Author Topic: New Backdoor Roth question  (Read 4293 times)

FastStache

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New Backdoor Roth question
« on: October 28, 2014, 11:11:54 AM »
I just read this thread, http://forum.mrmoneymustache.com/investor-alley/did-the-irs-just-give-an-extra-$35kyr-of-tax-free-growth-saving-space/, and I'm trying to understand how it can affect me.

Currently my base salary is getting close to 100K, and my 401K allows me to contribute 25% of my salary. For simplicity let's assume it will be 100K.

The IRS already allows me to contribute up 17.5K pre-tax which I do use. I also contribute 11K to a Roth IRA for me and my wife.

Next year the 401K contribution goes to 18K as most know on this board.

Does this mean if I contribute 18% of my contribution to pre-tax can I contribute the other 7% to a post-tax account that can be converted to a Roth.  I'm not sure I am understanding this correctly, and am looking for clarification.

Does my 401K need to have some special provision in it to allow me to do this, and what questions should I ask them?

seattlecyclone

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Re: New Backdoor Roth question
« Reply #1 on: October 28, 2014, 11:26:32 AM »
Yes, the law allows you to do this. Not all 401(k) plans allow this, though. There are two main questions you'll want to ask:

1) Does the plan allow traditional after-tax contributions?
2) Does the plan allow in-service withdrawals of the after-tax portion?

The first question will answer whether this is even an option in your plan at all. If you can't make these contributions, you're completely out of luck. When you ask it, there's a good chance they'll say that yes, you can contribute $18k to your Roth 401(k) account. You will need to explain that you're not asking about Roth contributions, but instead you're asking about traditional after-tax contributions. They're a different thing. Not too many people do the after-tax contributions, so your HR rep or 401(k) plan rep may not be aware of them. If they still don't know what you're talking about when you reiterate that you're not asking about Roth contributions, escalate your question to someone who knows what these are.

The second question will determine exactly how beneficial these contributions will be to you. If in-service withdrawals are not allowed, that means you will need to wait until you leave the company to roll this money over into a Roth IRA. In that time, this money could accumulate a significant amount of tax-deferred earnings. You will have to pay your standard income tax rate on this money when you withdraw it. The reason this matters is because this strategy of rolling over after-tax 401(k) funds to a Roth IRA is an alternative to simply holding this money in a taxable account. In the taxable account, you'll pay lower capital-gains tax rates on earnings, which is better than what you get from holding the money in the after-tax 401(k). So if you can do in-service withdrawals (or you plan to leave the company) before the money has a chance to grow much within the 401(k), this may be a good option for you. If not, you may be better off investing in a taxable account instead.

stuckinmn

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Re: New Backdoor Roth question
« Reply #2 on: October 30, 2014, 10:08:42 AM »
Seattle-

Question for you to make sure I understand how this works (I know there is another thread on this but it's getting cluttered).

I understand that if my plan does not permit inservice distributions, I can only do this megabackdoor roth strategy upon leaving my job.  My question is when are the gains from the after tax contributions taxed?  Is it at rollover or at ultimate withdrawal?

For example, say in my 401k I have contributed 100K pretax, with an additional 20K gains attributable to that amount, and have also contributed 50K after tax, with gains attributable to the after-tax of 10K.

Obviously when I roll over the 120K pre tax amounts it all goes into the rollover IRA to be taxed when I withdraw it.  When I rollover the 50K after tax to my roth, it is never taxed again. 

But what about the 10K in gains from the after tax contribution? Does it just roll into the regular IRA and it is taxed when I withdraw it, or is it rolled into the Roth and I owe ordinary income on it immediately?  If the former this makes sense to do as I'll have lower tax rates in retirement , if the latter I'd rather just have it in a taxable account and take advantage of the lower rate for dividends and cap gains.

Thanks in advance. 
 


brooklynguy

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Re: New Backdoor Roth question
« Reply #3 on: October 30, 2014, 10:27:53 AM »
I'll let Seattle correct me if I am wrong since currently he seems to be our most active resident expert on these matters, but I believe the new IRS guidance gives you the choice of how you want to handle the 10k in your example.  You can roll it into the Roth IRA (together with the 50k of after-tax contributions), in which case it will be taxed immediately at that time.  Or you can separate it out and roll it into a traditional IRA, in which case it won't be taxed until it is withdrawn (or converted into a Roth IRA).

stuckinmn

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Re: New Backdoor Roth question
« Reply #4 on: October 30, 2014, 11:51:35 AM »
Thanks Brooklyn.   

Have you (or anyone else on here) ever done after-tax contributions to your 401k?  Does the custodian actually segregate the contributions and resulting gains into separate accounts- one for pre-tax and one for post tax?  Prior to this I always just thought they left it in one account and listed a tax basis equal to your after tax contribution but then I never really thought about it since I had no real incentive to contribute before this ruling came out.   

seattlecyclone

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Re: New Backdoor Roth question
« Reply #5 on: October 30, 2014, 12:36:51 PM »
Thanks Brooklyn.   

Have you (or anyone else on here) ever done after-tax contributions to your 401k?  Does the custodian actually segregate the contributions and resulting gains into separate accounts- one for pre-tax and one for post tax?  Prior to this I always just thought they left it in one account and listed a tax basis equal to your after tax contribution but then I never really thought about it since I had no real incentive to contribute before this ruling came out.   

Yes, I have done this. My current employer allows after-tax contributions and in-service rollovers. My employer's 401(k) plan does have separate sub-accounts (also knows as "separate contracts") for pre-tax, traditional after-tax, and Roth contributions. The earnings on the after-tax contributions stay in the same sub-account as the contributions themselves. They only allow in-service distributions from the after-tax sub-account. Just because my plan separates the funds in this manner does not mean that yours does! My understanding is that this is a decision to be made by the plan administrator; your plan may put tax-deferred contributions in the same sub-account as after-tax contributions.

As to your previous question, I believe brooklynguy is correct that the new IRS guidance means you can choose when to pay tax on earnings in your after-tax sub-account. You can either roll the earnings into a traditional IRA and pay tax later, or roll it into a Roth IRA and pay tax now.

ZiziPB

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Re: New Backdoor Roth question
« Reply #6 on: October 30, 2014, 01:39:52 PM »
I also have made after-tax contributions and my 401k custodian (Fidelity) does keep track of them separately.

The best advice I can give is to read your plan Summary Description.  These are usually written in plain English and contain sufficient detail to answer all of your questions.

stuckinmn

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Re: New Backdoor Roth question
« Reply #7 on: October 30, 2014, 09:56:30 PM »
Thanks all.

I just checked my summary plan and it permits me to contribute up to 5% after tax and permits in service withdrawals of after tax contributions at any time for any reason.  I bumped my deferral up to 5 and I'll do a rollover after my end of year bonus hits.  I suppose I could theoretically do a rollover after each paycheck but that seems like a lot of work for minimal gain.  I think I'll stick to a quarterly rollover.

brooklynguy

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Re: New Backdoor Roth question
« Reply #8 on: October 31, 2014, 07:01:46 AM »
Thanks all.

I just checked my summary plan and it permits me to contribute up to 5% after tax and permits in service withdrawals of after tax contributions at any time for any reason.  I bumped my deferral up to 5 and I'll do a rollover after my end of year bonus hits.  I suppose I could theoretically do a rollover after each paycheck but that seems like a lot of work for minimal gain.  I think I'll stick to a quarterly rollover.

Doing a rollover after each paycheck has the benefit of minimizing earnings on the after-tax contributions, so you get the contributions and any subsequent earnings sheltered in the Roth right away (if that's what you are shooting for -- another strategy is to intentionally siphon off the earnings into a traditional IRA (to be folded into a Roth conversion pipeline strategy once you retire); see my latest post in the main thread on the mega-back door roth topic).

stuckinmn

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Re: New Backdoor Roth question
« Reply #9 on: October 31, 2014, 08:10:00 AM »
Brooklyn-  I understand the advantage of doing multiple conversions in order to immediately capture all earnings, but doing a rollover twice a month seems like more work than it's worth to just convert a couple of months of earnings from tax-deferred to tax free. 

After I get my year-end bonus amounts placed in I'll see how much work the rollover is.  If it is as simple as logging on and pressing a button then I'll do it after each paycheck.  Granted it was a decade ago, but the last time I did a rollover it was a moderate pain in the ass- nothing awful but not something I want to do twice a month either.    Every quarter seems about right for me to build up a critical mass of contributions to move over.

brooklynguy

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Re: New Backdoor Roth question
« Reply #10 on: October 31, 2014, 08:36:42 AM »
That makes sense.

PathtoFIRE

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Re: New Backdoor Roth question
« Reply #11 on: October 31, 2014, 10:37:22 AM »
I can't make aftertax contributions, so I don't have experience myself, but one potential problem I see is a conflict with the backdoor Roth. My understanding with the aftertax contributions is that you can't choose to withdraw JUST the contributions and leave the pretax earnings alone, you have to also transfer them. For most that would mean a traditional rollover IRA, although I guess transfer to another eligible account like another 401k is possible. However, now I will have a tIRA with pretax dollars, which will limit the backdoor Roth benefit. So I see 2 solutions to this, and it brings up one additional question. 1) You can either go through the hassle of immediately transferring your aftertax contributions to a Roth everytime you make a contribution as brooklynguy suggests, or 2) have the aftertax placed in a money-market type fund that will earn no earnings until you've accumulated enough over several months say to make it worthwhile to transfer.

This raises an additional question. A third option would be to get rid of the tIRA the same way many of us do once we discover the backdoor Roth, by rolling it into the 401k. I did that once, was a huge hassle. Does anyone know of have any experience with being able to transfer the pretax earnings from the aftertax "subaccount" directly into your pretax "elective deferral subaccount" of the 401k? In other words, when making a withdrawal of the aftertax portion of your traditional 401k, can you designate that the contribution or basis go to this Roth IRA, and the earnings go back into the 401k but on the pretax side?

ZiziPB

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Re: New Backdoor Roth question
« Reply #12 on: October 31, 2014, 10:48:40 AM »
Great question, PathtoFIRE, and something I am interested in as well. 

Another option that I would like to explore (that would work similarly to what you are asking about) would be an in-plan conversion, where the basis of the after-tax contributions would be converted into Roth 401k and the earnings lumped with the pre-tax portion of the 401k.  I would be very interested to know if that is a possibility.  My plan documents do not get into that level of detail, so I just don't know if that is something that the custodian would execute. 

seattlecyclone

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Re: New Backdoor Roth question
« Reply #13 on: October 31, 2014, 11:34:15 AM »
My understanding with the aftertax contributions is that you can't choose to withdraw JUST the contributions and leave the pretax earnings alone, you have to also transfer them.

I believe this is correct. My understanding is that you can't leave the earnings in the 401(k), you have to take it all out in one form or another.

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For most that would mean a traditional rollover IRA, although I guess transfer to another eligible account like another 401k is possible. However, now I will have a tIRA with pretax dollars, which will limit the backdoor Roth benefit.

Yes, if you are averse to paying any tax at the time of the conversion, you would have to split the earnings off into a traditional IRA. Then you would have pre-tax money in your IRA, which would also be a problem for doing a backdoor Roth IRA if you are still averse to paying any tax on the conversion. But if you do these after-tax conversions fairly frequently (quarterly should be more than enough), the amount of accumulated earnings should be relatively minimal (maybe a few percent). Why not just convert the whole thing to your Roth IRA directly and pay a few dollars of extra tax?

Suppose you make $5k of after-tax contributions each quarter. Suppose the stock market is doing great, growing 5% quarter over quarter. When you do your rollover at the end of the quarter, you'll have $5,000 of principal and about $125 of earnings (half of 5% since the average dollar in the account was only in the account for half the quarter). If you're in the 25% tax bracket, you'll pay an extra $125 in taxes over the course of the year (0.6% of the amount rolled over) by just rolling over the whole sum. That's in a really good year for the market. Most years you'll pay less. In exchange, you get an extra $500 of money in your Roth IRA to grow tax-free forever, do less paperwork on your rollovers, and leave the possibility of a backdoor Roth IRA open.

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1) You can either go through the hassle of immediately transferring your aftertax contributions to a Roth everytime you make a contribution as brooklynguy suggests

This would work. I do conversions after every paycheck because my employer's plan lets me do these rollovers online with a few clicks. If I had to call someone on the phone or mail in a paper form, I would likely do it no more than quarterly.

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2) have the aftertax placed in a money-market type fund that will earn no earnings until you've accumulated enough over several months say to make it worthwhile to transfer.

I guess you could do this, but why? You're giving up potential growth on your money just to avoid the possibility of owing tax on that growth. Unless your marginal tax rate is higher than 100%, this is a bad idea.

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A third option would be to get rid of the tIRA the same way many of us do once we discover the backdoor Roth, by rolling it into the 401k. I did that once, was a huge hassle. Does anyone know of have any experience with being able to transfer the pretax earnings from the aftertax "subaccount" directly into your pretax "elective deferral subaccount" of the 401k? In other words, when making a withdrawal of the aftertax portion of your traditional 401k, can you designate that the contribution or basis go to this Roth IRA, and the earnings go back into the 401k but on the pretax side?

My understanding is that the new IRS guidance only applies to 401(k) -> IRA conversions. So you would have to move the money through the traditional IRA and then roll it back into the 401(k). I could be wrong on this point. Again, if you want to go through even more paperwork (to not only split your conversion between two IRAs but then to roll the traditional portion back into the 401(k)) just to save a little bit of tax, be my guest.

PathtoFIRE

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Re: New Backdoor Roth question
« Reply #14 on: October 31, 2014, 01:37:42 PM »

Thanks for the reply seattlecyclone, you're probably right, we shouldn't be talking about much in terms of gains, this is all still theoretical for me as I still need to lobby HR to get this, so I didn't even think about what the actual numbers would be.