Backdoor Roth with existing Trad IRA

[Villanelle]

I'll be honest and say I've always mostly ignored info on the backdoor Roth because we were always under the Roth MAGI limits.  Suddenly, we aren't.   

I've been reading, but I'm a smidge confused on this:  thanks to a rollover from a 403b from a former employer, I have a modest traditional IRA.  (~$40k).  Clearly, this complicates things.  What do I (or can I) do to this existing trad IRA to allow me to start backdoor Roth-ing?  Or am I stuck?  DH is traditional-IRA-free so he's golden but I'm trying to figure out what to do for myself. 

[seattlecyclone]

So...backing up a little bit to explain why it's bad to have a pre-tax balance in a traditional IRA when doing the backdoor. When you do a Roth conversion and you have some pre-tax and some post-tax money in your traditional IRA, the conversion is prorated between the two buckets. This means a large fraction of it will count as a taxable conversion.

Your options include:
1) Roll your pre-tax IRA into a workplace plan with your current employer. This will reset your IRA balance to zero. Once this is done, then make your post-tax $7k contribution and convert it to Roth tax-free.
2) Make your $7,000 contribution and then convert the whole $47k to Roth. This will result in a one-time $40k addition to your taxable income this year, but in future years you'll be able to do the backdoor with no issues.
2a) Make your $7,000 contribution and convert part of the money to Roth. For example if you're $20k below the top of your current tax bracket you could convert half of it this year and half next year and stay in the same bracket.

[Villanelle]

So...backing up a little bit to explain why it's bad to have a pre-tax balance in a traditional IRA when doing the backdoor. When you do a Roth conversion and you have some pre-tax and some post-tax money in your traditional IRA, the conversion is prorated between the two buckets. This means a large fraction of it will count as a taxable conversion.

Your options include:
1) Roll your pre-tax IRA into a workplace plan with your current employer. This will reset your IRA balance to zero. Once this is done, then make your post-tax $7k contribution and convert it to Roth tax-free.
2) Make your $7,000 contribution and then convert the whole $47k to Roth. This will result in a one-time $40k addition to your taxable income this year, but in future years you'll be able to do the backdoor with no issues.
2a) Make your $7,000 contribution and convert part of the money to Roth. For example if you're $20k below the top of your current tax bracket you could convert half of it this year and half next year and stay in the same bracket.

Thanks.  I have no current employer.  I'm a 1099 (and don't make much--last year was my first year cracking 5 figures, and just barely). 

My unpredictable income also makes it tough to know exactly how much space we have at the top of a bracket.  Does the conversion have to happen in 2025, or can it happen before April 15 in 2026 (much like you can contribute to the prior year's IRA)? 

It sounds like maybe I should suck it up and do 2.  Or do nothing, since in about 5-7 years, DH will likely be retiring and well back under the income limits, so how much is 5-7 years worth of Roth-ing worth, compared to just putting it in a non-retirement account and not taking the 40k hit?

Gah.  It was easier when we were middle class.  lol 

[terran]

I have no current employer.  I'm a 1099 (and don't make much--last year was my first year cracking 5 figures, and just barely). 

Open a solo 401(k). It doesn't matter than you only make a little, all that matters is that you're self employed. First, you'll be able to contribute most of what you make, which will be more than the IRA limit you're talking about in this thread, and second you'll be able to roll the IRA into your solo 401(k), which will let you do a backdoor Roth too.

I'd look at E*trade and Schwab. Ask them if they'll let you roll the IRA into the plan, I'm almost certain E*trade will, I don't know either way about Schwab. They both let you make Roth contributions, which can be useful because traditional contributions reduce Qualified Business Income (QBI) which in turn reduces the QBI deduction. This effectively means that you only save 80% of the tax you normally would. For example, if you're in the 22% bracket then traditional solo 401(k) contributions only save you 22% x 80% = 17.6%. It might still be worth contributing, but if that brings your marginal tax savings below your expected marginal bracket in retirement then then you might want to make Roth solo 401(k) contributions instead, so it's nice to have the flexibility.

If you're certain you'd only want to make traditional solo 401(k) contributions then you could check with Fidelity too to find out if they'd let you roll the IRA into the plan.

Here's a good contribution calculator: https://obliviousinvestor.com/solo-401k-contribution-calculator/

[Villanelle]

I have no current employer.  I'm a 1099 (and don't make much--last year was my first year cracking 5 figures, and just barely). 

Open a solo 401(k). It doesn't matter than you only make a little, all that matters is that you're self employed. First, you'll be able to contribute most of what you make, which will be more than the IRA limit you're talking about in this thread, and second you'll be able to roll the IRA into your solo 401(k), which will let you do a backdoor Roth too.

I'd look at E*trade and Schwab. Ask them if they'll let you roll the IRA into the plan, I'm almost certain E*trade will, I don't know either way about Schwab. They both let you make Roth contributions, which can be useful because traditional contributions reduce Qualified Business Income (QBI) which in turn reduces the QBI deduction. This effectively means that you only save 80% of the tax you normally would. For example, if you're in the 22% bracket then traditional solo 401(k) contributions only save you 22% x 80% = 17.6%. It might still be worth contributing, but if that brings your marginal tax savings below your expected marginal bracket in retirement then then you might want to make Roth solo 401(k) contributions instead, so it's nice to have the flexibility.

If you're certain you'd only want to make traditional solo 401(k) contributions then you could check with Fidelity too to find out if they'd let you roll the IRA into the plan.

Here's a good contribution calculator: https://obliviousinvestor.com/solo-401k-contribution-calculator/

Re: the bolded, I think that Trad is all I'll be able to do for the next few years at least, based on income limits, unless I'm misunderstanding.  Or are you saying "only make trad IRA contributions", as opposed to doing the backdoor Roth? 

For the underlined, can you expand on this a bit?  If I set up a solo 401k and put... let's say $8000 in it, are you saying I can roll the existing trad IRA balance of $40k into that 401k?  And how do I do the backdoor Roth at that point?  Transfer money from the 401k to the Roth, and if so, would that be the entire $48,000 balance, into my existing Roth account? 

[terran]

If you're certain you'd only want to make traditional solo 401(k) contributions then you could check with Fidelity too to find out if they'd let you roll the IRA into the plan.

Re: the bolded, I think that Trad is all I'll be able to do for the next few years at least, based on income limits, unless I'm misunderstanding.  Or are you saying "only make trad IRA contributions", as opposed to doing the backdoor Roth?   

Unless I'm misunderstanding what you mean there are no income limits for contributing to Roth vs traditional solo 401(k), that's for IRAs. If you over the limit to be able to make direct Roth IRA contributions, thereby requiring backdoor Roth contributions, then you're also over the limit to make deductible traditional IRA contributions.

Open a solo 401(k). It doesn't matter than you only make a little, all that matters is that you're self employed. First, you'll be able to contribute most of what you make, which will be more than the IRA limit you're talking about in this thread, and second you'll be able to roll the IRA into your solo 401(k), which will let you do a backdoor Roth too.

For the underlined, can you expand on this a bit?  If I set up a solo 401k and put... let's say $8000 in it, are you saying I can roll the existing trad IRA balance of $40k into that 401k?  And how do I do the backdoor Roth at that point?  Transfer money from the 401k to the Roth, and if so, would that be the entire $48,000 balance, into my existing Roth account? 

I don't think there's a requirement that you contribute anything to the solo 401(k), but it would probably be a good idea anyway if you can afford it.

Yes, if you open a solo 401(k) with a custodian that allows it then you can roll the $40k traditional IRA balance into it.

At that point you no longer have a previously deducted traditional IRA balance because it's in the 401(k), so you can proceed with backdoor Roth contributions just like anyone else without a traditional IRA balance: make a non-deductible contribution to traditional IRA, convert the traditional IRA to Roth IRA, fill out Form 8606 showing that only non-deductible traditional IRA balances were rolled over to Roth so no tax is due. Throughout all of this you leave the previously deducted traditional IRA balance that you rolled over to the 401(k) as well as any new contributions to the 401(k) where it is. This is your employer plan just like if you were working for someone else.

[seattlecyclone]

Once you start a solo 401(k) you should be able to roll an IRA balance into it if the solo 401(k) provider you choose supports that in their plan documents and backend systems. Look into that before you pick one.

As far as 401(k) contributions are concerned you can do either traditional or Roth, up to 100% of the first $23,500 of net earnings. Those are the "employee" contributions. There's no income limit for Roth contributions here because it's an employer plan, not an IRA. After that you can do "employer" contributions of 20% and these need to be pre-tax. terran is right that the pre-tax contributions do reduce your QBI deduction.

It sounds like your spouse is still employed and earning a solid amount so you can still do a spousal IRA contribution even if you put all of your own earnings into your 401(k). If you're still doing this self-employment after he retires, one thing to be aware of is that money you put into a Roth 401(k) counts as "compensation" for the purpose of calculating your IRA contribution limit, while money you put into pre-tax 401(k) does not. What this means is that if you have some low earnings you can end up putting more than all of your earnings into retirement accounts: put 100% into the Roth 401(k) and then an additional MIN($7,000, $actual_earnings) into an IRA. Can be a useful tactic if you have a bunch of money in taxable and would like to transfer some to Roth.

Also be aware that as an employer with a 401(k) there are some reporting requirements that don't apply to IRAs. If the balance ever exceeds $250k you have to file an annual report with the Department of Labor, and you also have to file a final report when you close the plan regardless of the balance. There can be some stiff financial penalties if you fail to do this properly. It didn't seem too complicated when I closed my plan last year, and nobody has told me I did it wrong yet, so here's hoping.

[terran]

As far as 401(k) contributions are concerned you can do either traditional or Roth, up to 100% of the first $23,500 of net earnings. Those are the "employee" contributions.

All great points, but be careful here. "net earnings" has a particular meaning, it's not just everything you've earned from the business.

[Villanelle]

If you're certain you'd only want to make traditional solo 401(k) contributions then you could check with Fidelity too to find out if they'd let you roll the IRA into the plan.

Re: the bolded, I think that Trad is all I'll be able to do for the next few years at least, based on income limits, unless I'm misunderstanding.  Or are you saying "only make trad IRA contributions", as opposed to doing the backdoor Roth?   

Unless I'm misunderstanding what you mean there are no income limits for contributing to Roth vs traditional solo 401(k), that's for IRAs. If you over the limit to be able to make direct Roth IRA contributions, thereby requiring backdoor Roth contributions, then you're also over the limit to make deductible traditional IRA contributions.

Open a solo 401(k). It doesn't matter than you only make a little, all that matters is that you're self employed. First, you'll be able to contribute most of what you make, which will be more than the IRA limit you're talking about in this thread, and second you'll be able to roll the IRA into your solo 401(k), which will let you do a backdoor Roth too.

For the underlined, can you expand on this a bit?  If I set up a solo 401k and put... let's say $8000 in it, are you saying I can roll the existing trad IRA balance of $40k into that 401k?  And how do I do the backdoor Roth at that point?  Transfer money from the 401k to the Roth, and if so, would that be the entire $48,000 balance, into my existing Roth account? 

I don't think there's a requirement that you contribute anything to the solo 401(k), but it would probably be a good idea anyway if you can afford it.

Yes, if you open a solo 401(k) with a custodian that allows it then you can roll the $40k traditional IRA balance into it.

At that point you no longer have a previously deducted traditional IRA balance because it's in the 401(k), so you can proceed with backdoor Roth contributions just like anyone else without a traditional IRA balance: make a non-deductible contribution to traditional IRA, convert the traditional IRA to Roth IRA, fill out Form 8606 showing that only non-deductible traditional IRA balances were rolled over to Roth so no tax is due. Throughout all of this you leave the previously deducted traditional IRA balance that you rolled over to the 401(k) as well as any new contributions to the 401(k) where it is. This is your employer plan just like if you were working for someone else.

Yes, my brain just skipped over the "401k" part and thought IRA. 

And I've got it now, I think: I open the solo 401k and put the trad IRA money there.  That means I no longer have a trad IRA and can do a typical backdoor Roth.  Thanks!