Author Topic: 401k, Traditional IRA & Backdoor Roth IRA  (Read 6464 times)

SoCal Spartan

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401k, Traditional IRA & Backdoor Roth IRA
« on: August 23, 2013, 10:11:52 AM »
Hi everyone,

I'm relatively new to MMM but am quickly trying to adopt a more mustachian way of life. I've tried doing some research on retirement accounts but have some questions I feel would be best answered by the experts here.

Currently, I am working a contract that will likely become a full-time position within a month or so. I have about $2600 in a Fidelity 401k from a previous full-time position that I have been holding off on rolling over until I know what my current position will become.

Initially my thoughts were to contribute to the company 401k while also opening a Roth IRA and contributing to that as well. However, I have been reading up a bit on backdoor Roth IRA conversions and it seems like this may be the best way to maximize my investment dollars from a Traditional IRA. I will essentially be starting from $0 and therefore won't be taxed on any existing IRA contributions when converting to the Roth IRA. Also, I believe the company doesn't offer any matching for the 401k and I don't think I'll be making enough to max out both the 401k and IRA.

My plan is to rollover the existing 401k into the new company 401k and contribute to that while also maxing out a Traditional IRA and convert that into a Roth IRA. Does that all seem like the right course of action?

Thanks!

madage

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Re: 401k, Traditional IRA & Backdoor Roth IRA
« Reply #1 on: August 23, 2013, 10:25:58 AM »
Unless the 401(k) at your new employer is really good, I suggest rolling over your old 401(k) to a traditional IRA instead. The reasoning is that you have a much wider selection of funds and probably access to lower-cost funds in an IRA than a 401(k).

I don't understand why you want to contribute to a traditional IRA then convert to a Roth IRA. You'll owe taxes on the entire amount you convert, not just gains. If you want a Roth IRA, just contribute directly to a Roth IRA. The backdoor Roth is good for those who are not eligible to contribute to a Roth directly because of their income. It doesn't sound like you're in that situation.

GreenGuava

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Re: 401k, Traditional IRA & Backdoor Roth IRA
« Reply #2 on: August 23, 2013, 10:37:30 AM »
I don't understand why you want to contribute to a traditional IRA then convert to a Roth IRA.

There's an income limit to contribute to a Roth IRA.  A popular way around that - only available if you hold no pre-tax IRA money - is to make a non-deductible contribution to a new t-IRA, then immediately convert it to a Roth IRA.  This doesn't incur a conversion tax because the money isn't pre-tax.  It's an odd loophole.

I hope that's why OP wants to do this;  there's no benefit to doing this particular task otherwise.

SoCal Spartan

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Re: 401k, Traditional IRA & Backdoor Roth IRA
« Reply #3 on: August 23, 2013, 10:42:53 AM »
Thanks, madage! I feel a bit silly now, but I was under the impression you somehow skirted paying taxes on that money by converting from a Traditional IRA to a Roth IRA and therein was the benefit of the backdoor conversion -- not having too high of an income to be able to contribute to a Roth IRA. Lack of knowledge and wishful thinking I suppose.

As for forgoing the 401k in favor of a Traditional IRA: Wouldn't it still be wise to have both? As I said, I don't think I'll be able to max out each, but with the Traditional IRA limited to $5,500 in contributions, I will still have some extra to put towards the higher limit of the 401k. Assuming my salary will continue to increase, hopefully I'll have more to invest in the 401k down the road.

madage

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Re: 401k, Traditional IRA & Backdoor Roth IRA
« Reply #4 on: August 23, 2013, 10:47:35 AM »
Thanks, madage! I feel a bit silly now, but I was under the impression you somehow skirted paying taxes on that money by converting from a Traditional IRA to a Roth IRA and therein was the benefit of the backdoor conversion -- not having too high of an income to be able to contribute to a Roth IRA. Lack of knowledge and wishful thinking I suppose.

Welcome!

As for forgoing the 401k in favor of a Traditional IRA: Wouldn't it still be wise to have both? As I said, I don't think I'll be able to max out each, but with the Traditional IRA limited to $5,500 in contributions, I will still have some extra to put towards the higher limit of the 401k. Assuming my salary will continue to increase, hopefully I'll have more to invest in the 401k down the road.

I'm not saying to forego the 401(k) at all (especially if it has an employer match!). I'm saying there may not be a benefit to rolling your old 401(k) into the new 401(k) when you can roll it right now into a traditional IRA. You can roll the $2,600 in the old 401(k) into a traditional IRA today and still contribute $5,500 to an IRA (Roth or Traditional) for 2013.

SoCal Spartan

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Re: 401k, Traditional IRA & Backdoor Roth IRA
« Reply #5 on: August 23, 2013, 10:57:22 AM »

There's an income limit to contribute to a Roth IRA.  A popular way around that - only available if you hold no pre-tax IRA money - is to make a non-deductible contribution to a new t-IRA, then immediately convert it to a Roth IRA.  This doesn't incur a conversion tax because the money isn't pre-tax.  It's an odd loophole.

I hope that's why OP wants to do this;  there's no benefit to doing this particular task otherwise.

Thanks, GreenGuava! I wish that was the case, but unfortunately it was the "no benefit" option.


I'm not saying to forego the 401(k) at all (especially if it has an employer match!). I'm saying there may not be a benefit to rolling your old 401(k) into the new 401(k) when you can roll it right now into a traditional IRA. You can roll the $2,600 in the old 401(k) into a traditional IRA today and still contribute $5,500 to an IRA (Roth or Traditional) for 2013.

Thanks, madge! I realized after re-reading your response that was probably what you meant. No employer match, unfortunately, but I'll definitely explore rolling it over into a Traditional IRA. Now it will be deciding between a Roth or Traditional IRA... most likely the Traditional route, especially if I end up rolling over the existing 401k.

madage

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Re: 401k, Traditional IRA & Backdoor Roth IRA
« Reply #6 on: August 23, 2013, 11:08:25 AM »

Thanks, madge! I realized after re-reading your response that was probably what you meant. No employer match, unfortunately, but I'll definitely explore rolling it over into a Traditional IRA. Now it will be deciding between a Roth or Traditional IRA... most likely the Traditional route, especially if I end up rolling over the existing 401k.

You can have multiple IRA's, so the fact that you might roll your old 401(k) into a traditional IRA should have no bearing at all on whether you open a Traditional or Roth for additional contributions. If you want to simplify with a single IRA, you could also consider rolling the old 401(k) into a Roth IRA and pay tax on the conversion.

Undecided

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Re: 401k, Traditional IRA & Backdoor Roth IRA
« Reply #7 on: August 23, 2013, 01:27:54 PM »
I don't understand why you want to contribute to a traditional IRA then convert to a Roth IRA.

There's an income limit to contribute to a Roth IRA.  A popular way around that - only available if you hold no pre-tax IRA money - is to make a non-deductible contribution to a new t-IRA, then immediately convert it to a Roth IRA.  This doesn't incur a conversion tax because the money isn't pre-tax.  It's an odd loophole.

I hope that's why OP wants to do this;  there's no benefit to doing this particular task otherwise.

I don't think the bolded part is true; if you have some pre-tax IRA money when you make the Roth conversion, you would have to pay income tax (but not the early-withdrawal penalty) on some portion of the converted amount, but if less than all of your IRA money is pre-tax when you make the conversion, less than all of the converted amount would be taxable (basically applying a pro-rated basis of all your IRAs to the converted amount). That you may have to pay some taxes for the conversion doesn't automatically make it a bad choice (and doesn't mean it's not "available"). http://www.irs.gov/pub/irs-pdf/p590.pdf

madage

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Re: 401k, Traditional IRA & Backdoor Roth IRA
« Reply #8 on: August 23, 2013, 01:32:44 PM »

There's an income limit to contribute to a Roth IRA.  A popular way around that - only available if you hold no pre-tax IRA money - is to make a non-deductible contribution to a new t-IRA, then immediately convert it to a Roth IRA.  This doesn't incur a conversion tax because the money isn't pre-tax.  It's an odd loophole.

I hope that's why OP wants to do this;  there's no benefit to doing this particular task otherwise.

I don't think the bolded part is true; if you have some pre-tax IRA money when you make the Roth conversion, you would have to pay income tax (but not the early-withdrawal penalty) on some portion of the converted amount, but if less than all of your IRA money is pre-tax when you make the conversion, less than all of the converted amount would be taxable (basically applying a pro-rated basis of all your IRAs to the converted amount). That you may have to pay some taxes for the conversion doesn't automatically make it a bad choice (and doesn't mean it's not "available"). http://www.irs.gov/pub/irs-pdf/p590.pdf

Good catch, Undecided!

GreenGuava

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Re: 401k, Traditional IRA & Backdoor Roth IRA
« Reply #9 on: August 23, 2013, 06:50:20 PM »
I don't understand why you want to contribute to a traditional IRA then convert to a Roth IRA.

There's an income limit to contribute to a Roth IRA.  A popular way around that - only available if you hold no pre-tax IRA money - is to make a non-deductible contribution to a new t-IRA, then immediately convert it to a Roth IRA.  This doesn't incur a conversion tax because the money isn't pre-tax.  It's an odd loophole.

I hope that's why OP wants to do this;  there's no benefit to doing this particular task otherwise.

I don't think the bolded part is true; if you have some pre-tax IRA money when you make the Roth conversion, you would have to pay income tax (but not the early-withdrawal penalty) on some portion of the converted amount, but if less than all of your IRA money is pre-tax when you make the conversion, less than all of the converted amount would be taxable (basically applying a pro-rated basis of all your IRAs to the converted amount). That you may have to pay some taxes for the conversion doesn't automatically make it a bad choice (and doesn't mean it's not "available"). http://www.irs.gov/pub/irs-pdf/p590.pdf

You are correct;  you pay taxes on the fraction of (total pre-tax IRA money) / (total IRA money), applied to the conversion amount.  This is typically very expensive for those who need to do the backdoor Roth, and is generally considered to not be an option... but legally, it is an option.


I'm not saying to forego the 401(k) at all (especially if it has an employer match!). I'm saying there may not be a benefit to rolling your old 401(k) into the new 401(k) when you can roll it right now into a traditional IRA. You can roll the $2,600 in the old 401(k) into a traditional IRA today and still contribute $5,500 to an IRA (Roth or Traditional) for 2013.

Thanks, madge! I realized after re-reading your response that was probably what you meant. No employer match, unfortunately, but I'll definitely explore rolling it over into a Traditional IRA. Now it will be deciding between a Roth or Traditional IRA... most likely the Traditional route, especially if I end up rolling over the existing 401k.

If you go the traditional route, ensure that you can deduct the contribution.  Otherwise, it's generally better to go with the Roth.  Depending on how you invest the money, there might not even be a benefit to having all in one tax treatment.

Undecided

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Re: 401k, Traditional IRA & Backdoor Roth IRA
« Reply #10 on: August 23, 2013, 09:37:36 PM »

You are correct;  you pay taxes on the fraction of (total pre-tax IRA money) / (total IRA money), applied to the conversion amount.  This is typically very expensive for those who need to do the backdoor Roth, and is generally considered to not be an option... but legally, it is an option.


I think it's falsely simplistic to say it's not generally an option; it depends on circumstances. I don't think we're an unusual example:  My wife had some deductible contributions from a couple of years before we were married, then several years of non-deductible contributions and additional growth after we married, such that about 10% of her conversion was taxable, and we thought it was worth paying the tax to get the entire amount into the Roth. I just don't think people should apply presumptions here, but should really look at their own numbers.

firelight

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Re: 401k, Traditional IRA & Backdoor Roth IRA
« Reply #11 on: December 23, 2013, 12:56:01 AM »
I don't have any IRA and make more than the limit to deduct contributions. Is it possible to open a traditional IRA and then convert it immediately to a Roth IRA through backdoor conversion?