TL;DR: investment companies want you to roll your 401K into an IRA account with them – their incentives for this are not entirely altruistic. If you expect to be a ‘high income earner’ (see >$133K in 2017) at some point in the future, this could be a very bad idea, because it will limit your ability to take advantage of the backdoor Roth IRA. Also, if you’re young and considering contributions to an IRA, you should seriously consider the Roth IRA instead.
An ounce of prevention is worth a pound of cure
It’s tax season, and I’ve seen ads from every financial advisor under the sun telling me to roll over 401K plans from previous employers into an IRA with them. (see Betterment ad below)
If you think you might earn more than $133K at some point in the future, this is terrible advice!
While these companies might mean well (trying to save you fees, or provide better advice), they could be setting you up for a big fail.
Allow me to explain. When you earn more than $133K as a single filer ($186K for married filing jointly), the government phases out your ability to contribute to an IRA… well, at least they phase out the tax deduction that comes with that contribution. Fortunately, there’s something called a backdoor Roth IRA – how it works is that you contribute to a non-deductible IRA, then instantly convert it to a Roth IRA. You won’t get the tax deduction for the IRA contribution anyhow, so converting it straight into a Roth IRA doesn’t cost you anything extra.
So far this is great. Roth IRAs kick ass, letting you grow your assets and withdraw them tax free when you’re older.
But here’s the rub – if you have any money in an existing IRA account anywhere, the backdoor Roth IRA becomes a lot more complicated. You see, when you do a conversion from IRA to Roth IRA, the government needs to determine what amount of that money (if any) they need to tax. If all your IRA money went in to a deductible account tax free, then the answer would be that they will tax all of it at the time of conversion. Conversely, if half your money went into the IRA tax free (deductible), but the other half went in after taxes (non deductible), then they would elect to tax half of any money that gets converted to the Roth IRA. The core idea here is that you can’t designate which IRA funds are getting converted. All IRA funds are treated as one big pool. Any taxes you’ve already paid for non deductible contributions will not be taxed again, but any deductible contributions or investment gains will be taxed at the time of conversion.
A few examples might be helpful:
- If you have no money in an IRA, then contribute $5,000 non deductible in 2017 and pay the taxes on that contribution now, you’ll be able to convert all of that money to a Roth without paying any additional tax (assuming there was no investment gain from the time of contribution to conversion)
- If you have an existing IRA with $10,000 in it (all pre-tax – I.e. deductible), then contribute $5,000 in 2017 and pay the taxes on that contribution (non deductible), you have IRA accounts worth $15,000 with a $5,000 tax basis (I.e. the amount you’ve already paid in tax). If you later choose to convert $3,000 to a Roth IRA, they will prorate your basis across the $15,000, meaning that only 1/3 of the $3,000 you convert will be tax free… the other 2/3 ($2,000) will trigger a tax payment at your current marginal tax rate (which is pretty high given we’re having this conversation)
Hopefully from the second example you can see how you’ll be forced to pay tax early on your deductible IRA funds if you try to do the Roth conversion. Paying taxes that can be avoided really sucks. So the takeaway here is that you want to avoid having deductible funds in an IRA if you hope to use the backdoor Roth IRA. But if you go converting $20K of 401K assets into an IRA, that’s exactly what you’ll do! 401K assets are by definition deductible funds, meaning you haven’t paid tax on them yet.
Despite this being a widely known phenomenon, I’ve rarely seen any of the financial advisory firms warning against this sort of fuck up. Perhaps they don’t think many people will be eligible for the backdoor Roth (they’re wrong!), or perhaps they’re just greedy lemmings parroting financial advice without considering circumstances and consequences. In any case, you’re smarter than that, and now you know what to do.
As a final thought, for those young folks in high school or college, if you’re going to make contributions to an IRA, that’s a great idea, but make sure to contribute to a Roth IRA instead – it’s likely your annual earnings will be so low that you owe little to no tax on that money anyhow, so it’s better off in a Roth account… and if you’re so lucky as to be excluded from IRA deductibility in the future, you’ll be able to use the backdoor Roth without any penalties or problems.
An ounce of prevention is worth a pound of cure – and remember, enjoy the journey!