SEP IRA with yearly conversion to Roth?

[startingsmall]

I've been doing some research on setting up an SEP IRA for my freelance business, then immediately converting that money to my Roth.

I'd like to get some more contribution money into my Roth in preparation for a future downshift and this SEEMS to be a valid way to do it. It was actually my dad that suggested it... apparently he waits for TurboTax to tell him each year what he can contribute to his SEP IRA, funds the SEP, then immediately converts to his Roth so that the money can grow tax-free. (He's above the Roth contribution limit. I'm not, but it seems that conversions and the normal contribution don't interfere with each other?) He deducts the SEP contribution on the previous year's taxes (so, on his 2018 taxes in a few months), then the amount he converts is added as income on his current year's taxes (so, 2019 taxes which will be filed next year).

He made this sound totally easy and straightforward, but I'm doing some research to make sure that I understand correctly. I ran into a LOT of talk about pro-rata calculations. I do have another IRA right now, but it's a rollover IRA.... so all of the money in there is also deductible/pre-tax contributions, like the SEP IRA would be (if I'm understanding correctly). It seems like (based on my reading of the IRS form 8606), the pro-rata calculations only apply if you have a combination of deductible & nondeductable money in IRAs..... so because both my rollover IRA & SEP IRA are deductible accounts, I won't have to worry about that?

Hoping someone has a better (or more confident) understanding of this and can help me out! Thanks!

[MTBmustachian]

I'll be interested in someone who has a slightly better analysis of this, as I just opened a SEP IRA in addition to my other accounts and need to stick some funds in for 2018.

funds the SEP, then immediately converts to his Roth so that the money can grow tax-free.

I'm not sure I understand this. If you stick money in your SEP, it grows there tax-free. A SEP is just another type of IRA.

Also, one thing I don't understand is this. If he deposits to a SEP, he can write that off on his taxes. But I believe whenever you roll over money from an IRA (of which a SEP is just one type) to a ROTH IRA in a ROTH ladder that you have to pay taxes on the amount that you rollover. So in essence, I believe your dad should be paying the same amount either way. If he doesn't, he's just tax dodging or not reporting correctly.

Again, this is based on my understanding of the matter--I would be interested in hearing from somebody who has experience with this.

[seattlecyclone]

Yes, the pro-rata rules are only about if you have a mix of pre-tax and post-tax assets in your traditional IRA. I have done a SEP for my small side income the past couple of years, and immediately converted to Roth in order to avoid pro-rata issues when performing the backdoor Roth. It's easy to do this.

As I see it you're looking at two separate issues.

1) Should you contribute a good chunk of your business income into a retirement account? Probably. The long-term tax benefits of doing so can be significant.
2) Should you make pre-tax or Roth contributions into that retirement account? That's a tougher question. In a low-income year Roth can make sense, but generally you're better off making pre-tax contributions when you're in a higher tax bracket and then converting after retirement puts you in a lower bracket. If you do decide to perform a Roth conversion, there's no reason it has to come from your SEP, or in the same amount as you just put in the SEP. Converting from the rollover IRA will have the same effect.

[seattlecyclone]

I'm not sure I understand this. If you stick money in your SEP, it grows there tax-free. A SEP is just another type of IRA.

The money grows tax-deferred in a SEP IRA, just like in any other flavor of traditional IRA. Converting it to Roth will cause the growth to be tax-free, at the expense of losing the tax-deferment on the principal.

Also, one thing I don't understand is this. If he deposits to a SEP, he can write that off on his taxes. But I believe whenever you roll over money from an IRA (of which a SEP is just one type) to a ROTH IRA in a ROTH ladder that you have to pay taxes on the amount that you rollover. So in essence, I believe your dad should be paying the same amount either way. If he doesn't, he's just tax dodging or not reporting correctly.

Yes, you have to pay tax on the Roth conversion. Contributing to the SEP and immediately converting to Roth is basically the same thing as making contributions to a Roth SEP account, except that type of account doesn't actually exist.

[startingsmall]

2) Should you make pre-tax or Roth contributions into that retirement account? That's a tougher question. In a low-income year Roth can make sense, but generally you're better off making pre-tax contributions when you're in a higher tax bracket and then converting after retirement puts you in a lower bracket. If you do decide to perform a Roth conversion, there's no reason it has to come from your SEP, or in the same amount as you just put in the SEP. Converting from the rollover IRA will have the same effect.

My dad's logic for trying to convert everthing IRA to Roth is that, while my tax bracket may go down over time, the amount of money that is actually IN the accounts (and therefore the amount that will be taxed) will increase with time. I know that converting now instead of later kind of goes against the traditional Roth ladder setup, but I couldn't find the flaw in his logic. What am I missing?

I currently max my employer's 401k, our family HSA, and Roths for both husband and myself. The SEP IRA sounds like a good place to put extra money, regardless of whether I'm converting to a Roth, but my dad's logic seemed sound.

As for converting the Rollover IRA to Roth, that's nearly $100k and a whole lotta taxes! So I figured I'd leave that and the 401k as tax-deferred accounts, but work on expanding the tax-free Roth money (largely so I can have more money that I can access before 59.5 yrs old).

[startingsmall]

Also, one thing I don't understand is this. If he deposits to a SEP, he can write that off on his taxes. But I believe whenever you roll over money from an IRA (of which a SEP is just one type) to a ROTH IRA in a ROTH ladder that you have to pay taxes on the amount that you rollover. So in essence, I believe your dad should be paying the same amount either way. If he doesn't, he's just tax dodging or not reporting correctly.

Yes, he's paying the same taxes as if he didn't put the money in the SEP (although he's putting the taxes off for a year, it seems). But he's getting more money into his Roth for tax-free growth than he would be able to otherwise, which is the real advantage.

[MTBmustachian]

I know that converting now instead of later kind of goes against the traditional Roth ladder setup, but I couldn't find the flaw in his logic. What am I missing?

As I understand the ROTH ladder, a potential flaw, depending on how soon you'll want the money, is that you can only withdraw your contributions to your ROTH account. So if you ladder the money out of your SEP now, and it grows in your ROTH account for, say, 10 years, 10 years later you will only be able to withdraw the contributions, and not the gains you made in those years. You'll only be able to withdraw the gains penalty-free once you reach retirement age (currently 59.5 I believe, but that could be raised).

But he's getting more money into his Roth for tax-free growth than he would be able to otherwise, which is the real advantage.

But see above--there will actually be LESS money available for him to withdraw before he turns 59.5, is my understanding.

Personally, I'm planning to sort of split the difference. Do max contributions to ROTHs for both my spouse and I, max out SEP IRA, and then ladder the SEP into the ROTH later.

[startingsmall]

I know that converting now instead of later kind of goes against the traditional Roth ladder setup, but I couldn't find the flaw in his logic. What am I missing?

As I understand the ROTH ladder, a potential flaw, depending on how soon you'll want the money, is that you can only withdraw your contributions to your ROTH account. So if you ladder the money out of your SEP now, and it grows in your ROTH account for, say, 10 years, 10 years later you will only be able to withdraw the contributions, and not the gains you made in those years. You'll only be able to withdraw the gains penalty-free once you reach retirement age (currently 59.5 I believe, but that could be raised).

But he's getting more money into his Roth for tax-free growth than he would be able to otherwise, which is the real advantage.

But see above--there will actually be LESS money available for him to withdraw before he turns 59.5, is my understanding.

Personally, I'm planning to sort of split the difference. Do max contributions to ROTHs for both my spouse and I, max out SEP IRA, and then ladder the SEP into the ROTH later.

That definitely makes sense. My dad is already 66, so obviously that isn't on his mind.... but could be an issue for me, depending on when I decide to start withdrawing. (Likely sometime between 50-55, but depends on a lot of different factors.) Will have to do some calculations and look at pros/cons. Thanks!

[MTBmustachian]

My dad is already 66, so obviously that isn't on his mind.

In that case, it's just a discussion of whether a ROTH IRA or a Trad IRA is better, right? There's a ton of articles out there on the topic.

[startingsmall]

My dad is already 66, so obviously that isn't on his mind.

In that case, it's just a discussion of whether a ROTH IRA or a Trad IRA is better, right? There's a ton of articles out there on the topic.

He went into a bunch of reasons for preferring the Roth in his situation (something to do with passing inheritance to my brothers and I and the tax implications with Roth vs Traditional IRA).  He definitely has his own finances under control, just wondering if this particular situation is one where I should take his advice or if there was a reason it wouldn't apply in my situation.

[seattlecyclone]

My dad's logic for trying to convert everthing IRA to Roth is that, while my tax bracket may go down over time, the amount of money that is actually IN the accounts (and therefore the amount that will be taxed) will increase with time. I know that converting now instead of later kind of goes against the traditional Roth ladder setup, but I couldn't find the flaw in his logic. What am I missing?

You're missing the commutative property of multiplication. If you're multiplying the same numbers together, it doesn't matter in which order you multiply them.

You're also missing that the number of dollars of tax you pay isn't the important thing, it's the number of dollars you get to keep after you pay your tax.

Suppose you have some amount of pre-tax income I that you want to save for retirement. Suppose your investment will grow by a factor of G by the time you want to withdraw it, your marginal tax rate right now is T_n, and your marginal tax rate in retirement will be T_r.

If you save in a pre-tax IRA, you put the full I into the IRA. It grows to G * I by the time you want to withdraw, at which time you would have to pay taxes. You get to keep (1 - T_r) * G * I.

If you save in a Roth IRA, you pay tax before you contribute, so you only get to put in (1 - T_n) * I. It grows by a factor of G by the time you want to withdraw, and the withdrawal is tax-free, so you get to keep (1 - T_n) * I * G.

If T_n = T_r, you get to keep the same amount either way! You paid more tax in the traditional IRA because you waited to pay your tax until after the money grew, but due to the commutative property of multiplication the amount you get to keep is identical given constant tax rates.

If you expect to have a lower tax rate in retirement, you'll get to keep more by contributing to traditional.

As for converting the Rollover IRA to Roth, that's nearly $100k and a whole lotta taxes! So I figured I'd leave that and the 401k as tax-deferred accounts, but work on expanding the tax-free Roth money (largely so I can have more money that I can access before 59.5 yrs old).

I'm not saying you would necessarily convert the whole rollover IRA. Roth conversions aren't an all-or-nothing thing. You can convert a little bit each year if you decide that's a good idea. What I was saying is that converting $1,000 from your SEP IRA to Roth is the same as converting $1,000 from your rollover IRA to Roth. The right amount to convert will almost certainly not be exactly the same as your annual SEP contribution. It may be more or less than this, with $0 being a pretty likely right answer.

[startingsmall]

You're missing the commutative property of multiplication. If you're multiplying the same numbers together, it doesn't matter in which order you multiply them.

You're also missing that the number of dollars of tax you pay isn't the important thing, it's the number of dollars you get to keep after you pay your tax.

Suppose you have some amount of pre-tax income I that you want to save for retirement. Suppose your investment will grow by a factor of G by the time you want to withdraw it, your marginal tax rate right now is T_n, and your marginal tax rate in retirement will be T_r.

If you save in a pre-tax IRA, you put the full I into the IRA. It grows to G * I by the time you want to withdraw, at which time you would have to pay taxes. You get to keep (1 - T_r) * G * I.

If you save in a Roth IRA, you pay tax before you contribute, so you only get to put in (1 - T_n) * I. It grows by a factor of G by the time you want to withdraw, and the withdrawal is tax-free, so you get to keep (1 - T_n) * I * G.

If T_n = T_r, you get to keep the same amount either way! You paid more tax in the traditional IRA because you waited to pay your tax until after the money grew, but due to the commutative property of multiplication the amount you get to keep is identical given constant tax rates.

If you expect to have a lower tax rate in retirement, you'll get to keep more by contributing to traditional.

THANK YOU. This is exactly the explanation that I was looking for!!  My dad is a bit more of the "keep the government off my money" type, so that's probably coloring his interpretation.... but after listening to him explain it for half an hour, I couldn't rationally think my way through the math anymore. LOL.

So go ahead and contribute to the SEP IRA, as another place to stash tax-deferred money, but hold off on conversions until 5 years before needing the money. Gotcha.

[PDXTabs]

I'd like to get some more contribution money into my Roth in preparation for a future downshift and this SEEMS to be a valid way to do it.

Some people love Roths. I would be reluctant to pay taxes now if you are going to downshift in the future. That is, if you future tax rate will be lower than your current one. Also, I'm not convinced that Roths are covered in our tax treaties with most foreign countries. You could end up double taxed and very sad if you retire abroad as far as I can tell.