Tax Planning for Rollovers
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.
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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.
So, when should you leave the money in an old 401(k) or 403(b) rather than roll it over to an IRA?
Other than these scenarios, I recommend rolling over your nest egg to an IRA with a reputable fiduciary. Just some of the reasons are: