for you is to open a solo 401(k) to roll your current 401(k) into when you change jobs. All you need is a nonzero amount of self employment income, which could be as simple as mowing a couple lawns or walking a couple dogs. You could even roll your current IRA into that 401(k) if you open it with a brokerage that allows IRA to 401(k) rollovers.
Title: Re: Roth 401(k) and backdoor conversions vs. traditional 401(k)
Post by: Zee on May 02, 2013, 08:46:28 AM
I faced a similar situation.  While it may not be exactly what you are facing, perhaps describing how I approached it may provide some useful information for you. 

In 2012, my wife and I exceeded income limits for Roth IRA contributions.  The backdoor Roth IRA contributions provided a way to continue funding our Roth IRA accounts. 

1.   I had funds in a rollover IRA at Vanguard which was from a 401k at a previous employer.  I had to complete a rollover-IN of this account to my 401k at my current employer (expense ratios on the index funds were similar to those at Vanguard so not a significant issue).  This was done to create a $0 tax basis in the traditional IRA so that we are not subject to the pro-rata rule (see links below for details). 
2.   Prior to tax filing we “recharacterized” our 2012 Roth IRA contributions to the traditional IRA since we exceeded the income limits and technically could not contribute to Roth IRAs for 2012. 
3.   Upon settling of recharacterization, I then did a “conversion” of the funds in the Traditional IRA back to the Roth IRA.  Since the traditional IRA account originally had a $0 balance prior to the recharacterization, the funds that were recharacterized and then converted back to the Roth IRA were not subject to taxes according to the pro-rata rules.

Moving forward, I will likely make contributions to the traditional IRA (currently has a $0 balance) and then do a conversion to the Roth IRA so long as I can expect our combined income (married, filing jointly) to exceed Roth IRA contribution limits.  I prefer to diversify the tax treatment of our accounts as my wife and I each have our respective 401ks, Roth IRAs, and I have a taxable brokerage account. 

I suggest consulting a qualified tax professional as your situation may vary.  This appeared to be the best way for my personal situation in order to take advantage of the Roth IRA.  As an aside, I found the representatives in Vanguard’s retirement center to be very knowledgeable about the recharacterization/conversion process.
Title: Re: Roth 401(k) and backdoor conversions vs. traditional 401(k)
Post by: Joet on May 02, 2013, 11:27:19 AM
The limitation for defined contribution plans under Section 415(c)(1)(A) is increased in 2013 from $50,000 to $51,000.
401k pretax + match + post tax contribs must be =<$51K/yr for 2013 tax year
In my particular case, the post tax is then around $25k to stay under this limit.
This does not include the $5,500 /yr IRA-->backdoor Roth conversion you can ALSO do

Free lunch if your employer supports in-service withdrawl of after-tax portion, and you dont have any dangling IRAs from prior employers [roll them into your current 401k is an option to hide their tax basis from pro-rata rules]
Title: Re: Roth 401(k) and backdoor conversions vs. traditional 401(k)
Post by: stouset on May 02, 2013, 12:44:17 PM
Thanks for the suggestions, guys. I think at this point, my plan is to maximize my traditional 401(k) contributions and my Roth IRA contributions through the backdoor. I'll move my existing rollover IRA funds into my employer's 401(k) before starting backdoor conversions. And once my wife or I have left our current positions, I'll start evaluating a solo 401(k) for the sake of protecting my pre-tax funds from the pro-rata rule.

I'll definitely check with a tax professional first, though.
Title: Re: Roth 401(k) and backdoor conversions vs. traditional 401(k)
Post by: Joet on May 02, 2013, 01:04:16 PM
woot, that was my recommendation. Seems like the best idea if you look forward to years say between 40-something and 67/8 or whenever full SS kicks in where you might have a zero income to do the 401k--Roth conversions vs whatever non-zero income tax rate you have now!