Why you might not want to rollover that old 401k
*The rollover strategies discussed also apply to 403b, 457b, 401a and other employer sponsored qualified retirement plans
For many high wage earners, making contributions up to annual Roth IRA limits (6k/$7k over 50; 2020) via the backdoor Roth IRA strategy is an appealing way to generate income tax free growth and income for future years. The backdoor Roth strategy entails making a non-deductible IRA contribution and immediately converting that contribution to a Roth IRA account. If you have no other rollover tax deferred IRA accounts when you execute this strategy, then you have simply moved money from a taxable account into a tax-free account.
What If I have existing Rollover IRA and/or Traditional IRA Assets?
When executing the backdoor Roth strategy, if you have any tax-deferred Rollover or Traditional IRA Assets, i.e. you haven’t paid income taxes on them yet, the Roth conversion will result in at least some of those funds being taxed in the year of the conversion.
For example, let’s say you have a Traditional IRA or Rollover IRA worth $60,000 and make a non-deductible contribution of $6,000 to this IRA in accordance with your backdoor Roth IRA strategy. When you convert the same $6,000 from your Traditional or Rollover IRA to Roth IRA assets, you’ll actually be taxed on ~91% of the conversion, which creates extra taxable income of $5,460 for the tax year.
This overlooked tax trap results from IRS rules which mandate, for tax calculations, your tax-deferred contributions and gains and non-deductible contributions from all IRA accounts (Rollover, Traditional & Roth) are combined into a theoretical IRA pot. From this theoretical pot, the IRS requires you to calculate the ratio of tax-deferred dollars to non-deductible dollars; the percentage of tax-deferred dollars in your theoretical account is the percentage of your Roth IRA conversion that will be taxed.
In this example your non-deductible $6,000 contribution to your Traditional IRA or Rollover IRA is divided by the total account value of $66,000—just roughly 9% is not subject to income taxes at the time of conversion.
The aggregation rules are one of the few reasons you should carefully think about not rolling over an old 401k or other employer plan. If the funds remain in a 401k, 401a, 403b, 457b etc. they are not subject to the aggregation rules.
While there’s no avoiding taxation of previously deducted personal Traditional IRA contribution assets during a backdoor Roth IRA strategy execution or other Roth conversion, there are sometimes opportunities to clean up existing Rollover IRA accounts to avoid this unpleasant tax consequence.
The Difference Between a Rollover IRA and a Traditional IRA
Though they’re nearly identical, there is a subtle, but significant, difference. You can roll over a 401k to a Traditional IRA or Rollover IRA. If you choose to roll funds into a Rollover IRA, rather than a Traditional IRA, you maintain the ability to roll those funds into another current or future 401k plan, if the plan documents allow.
Why Does That Matter?
There are 401k plans that allow IRA roll-in contributions, but they must come from a Rollover IRA, not a Traditional IRA. If your company has such a plan, you can roll your existing Rollover IRA account into your 401k plan which eliminates the tax-deferred IRA portion of your aggregate portfolio, allowing a high earner to execute the backdoor strategy completely tax-free. Without this keen planning taxes would be paid at high income brackets on the conversion, which is counterproductive to high earner’s overall tax strategy.
Don’t Commingle Rollover IRA and Traditional IRA Assets
If you commingle “regular” Traditional IRA funds and Rollover IRA funds you lose the ability to roll-in former Rollover IRA assets. It’s important to keep the Rollover IRA and Traditional IRA accounts separate. Consider opening a stand-alone Traditional IRA for annual personal IRA contributions and a separate Rollover IRA for rollover assets.
As always, things are rarely as simple as they seem. You should work with a competent Financial Planner to determine the best advice on your personal tax planning strategy.
Questions about tax minimization strategies regarding your 401k rollover or rollover IRA? Click here to setup a no cost discussion with us today!
As financial planners, we meet with many parents concerned about how they will pay for their child’s college education. These parents often ask about the Future Scholar program, the 529 college savings plan for residents of South Carolina. We created our educational savings guide below to explain how a 529 program works, the benefits of a 529 plan and the disadvantages of a 529 plan, and help you determine whether or not the SC Future Scholar Program is right for your family.
What is the South Carolina Future Scholar program?
Paying for college can feel like a monumental task for any family, no matter how financially comfortable they may be. Although tuition inflation in higher education has slowed in recent years, the price of a four-year college degree is still very high.
State governments have developed a special type of savings plan designed to help families save for this significant financial expense: the 529 college savings plan. In South Carolina, the plan is called the Future Scholar program, and it includes tax benefits designed to ease the burden of college tuition and encourage regular contributions.
How does a 529 Plan work
Any U.S. citizen can open a 529 savings account for a child regardless of their income level or their relationship to that child. There can even be multiple accounts for the same child as long as all combined contributions across these accounts do not exceed $520,000 in South Carolina. The maximum aggregate contribution limits vary by state.
Most 529 plans allow participants to deduct part or all of their contributions on their income taxes and contributions to the SC Future Scholar Program are tax-deductible on the state level.
And like any savings account, the money in a 529 account grows over time through additional contributions and interest earned. Unlike other savings accounts, however, the interest earned and the withdrawals you make are also tax-free.
Money can be withdrawn from a 529 college savings plan for tuition and fees, room and board, books, computers and other supplies required to attend any eligible institution offering post-high school education: two and four-year colleges, graduate and professional programs, and even certain vocation/technical schools.
Benefits of a 529 Plan
Disadvantages of a 529 Plan
How Do I Open an SC Future Scholar Program 529 Plan?
The SC Future Scholar Program is managed by a group called Columbia/Threadneedle, created by the merger of Columbia Management Investment Distributors of the US and Threadneedle Investments of the UK. Columbia Management is owned by Ameriprise, a national broker/dealer and financial service firm.
There are two ways to invest in the Future Scholar program. If you are a South Carolina resident, you can open and fund your accounts online directly with Columbia/Threadneedle or you can invest through the broker or your choice. See the sections on fees and expenses to understand the differences between these two approaches.
What is the Current Ranking for the SC Future Scholar Program 529 Plan?
Each year, Morningstar publishes a ranking of all 529 college savings plans across the country, awarding them gold, silver, or bronze status—or below. The SC Future Scholar plan landed solidly in the middle of the pack this year with a Neutral rank for the direct option.
If I Want a Gold 529 Plan, What are My Options?
The younger your beneficiary, the greater the value of lower fees and better fund selections. South Carolina residents can get the biggest bang for their buck by opening and contributing to the SC Future Scholar Program to capture state income tax savings. As their child approaches college age, they can execute a custodian-to-custodian transfer to a better 529 plan, such as the gold rated Utah Educational Savings Plan. Because a custodian-to-custodian transfer is not taxable, you can have your cake and eat it, too.
How Do I Get the Most Out of My SC Future Scholar Program Plan?
How Do I Calibrate My Investment in a SC Future Scholar Program Plan to Maximize My Investment or Manage My Risk?
Because you can only change the investments in a 529 plan twice each calendar year, many investors choose to select an age-based or a risk-based portfolio that is rebalanced by the plan administrator. The SC Future Scholars Program plan offers the following asset allocation portfolios:
The age-based portfolios are divided into Aggressive, Moderate, and Conservative tracks. Different asset allocation portfolios can be used at different ages to create a glide path toward your child’s college entrance date.
If you purchase share through a broker, there are some small differences in the allocation portfolios because they offer some actively managed fund choices not available to direct buyers.
Ready to take advantage of significant state income tax savings while creating future educational opportunities for a child? Talk to Oak Street Financial Advisors about the best way to set up and calibrate your SC Future Scholars Program 529 Plan today.