Backdoor Roth IRA w/ existing IRA - Help!

[BiggerFishToFI]

I am fortunate enough this year to be above the Roth IRA contribution limits and am looking at doing a Backdoor Roth IRA. However, I have an existing traditional IRA at Vanguard with a value of $23,600. Total investments are ~$640k

My work 401k is through American Funds with an E/R of ~0.95% (not great) and a balance of $124,000

I understand my options to be:

1) Roll the traditional IRA into my work 401k, then I can do the backdoor Roth without any "pro-rata" problems. Pay a premium expense ratio until I change jobs or my work gets a better 401k plan. This needs to be done before December 31?

2) Convert the traditional IRA into a Roth IRA, pay taxes at my top bracket (24%) on $23,600. About $5,600. This also needs to be done before December 31st?

3) Perform the backdoor Roth contribution and deal with the "pro-rata" rule. This needs to be done after December 31st? I vaguely understand it would work something like this:

    a) Contribute $6000 after tax to the IRA, IRA value is now $29,600 (assuming no growth until December 31)
    b) Pro-rata formula says $6000 / $29,600 =  20.2%. 20.2% * $6000 = $1,216.
    c) $1,216 of the $6000 converted will be considered after-tax and $4,783 of the $6000 will be considered pre-tax.
    d) So on my 2020 return, I pay tax at my marginal rate (24%) for the $6000 earned and contributed plus tax at my marginal rate for the $4783 converted? $1,440 + $1,148 = $2,588

What is the best option in your opinion? Options 1 & 2 seem better for simplicity's sake this year and for future years.

I'm leaning towards Option 1 at the moment and biting the bullet on giving American Funds even more money. I likely won't have that account for more than 5-10 years. Don't like the idea of paying an extra $5k in taxes this year. Pro-rata makes my head hurt.

Thanks in advance!

[ixtap]

Does your workplan offer the components necessary for a mega backdoor Roth? This would allow for greater Roth contributions without messing around with your current IRA.

You mention the 24% bracket, does that mean that you do not have state taxes to consider?

Whether or not it is worth paying taxes on your current traditional IRA in order to have access to Roth depends partly on your overall timelines. If you are young and looking forward to a traditional long career ahead of you, with decades of expected earnings that require the backdoor to have access to Roth, that would tip the balance in your favor. If you will retire in a couple of years and have a significantly lower income, that would make less sense.

[reeshau]

3) e) you now have $4,783 of after-tax contributions to keep track of, for the life of your IRA.

I'm with @ixtap on this.  Your IRA balance isn't that big; if you have a long-term strategy to build a Roth IRA, and $23k of extra income doesn't move you to the next bracket, I would choose #2, and save dealing with the remnants.  You don't mention it, but just to say: you can do #2, and still make your contribution for the year, as well.

While your contribution could be made as late as April 15, you would need to do your rollover this calendar year in order to count for 2020.  Or, if you think your income will be lower next year (maybe bonus payoff, if any, won't be as sweet?  You mention you are fortunate this year) then you could do both in Q1 of next year. (Contribution for 2020, and rollover for 2021.)  Then go ahead and make another contribution for 2021, if you want, since you have the account anyway.

[seattlecyclone]

The contribution and conversion are two separate transactions. It's important to remember this.

For contributions between January 1 and April 15, you can choose which tax year they apply to.

Conversions always apply toward the calendar year in which they actually happen.

Your options (2) and (3) are really just two points on a continuum. If you make a non-deductible contribution without first clearing out your pre-tax balance into your 401(k), and then convert some to Roth (whether you convert $1 or $6,000 or the full balance or anywhere in between), 20.2% of the amount you convert will be non-taxable and the other 79.8% will be taxable.

I don't really recommend planning to keep some post-tax basis in a traditional IRA for a long period of time. The gains will be taxed as regular income when you eventually withdraw or convert to Roth. Compare this to a taxable account where you pay lower capital gains rates. No, if you're going to make after-tax contributions you should probably plan to convert it to Roth before it grows much. Whether your existing IRA balance is better off being rolled into your 401(k) or converted to Roth along with your after-tax contribution is something you'll need to decide for yourself based on your expected time at your job, expected tax rates now and in the future, and other factors that others have touched on.

[BiggerFishToFI]

Thanks all. A couple more questions at the bottom.

I'm going to go ahead and get this IRA rolled into my 401k this month. I'm working with my employer to get a lower fee 401k plan, so hopefully, that can happen sometime in the future.

I expect my tax rate to be lower when FIRED (less than 10 years out), and will plan on Roth conversions at that point. Time will tell whether this is the best decision or not.

Just for a sanity check here is my plan:

I will roll my existing pre-tax IRA into my 401k this month (prior to December 31st, and prior to any Roth conversion). I can then contribute $6k post-tax for 2020 anytime until April 15, 2021 and convert it to Roth at any time after I contribute. Although I will want to do this ASAP after contibuting to avoid any gains? Should I contribute strictly to a money-market fund?

I can also contribute for 2021 anytime between January 1st, 2021 and April 15, 2022 and convert it to Roth ASAP?

Thanks again.

[terran]

Yes, it sounds like you have a good handle on it. I'm not sure I'd recommend this, but if you're doing the conversion in 2021, then technically you don't actually have rollover the previously deducted traditional IRA to your 401(k) until the end of 2021. The reason I hesitate to recommend this is because at that point you've locked yourself into the non-deductible IRA contribution and Roth conversion, so if something goes wrong with the rollover (like it turns out your employer's 401(k) won't allow it after all) then you're stuck with paying tax on much of the Roth conversion.

[seattlecyclone]

I will roll my existing pre-tax IRA into my 401k this month (prior to December 31st, and prior to any Roth conversion). I can then contribute $6k post-tax for 2020 anytime until April 15, 2021 and convert it to Roth at any time after I contribute. Although I will want to do this ASAP after contibuting to avoid any gains? Should I contribute strictly to a money-market fund?

Yes to converting ASAP after the contribution. As to the interim fund, it doesn't make much difference if you do actually convert it soon. If you forget about the conversion for a while, wouldn't you rather invest in something for the interim that grows more? I'd rather pay tax on $100 of growth (keeping the remainder) than pay tax on $1 of growth.