*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.

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.
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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.

​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.

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.

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.
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I often get the question of what to do with an old 401(k) or 403(b) sitting with a former employer. In short, there are only a few circumstances where you would want to leave it be, but in those circumstances it can be extremely advantageous to do so.
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So, when should you leave the money in an old 401(k) or 403(b) rather than roll it over to an IRA?

• When you’ve left the employer at ages 55- 59 ½
  • In this instance, you can withdraw money without penalty and without having to wait until 59 ½
• When you have appreciated employer stock
  • This is not a common scenario so I’ll save you some headache and not delve into net unrealized appreciation
• When your former employer actually offers a decent plan
  • You may THINK your plan is amazing, odds are it’s not
  • Most plans don’t offer a fund menu that can be molded into a truly diversified portfolio
• Better protection from personal law suits
  • Generally, your assets are safer in a 401(k) or 403(b) plan in this scenario
• If your plan allows for employee loans and you need to access the money you can do so in a 401(k) or 403(b) without penalty

 
Other than these scenarios, I recommend rolling over your nest egg to an IRA with a reputable fiduciary. Just some of the reasons are:

• Flexibility
• Access to a wider range of investment options, not just the 10-15 offered in your employer plan
• Ability to construct a truly diversified portfolio based on your risk tolerance and return needs
• Lower fees
  • Some argue that you can get lower fees in a big 401(k) program, but in my experience many plans are more expensive than you may realize when all expenses are considered. Not just mutual funds expenses, but third party administrator fees, third party transfer fees, and other expenses that are embedded in the plan.
• Professionally managed and re-balanced
  • Most employees must choose their own funds haphazardly and do not re-balance their portfolios consistently