My most recent ACEP NOW column concerns the Backdoor Roth IRA. It takes a while to wrap your head around this one, so I don’t mind addressing the subject multiple times. I’m still getting emails, forum posts, and blog comments every week with good questions about the Backdoor Roth. If you’re an attending physician, and not already funding one of these for yourself and your spouse, you’re probably making a mistake. Here’s an excerpt:
The second type of retirement account is a tax-free, or Roth, account. These accounts, named after Sen. William V. Roth Jr. of Delaware, also allow tax savings but in a different manner than a tax-deferred account. You contribute after-tax dollars to a tax-free account such as a Roth IRA or a Roth 401(k). The money then grows without taxation and, in retirement, is withdrawn from the account and spent tax-free. While the bulk of an attending physician’s retirement savings during peak earning years should probably be in tax-deferred accounts, it will be extremely handy to arrive at retirement with significant amounts of both tax-deferred and tax-free assets. Aside from contributing to tax-free accounts, it is also possible to convert tax-deferred accounts to tax-free accounts by paying the taxes due in the year of the conversion.
Prior to 2010, there was an income limit both on making contributions to Roth IRAs and on converting traditional IRAs to Roth IRAs. If you made a typical emergency physician income, you could neither contribute to a Roth IRA nor convert one of your traditional IRAs. However, starting in 2010, that income limit was removed from the conversion process, although not the contribution process. Under current law, a typical emergency physician cannot contribute to a Roth IRA but can contribute to a traditional IRA and then convert it to a Roth IRA.
The trickiest part about doing a backdoor Roth IRA is dealing with the pro-rata rule. A typical emergency physician can neither contribute to a Roth IRA nor deduct a traditional IRA contribution, although a traditional IRA contribution is permissible. This is known as a nondeductible traditional IRA. However, when doing a Roth conversion, the IRS does not permit you to just convert the nondeductible dollars into a Roth IRA. The traditional IRA must be converted pro-rata.
Read the rest of the article here, then come back, leave a comment, and answer the poll. Are you doing a backdoor Roth IRA? If not, why not?
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The article provides a great description of the process of entering through the back door, but could use a bit more robust support for why the back door is attractive, as noted in the post title. Maybe good fodder for a future post with some numerical samples or matrix of ages, marginal rates, etc. As always, keep up the good work.
I suppose I sometimes forget that, since it’s so obvious to me. You’re a comparing a taxable, non-asset protected account to a tax-free, most likely completely asset protected account with excellent estate planning benefits. It’s “no-contest.”
Dr. JB,
No analysis or matrix is needed for this strategy. It is a way for high income earners to get money into a Roth account with no other taxes due. If your asking to compare a Roth to a taxable account then I think it is pretty obvious as to which account has the most benefits. Roths are great for asset protection, both tax free and tax deferred, access to basis before 59 1/2, estate planning. The only reason not to do this is because you have a lousy 401/403 and you don’t want to move traditional Ira’s into the plan.
JT- Can you comment on my question below:
When a SEP-IRA is rolled into a 401k, will the 401k rules of asset protection and ability to tap assets between 55-59 1/2, apply to the SEP-IRA rollover also? Or does the rollover somehow “corrupt” the protections and advantages of the 401K?
I have never found a direct answer to this issue. We are close enough to retirement that the years left to do a Backdoor Roth are few. The amount invested in Roth would not be worth messing up the ability to withdraw early at 55.
Dr. Mom,
I am not an asset protection attorney. I am an Enrolled Agent and financial advisor so take that for what it is worth.
Asset protection is mostly a state issue, all states are different. In general, IRA’s have less protection against creditors than 401ks. I think the max protection afforded IRAs in federal bk law is $1mill and there is no limit for 401ks. I could be wrong, I work with mostly residents, fellows, new attendings so only a couple of clients have more than $1mill. Florida law provides no limit for IRA protection among other great asset protection benefits, such as whole life insurance, have you heard of the benefits of a whole life policy recently? That was meant to be funny.
I haven’t heard or seen anything in tax code saying that there are any lost benefits from rolling a SEP into a 401k. The only time rollovers can really hurt you are the penalties for rolling out of a Simple IRA within 2 years of participating in the plan. Also, the rules for Roth conversion money are different than straight Roth contribution rules.
SEP IRA’s don’t have the separation of service rules that qualified plans do. So right now I don’t believe you can even do separation of service withdrawals from your SEP account. The IRS doesn’t have any time period (or “seasoning requirement”) for allowing a rollover from an IRA into a qualified plan to allow for separation of service withdrawals.
As far as corruption of the rollover is concerned I would imagine that this shouldn’t be an issue from a tax standpoint.
You need to speak to an attorney in your state as to whether the rollover could subject the IRA assets to be reachable in a lawsuit. The only reason I say this is for fraudulent transfer rules. I doubt this would be considered a FT but maybe it could. In Florida, cash value life insurance and annuities are protected from lawsuits save that they were in place before you do become aware that you maybe sued. People who try to put money in these vehicles after the fact can lose their money. I highly doubt this extends to IRA rollovers to 401ks. Again, 401ks generally have better asset protection rules than IRAs.
Thanks for clarifying your whole life comment was a joke!! And for your answers. I am less worried about making an unknown error by doing our SEP-IRA to 401K rollover from an asset protection standpoint than in our ability to tap the 401K at age 55 for job separation. My understanding is when you roll the 401k into an IRA you lose that ability. I have never clearly seen if the opposite is true or if rolling the IRA into a 401K hurts or changes your ability to tap the funds at 55. We are still in education mode but would like to gain some funds in a Backdoor Roth just for tax diversification and estate benefit. Thanks again!
One of the big problems in my view of using permanent insurance as “protection” is that unless its a limited or single pay policy that it requires ongoing premiums to keep it in force (this is besides the fact that these things are horrible investments). Thus if you get wiped out, there isn’t any money to keep it in force and you lose that too.
No one keeps track of the fact that 401(k) dollars come from a SEP-IRA or a direct contribution.
I believe this is correct. Roll away!
Thanks guys!
So with the Pro-Rata rule being applied to about 90% of my 80K IRA (this is the first year we had a 401K so I have a lot of traditional IRA contributions.) Can I just let it all stay mixed for now and when income goes down then do the backdoor? I only ask because this year is a great year for my income as there were minimal expenses unlike past years, and I hope to make it to the top bracket. I think next year income will be back down because we will have more expenses again, and I will be back into a lower bracket.
We are in a high marginal bracket with significant IRA’s, so it doesn’t make sense for us to use it now. We plan to use it in lower income years (if still available) particularly in early retirement. If it is no longer available, we may miss some estate planning benefits and the flexibility of tax diversification in retirement, though. We did consider rolling my husband’s SEP-IRA into his 401K to make room. I would like to hear if WCI thinks that is a good idea in general. The analysis got very muddy for us. Most of what we read talks about the benefits of rolling your 401K into your IRA. He has a solo practice so the accounts have all the same offerings, fees, etc.
If you have made any nondeductible IRA contributions to a Traditional IRA, be sure you are filing Form 8606 on taxes annually to claim them. It establishes your nondeductible basis so when you can use the Backdoor Roth, you will only be taxed on earnings. We had to go back and file ours as we and our accountant missed that particular tax detail. It was no big deal but certainly something that needed to be addressed before using the Backdoor Roth if applicable.
Huge IRAs, a high tax bracket, and no way to roll them into a 401(k) is a good reason not to do a backdoor Roth IRA. Unfortunate, really. Rolling a SEP into a 401(k) is often a good idea.
There is a lot of press out there that suggests moving your 401(k) to an IRA upon separation from an employer, but that ignores the backdoor Roth IRA pro-rata issue. You usually get lower costs and more options by going to an IRA, but you lose a little asset protection and more importantly, the ability to do backdoor Roth IRAs. You might also lose a distribution option if you retire between 55 and 59 1/2, as some 401(k)s allow for withdrawals without penalty after separation but before 59 1/2.
When a SEP-IRA is rolled into a 401k, will the 401k rules of asset protection and ability to tap assets between 55-59 1/2, apply to the SEP-IRA rollover also? Or does the rollover somehow “corrupt” the protections and advantages of the 401K? Are you aware of any specific reasons NOT to roll a SEP-IRA into a 401K? Thanks for another thought provoking piece.
Higher expenses and poor investment choices are the main reasons people don’t want to roll money into a 401(k). Even a Solo 401(k) at Vanguard has higher expenses (and slightly more hassle) than a SEP-IRA at Vanguard. But I judge the backdoor Roth IRA to be worth it.
Dr. Mom, thanks for the form 8606 advice, I’ll remember that. Up until this year it didn’t make sense to do a back door because I could take the deduction. Now I would love to, but I think that I will also wait until income comes down a bit and then convert if the option is still there. I’ll take a look as I get closer to the end of the year. I still have quite a bit of deductions, some of which are due to a 401K option I never had before, so it might make sense to convert a part of it depending on where I end up in the tax brackets.
WCI, when does the conversion have to be done by, Dec. 31, April 15th or when taxes are filed? Ideally after the end of the year is best so I can really see all the final numbers, but I obviously don’t have control over that.
Ricky, if your IRA is completely funded with tax deductible contributions you could consider rolling it into your 401K if allowed as WCI described. Then you would be free to use the Backdoor Roth with new contributions. We are grappling with rolling my husband’s SEP into his 401K to open the Backdoor Roth for us. (See WCI’s points above.) My old Traditional IRA has some deductible and some nondeductible contributions and I have no where to roll it into, so it gets more complicated with pro rata rules and tax consequences.
Dr. Mom, sadly that’s not an option with my 401K, no loans. no hardship deferrals, no rollovers etc. It’s a very simple 401K, but expenses are rock bottom!
Ricky,
Its not often that I see a 401k/ 403b that doesn’t allow roll-ins. You may want to double check and see, usually employers like big 401k balances, not low balances.
Yep, I’m sure because I set it up. It made things simple and less expensive for the business, hence no withdraws or loans also.
Then change the plan to allow Roll-ins.
All you have to do is have the TPA amend the plan document. Shouldn’t be much of a cost (probably a couple of hundred bucks). Definitely worth it!
You can do the conversion whenever, but the 8606 is a little more straightforward if you do the contribution and the conversion in the same year (especially if there are no earnings between those two events.)
Thank you. I already put this years money into the IRA, I do it in January so I have the entire year to hopefully grow. Sadly, this year I shot myself in the foot because we have the 401K now, so my January deposit won’t be deductible.
I wasn’t planning on doing the 401K because the numbers never made sense as a business owner before. I’ll have to talk to Konstantine, who I found through here actually (he will appreciate the plug), and see if he has any other ideas.
Thank you for the plug 😉
Sure, it is still possible to do a 401k plan this year, through a process called QNEC. It is basically a one-time plan design, and it may or may not make sense in each individual case, but it never hurts to run the numbers. Before doing that, it always makes sense to do a side by side analysis just to make sure that a retirement plan makes sense given the cost, tax bracket and contribution amount. You want your plan to make sense going forward as well, so the analysis has to include this as well. But having the plan accept incoming rollovers is a nice feature to have.
Ricky,
I didn’t notice that anyone caught your question on the timing of the conversion, so I’ll step in to answer if you don’t mind. The conversion has to be done by 12/31, but that doesn’t mean you are stuck with it. You have until 10/15/15 to do what is called a “recharacterization” of any or all funds you converted in the prior year. A recharacterization allows you to literally change your mind – say, if the stock market tanked after you converted or if you decide you don’t want to pay any or all of the tax due on the conversion.
To recharacterize, you move the original fund(s) and any earnings back to the original account it came from. Much has been written on this topic and whether you should open multiple Roth conversion accounts in case you want to segregate funds that you may move back.
It’s also worthwhile to note that you can convert actual funds rather than liquidating and moving the cash. This is typically what we do with our clients since we maintain all of the character of the original balanced portfolio.
I hope this is helpful.
The issue is the coffee and the cream problem. It’s harder to separate the non-deductible from the deductible than to keep them separate in the first place. You may be able to separate the basis (for instance, if your 401(k) doesn’t accept post-tax money as a rollover), but it can make it trickier.
I kept my deductible and non-deductible IRAs separate, which did help when I rolled them into my 403b a few years ago. But I still had to separate out the gains in the non-deductible IRA, which I rolled into the 403b, from the original non-deductible basis, which I kept in the IRA and converted to a Roth. I didn’t do a perfect job because of course the share price fluctuated during the process, so I had a tiny bit of gains left in the IRA when I converted and had to pay taxes on them, but it wasn’t much. My point though is that all I had to know was the amount of our non-deductible contributions, keep that in the IRA, and roll everything else into our work plans. It was pretty simple.
For what it’s worth, the IRS tried to claim we owed taxes on those gains as well as on our separate deductible IRAs that were rolled into our work plans, in spite of the proper forms being generated by our IRA trustees. But they backed off after our accountant wrote them a letter.
There is no such thing as a “non-deductible” IRA, only non deductible contributions. Your IRA custodian has nothing to do with your tax issue, the problem was with your tax professional. They probably never filed the 8606.
Yes, I’m aware of that, thanks. I was using “non-deductible IRA” as a shorthand for “IRA containing only non-deductible contributions plus gains.”
My accountant had filed the 8606 each year. Plus the IRS was also demanding we pay taxes on the entire amount of the IRAs containing only deductible contributions, which had been rolled in their entirety (basis and gains) into our respective 403b and 401k, and were reported correctly to the IRS as a direct rollover. It was either a screw-up or just hopeful fishing on their part, and they backed off after a one-page letter.
Don’t feel bad Pyrite, I use the same term, although he is technically correct that there is no such thing.
FYI… I wasn’t trying to be snarky regarding my comment. This is a confusing subject for people and I think it makes it easier to comprehend when you break it down to its core. Roll all IRAs to 401k/403b plan, contribute to regular IRA (cannot deduct due to high income), convert to Roth IRA with no tax due because the IRA had non-deduct contributions and was 100% basis.
It may even make sense to contribute to an IRA without converting it (if one isn’t comfortable with the idea of the “backdoor” Roth), tax deferral and asset protection come to mind as benefits. This would be similar to an non-qual annuity when taking money out.
A taxable account will generally be better than a non-deductible IRA. Yes, you lose asset protection, but it takes decades for the tax-deferral to make up for the higher tax rate on the earnings (when compared to the better LTCG and qualified dividends rate.) Plus you lose the ability to TLH and get the step-up in basis at death. Not to mention the loss of flexibility etc. The only good reason I can think of to do a non-deductible is to convert it to a Roth at some point. Maybe not this year, but within a few years. I agree it’s similar to a non-qualified annuity- also generally a bad idea.
I’m new to this but I’m considering something similar to what you did: rolling my deductible IRA (rollover of 401k from prior employer) and the earnings from my non-deductible IRA into my current employer’s 401k.
Did you make two separate rollovers or did you first transfer the earnings of the non-deductible IRA into the deductible IRA? Seems that the latter would be easier (both my accounts are at the same institution).
Thanks.
I don’t think you can just transfer the earnings out. You need to roll the money to an account that doesn’t accept the basis, so the basis must be left behind. Practically speaking, that means rolling straight to a 401(k).
I really don’t understand these… I have ~17k in an IRA at Vanguard and an old 401k I rolled over to Vanguard worth ~ 54k. Can I roll both of these to backdoor roths? Is it expensive at the end of the year taxwise?
You’re not getting it. The point of a backdoor Roth is a way to make Roth IRA contributions, not a way to do Roth conversions, which is what you’re describing. They get combined because of the pro-rata rule. If you can roll your two IRAs into a current 401(k), there are no tax consequences, and then you could start doing backdoor Roth IRAs. You could also just convert the entire IRAs, but it’s going to cost you something like $20K in taxes.
Ok, I’ll have to look into if I can roll my old stuff into my now 403b. If not would you recommend paying ~20kin taxes to convert to roths so that I can then do backdoors in the future? I am 35, making ~400k. Thanks for the help/advice.
Use this calculator to figure it out.
http://www.bankrate.com/calculators/retirement/convert-ira-roth-calculator.aspx
Most of the time it doesnt make sense, but for small amounts, it may reduce the hassle a lot, esp if you have income to put in extra 11k each year.
Hard choice. I think I probably would pay the $20K. Certainly wouldn’t be wrong to choose not to.
Why is that? Is it simply for simplicity’s sake? Mine would cost about the same and I’ve been going back and forth between changing the business 401K documents to allow rollovers for a time, or just paying the taxes and having a bigger Roth. I like the idea of having a larger Roth to either draw from in retirement, or pass on to the kids/grandkids, but not sure I like it to the tune of a 20K tax bill.
Simplicity’s sake plus you get a larger Roth out of it. It’s not like that’s a bad thing.
Ok, so I checked into it. It seems I can roll over my old 401k and my ira into my 403b, they will be going from vanguard to tiaacref. So that saves me 20k in taxes?! Then I can start doing backdoors next year? Thank you so much for your help!
Yes. That’s how it works. I like Vanguard better than TIAA-CREF, but TIAA-CREF isn’t bad. Was the old 401(k) Vanguard? You could roll the IRA there.
Top things to do if you plan on pursuing this strategy.
1) roll all traditional, Seps, Simples into qualified plan at work. Do this before starting the strategy. Hopefully you have a good plan at work, not always the case.
2) make sure your tax person files form 8606. Your IRA custodian has nothing to do with reporting to the IRS that you will not be deducting your contribution. If this form isn’t filed, you will get a CP 2000 letter asking for many thousands of dollars from the conversion. You have to check your return to make sure it was done, many tax people don’t have a clue about this.
Thank you very much!
Im just a lowly resident with some extra money from moonlighting, but I opened a roth a few months ago because I figured that I would not always be able to do that after I get “attending money.” If I get to that point, can I use my existing vangaurd roth when I make the conversions? Sorry if this is a dumb question but I think im finally starting to understand the concept behind the back door.
Matt,
1) are you in IBR and trying for PSLF? If so, a Roth may not be right for you.
2) As long as you don’t have any other traditional IRAs you will not have to worry about aggregation rules. You should be able to use the same Roth account for your conversions, this may vary depending upon the custodian. You will have to open a traditional IRA account to convert from.
3) I work mostly with residents and fellows for taxes/student loan strategies/ disability insurance, and financial planning. Let me know if you have any questions
I am not in either of those things. I have a relatively small amount of student loans that are currently in forebearance. Thanks for the answer!
Obviously I think a traditional would be better option for a single resident in the 25% tax bracket, and paying 15% of their discretionary income to IBR. That is a savings of 40% (today, not some hypothetical future tax bracket) to their cash flow for every dollar they invest in a Traditional account. The traditional could then be rolled over to a qualified work plan at a later date to accommodate the roth conversion strategy. If tax rates increase with inflation and a normal MD ends up in the equivalent of the 28% bracket in retirement then they win using this strategy. What am I missing?
You’re only missing the fact that the resident is in a 15% bracket and may never be there again. Plus he has maximum time to compound the Roth portion of his portfolio.
Upside of traditional:
Slightly lower IBR payments (but that just means you end up paying back more later- no real savings and in fact less)
Possibility of slightly more PSLF/IBR/PAYE Forgiveness
Downside of traditional:
Saving taxes at just 15-25% and possibly later paying them at marginal rates of 25% or more
Lower post-tax contribution amount ($5500 post-tax is more than $5500 pre-tax)
Missed opportunity for Roth contributions at a low tax bracket, and thus a lower Roth to tax-deferred ratio in retirement
Personally, I think for a typical resident, the downsides of making a traditional IRA contribution outweigh the upsides. But if you’re sure you’re going to get forgiveness, I can see why someone would choose traditional. I just wouldn’t.
And your 40% figure isn’t real savings. It’s just cash flow. It’s like saying traditional is better than Roth because it puts more money in your pocket now. While true, that ignores the fact that the Roth guy will have more money later.
As is always, the answer to any financial question is,”it depends”.
I 100% agree for those that fall in the 15% bracket.
Most residents single residents will end up in the 25% bracket. A $52,000 resident salary – $2,500 (student loan interest) = AGI of $49,500. – $10,000 for exemption and standard deduction. This is $39,500. $3000 into the 25% bracket. Its not like these “lowly” residents (another contributor’s phrase) are going to want to put too much into the IRA, they still need to live.
Finally, for the person in question, he would almost certainly end up in the 25% bracket if he is moonlighting, not to mention paying SE tax.
Cash flow is important. That cash flow can help the resident pay less tax today, less in student loans (again for someone committed to PSLF), and save for retirement. If not committed to PSLF then yes, the smarter thing to do is Roth.
I give lectures to residents often. My recommendation is to consider a Roth, even if it means forgoing 401/403 in residency. Cash flow is important, particularly to pay off accrued interest on loan.
Tax burden is not a priority when trying to keep a head above water in the low brackets.
I think for those who are committed to PSLF, the less they pay to IBR is like a 15% tax savings, when added to their 25% tax bracket it is like saving 40% on the amount contributed to a traditional IRA. If they are not committed to PSLF, then yes, Roth is probably best option. I currently work with cardiologists who do 6-7 years of training, some are taking jobs with the VA. PSLF can work out great for this scenario, and doing a traditional IRA makes a lot of sense for those in the 25% tax bracket during residency and fellowship.
Yes you can. I also disagree with JT that being in IBR/PSLF is a reason to do traditional over Roth. Residents should do Roth, even if it means slightly higher IBR payments or slightly less PSLF forgiveness.
You can have multiple roth custodians. Or you can have one. So you can continue with vanguard as an attending
Thanks! I have been reading on this subject for a while but I think it is finally starting to make sense. I don’t anticipate being over the contribution limit as a first year (half year) attending next year so I should be able to make 2 more direct contributions to my roth, as well as open a spousal roth before going back door, but wanted to make sure I could use those same accounts!
I may as well plug my article in the emra magazine from last month. Page 27 of the PDF
http://www.emra.org/uploadedFiles/EMRA/EMRA_Publications/EmRes-2014AugSept-web(3).pdf
Maybe it will help some people understand what is going on
If you’re going to plug it, you’ve got to use a link that works!
http://viewer.zmags.com/publication/e9e987ae#/e9e987ae/26
Good article by the way; thanks for writing it.
Thanks, the file extension didn’t parse
Thank you for the insightful article!
Do you have to follow this process of contribution and conversion each tax year, or can you contribute directly into the converted ROTH IRA after the initial conversion? (assuming income exceeds the maximum threshold each year)
Mark, yes, you must follow the process, not necessarily every year but this is the only way for high income earners to get money into a Roth account without having large tax bills. To be clear, you cannot contribute directly to a Roth account if you make too much income.
Love this topic. Looking for some advice for my situation. I would love to start contributing to a back door ROTH, but currently I have $6k in a traditional IRA and my wife has $23k in a traditional IRA. It sounds like the best thing to do would be to roll this money into 401ks. However, my wife works PRN and was told that PRN employees cannot contribute to the 401k at her work. Does anyone know if she would be eligible for an individual 401k? Is it possible to roll her account into my 401k or 403b? I suppose worst case scenario I could just convert and pay the taxes (highest income bracket). Thoughts?
Solo 401ks are for self employed business owners. Does your wife have any 1099 income? You can roll your IRA into your plan, your wife’s funds will always be separate, she cannot roll those into a plan in your name. Depending on your age, you may want to consider converting her amount into a Roth and just paying the taxes.
I would have loved to been able to do a backdoor Roth, but unfortunately at this time the tax bite would be too great for me. I’ve got ~135k in an unmatched 401k from work, 50k in a TIRA w/Vanguard(all non-deductible contributions), 10k in a Roth IRA(with Vanguard and from a time when I was making substantially less income),75k in a Vanguard taxable account and am in the 33% tax bracket. I’m 54 yrs. of age and plan on retiring in 12.5 more yrs.to a substantially lower(ie.15-25%)tax bracket than I’m currently in.
What are you talking about with the tax bite? There should be no tax bite to just converting your entire $50K TIRA and going from there. You didn’t get a deduction so the only taxes you’d have to pay would be on the earnings. That seems totally worth it to me.
AR,
If what you say is accurate and the only TIRA that you have is all non-deductible contributions then you can just convert that TIRA to a Roth and only pay taxes on the gains, that basis will not be taxable.
JT, the problem is that paying the taxes on the gains would be over $7000. And considering that I’ll be in a much lower tax bracket in retirement years, I don’t think it would pay. I’d probably have to lose at least half the value of my TIRA to make it feasible.
How much is gain and how much is basis and what bracket are you in? If you indeed made the calculation correctly, then I can see why it would give you pause to convert the whole thing. I’d probably still do it, but it wouldn’t be unreasonable not to. You can always convert your first full year of retirement when you’re in a lower bracket. You may also be able to separate the basis by rolling just the gains into a 401(k). Check your 401(k) rules to see if that might be an option. That would leave you just the basis which you could convert for free.
AR, so you have over $20k in gains in the TIRA? I would probably still pay the tax, make that entire amount a Roth and start doing $5500/ 11k if married of “backdoor roth” conversions. Are you an MD? Do you have a lot tied up in private practice? I don’t mean to judge but I have to say but it sounds like you are a little bit behind. My wife is 41, I am 36, she is an OBGYN and I changed careers (i.e. very low income for about 3-4 years) and we have 2 young kids. Our net worth is significantly higher. I smell a bad divorce in your past.
The online calculator that I used shows me that I’d owe $7750 in fed taxes. Truth be told, I’m a dentist who ran an unproductive practice for 15 yrs. and got off to a very late start funding our retirement. I’ve been working as an associate(non-owner/W-2) for the past 8 yrs. My wife and I started our TIRA’s about 8 yrs. ago. She’s 49 yrs. old,has ~33k in her TIRA and 11k in her Roth(no 401k though). We will be living on considerably less income when I retire, though we plan on having paid off our mortgage(our only debt)at that time. And hopefully our two kids, 21 and 17, will be out of the house by then.
Jim,
1) What is your opinion about contributing to a Roth 401K vs a backdoor Roth IRA? Is either one preferable to the other?
2) Regarding the step doctrine, if you waited some period of time between the contribution to the IRA and conversion to Roth, wouldn’t the gains be subject to tax? Wouldn’t it be preferable to do the conversion immediately after the contribution to avoid the tax on the gain?
1) I don’t see that as an either/or question. For a typical doc in his peak earnings years, you would want to max out your regular 401(k) first, then if you want to save more, do a backdoor Roth IRA. The first question is tax-deferred vs Roth 401(k). The second question is more Roth vs taxable.
2) Yes, the gains would be subject to tax. Or you could leave it in something that isn’t going to gain anything. But either has a downside in my view to just converting the next day. The date of conversion isn’t reported to the IRS anyway and I haven’t heard of anyone being prosecuted/audited by the IRS for it.
If can’t afford to do it by dec 2014, is it possible to still do this by the 2015 deadline for 2014 contributions (will have 0 in any IRA at dec 2014)?
You can make your traditional IRA contributions for 2014 up until April 15, 2015. You can technically do the conversion step at any time after the contribution, including years later.
I’m considering transferring my traditional IRA into my 401k work plan, in order to have a zero balance traditional IRA to start doing back door Roth IRAs next year.
However, my work 401k fees are substantial at 1.6%, compared to 0.10% for my traditional IRA.
If I want these funds to grow for another 25 years, am I better off just leaving the traditional IRA funds where they are, and not doing back door Roth IRA contributions for my wife and I for 25 years?
You’ve got a very clear understanding of the issues. It’s definitely a dilemma. While 1.6% sucks, it really comes down to how long you’ll be using that 401(k). If you expect you’ll be there for 10-20 more years, then maybe it’s not worth rolling over a HUGE IRA. If it isn’t huge, have you considered just converting it all to a Roth and paying the tax due? It’s not like more Roth is a bad thing. You could even do it over 2-3 years to spread out the pain.
Even worse than the high fees is lack of diversification and a poor choice of available funds. This can cost you even more than the 1.6% in underperformance. Who is your employer? It is possible to change the investment lineup. One service we provide to retirement plans is lowering investment cost and making other improvements to the plan (which should ultimately benefit the owners as well as all of the participants). It is easier than ever to do this, and there are no reasons why such expensive funds should be used.
If I’m understanding correctly, my husband has a rollover IRA that needs to be rolled into his existing 401K prior to the end of the year to take advantage of the backdoor roth. However, that is his separate account and I could set up a traditional IRA and then convert to Roth at any time? I am in the process of doing this and want to make sure there is nothing impeding this while he gets the rollover into his 401K taken care of. Please let me know if I am on the right track so we can start taking advantage of this ASAP. I don’t want to miss the contribution for 2014 if I am able to do it.
You have until April 15 to make your contribution. The pro-rata rule is per individual. So if your husband has a rollover IRA, that has nothing to do with your ability to do a backdoor Roth. When you do taxes married filing jointly, you file two 8606s.
Great!! Thanks so much for the direction. I should have been doing this the past couple of years since we heard about this while my husband figured out the pro-rata details….. I guess lesson learned. Any more advice about MEGA back door Roths? I recently read your article as well as others regarding this. My husband is finding out what his 401K will allow at work to see if that’s even an option for us. His concern is how much is reasonable to have in a Roth IRA. We have a lot in tax deferred investments and think there is much that could be to our advantage by doing this. I read about a maximum contribution overall of $52K….where does this number come from?
I think the better question is how much is reasonable to have in tax-deferred accounts. I tried to address that issue here:
https://www.whitecoatinvestor.com/the-proper-ratio-for-retirement-tax-diversification/
I’m not sure what else I can add about Mega backdoor Roths. If your 401(k) allows after-tax (but not Roth) contributions, it’s a good option for you. Can also work with a SEP-IRA that is completely converted each year. The $52K limit is per employer and comes from the IRS. It includes both employee and employer contributions. This might help:
https://www.whitecoatinvestor.com/beating-the-51k-limit-friday-qa-series/
Okay I get it mostly. One caveat is that my husband is a W-2 employee for the hospital, therefore not self-employed so to speak. Therefore cannot do a SEP IRA I believe. He is just over 50 and would like to think he can retire in ten years if he wanted to. I am 42 and work only on call, but also have 401K available to me. We will be in the highest tax bracket likely as long as he works. We are definitely starting the backdoor roth this year and again next, but are trying to come up with a good investment strategy going forward from here.
He currently holds @$270K in rollover IRA (we are rolling to his 401K)
@$370K in 401K
@$500K in Vanguard ETFs
together we have a $118K municipal bond
I have @$48K in a pre-existing Roth and haven’t been able to contribute to it (therefore the need for doing backdoor Roth in a hurry!!)
We also have 6 month emergency fund in money market with Vanguard, as well as 529 funds available for college tuition.
In the past year or so we have had the opportunity to contribute to a 451/457?? with no contribution limits through my husbands work. Again…..this is a tax deferred option. However, it does or could help by lowering our AGI, but……we still remain in the top tax bracket.
I am a little unsure of where to focus our efforts after doing the backdoor Roth and I guess it all hinges on whether the Mega backdoor roth is available through my husbands 401K plan (which is with Fidelity). We are currently checking on this. I will end this with–the Mega backdoor Roth seems quite a bit more scary to me than regular backdoor Roth. If I understand correctly it is essentially the same process inside a 401K plan with a much bigger payoff. Is this then considered a Roth 401K? I’m not sure I understand what that is.
Forgive me for beating a dead horse….. You are the only one who seems to understand the struggles of a high income family doing their best to invest with our government regulations.
With many moving parts and a good amount of money in play I think that you should consider hiring an adviser who can really dig into your finances and provide holistic ongoing advice to you that considers all of your finances as a whole.
As you mentioned, lowering AGI might work given the limitations for tax deferral, and you can probably benefit more from optimizing every part of your investment strategy. Can you benefit from continuing investing in municipal bonds? Are you using the best investment strategies in all of your accounts? Should you be contributing to a 457 plan (is it a governmental or non-governmental)? Tax deferral is a big benefit if you are in the highest tax bracket, so going crazy on the Mega Roth may or may not be the best strategy, but it can be part of an overall strategy. After-tax investing is also important (given the 20% LTCG tax rate and 3.8% NII tax, as well as state taxes), so that has to be done tax efficiently.
You need to first develop an overall strategy, and then look at every part of it to see if it can be improved.
Thanks for the advice. Currently the advisor we had been working with is an insurance agent “financial planner”. That is where the municipal bond came from as well as a $500K permanent life policy on myself that he talked us into…… That being said his other suggestions were annuities, etc. I think we are in process of finding someone else after our research and setting up quite a bit through Vanguard.
I believe it is actually a 451 (non-government) which we are currently only investing production bonus $$ into as it seemed a little risky as well. I will re-read and re-evaluate the withdrawal strategy article as we have discussed this as well. I think it will help us balance it all our.
Thank you so much for your comments and hard work on this topic. I have passed out a few of your books to friends in the same situation. Hopefully they are following your blog and getting the newsletter too. Such a valuable tool!! And thank you for being so considerate in taking questions and answering very timely.
I feel into the trap of this permanent life insurance too, got rid of it this year. Just more happier, if not anything else. Make sure you have enough term insurance.
How do you get rid of the permanent life? Just quit paying the premium? The problem with maxing 457 is that it is private and there is no contribution limits. We could theoretically contribute 100% income if we wanted to….. so the puzzle is how much is the right amount. Obviously we would and could be in a very low tax bracket on retirement, therefore minimizing taxes upon withdrawal. I do think the ability to have the roth IRA withdrawals to help balance that is essential and feel like we’ve missed a big opportunity here with the backdoor. That is where my question about MEGA backdoor comes in. I believe my husband’s 401K can and will help accomplish this, but how much to put there is a mystery to me still. Will have to run the numbers. Is there anyone out there reading this who might have done this mega backdoor with success? I’m not sure if you, Jim, with WCI have ever done this yourself??
All insurance have cash value which is = total premiums paid- cost of insurance. Call up your agent, ask what is the surrender value of your policy. Plus how much premiums are you paying in it? Do you have term policy.
All 457bs whether governmental or private have a limit. I think its 18K for 2015.
Again taxable is a great way of keep investing if you have maxed out, 401k, 457b, backdoor ROTH.
Good thing is you can max out 401k to 53K (2015) and add 457b on top of it. The 53K limit does not include 457b. Also be careful roll overs are pretty limited in 457b. But again 18K a year is not a very big amount.
I’d double check on that contribution limit. Usually it’s $17.5K for a 457. I don’t know how much I’d put in if it were unlimited. Would depend on a lot of things like investment options, costs, how much I already had in there, how much I want to save each year etc.
I haven’t done a Mega backdoor Roth via a 401(k), but if you’re allowed to make after-tax (not Roth contributions) above and beyond your employee contribution ($17.5K) and any match, and you’re allowed to do an in-service withdrawal, then it is probably a good idea. Remember it’s post-tax money, so there’s no cost to doing it. Search Mega Backdoor Roth on bogleheads.org. There are a number who have done it, but I don’t know any docs who’ve done it. Many docs (like me) have a 401(k)/Profit sharing plan and can do $52K in tax-deferred, so no point in the Mega Backdoor Roth.
Do you mean a 457 non-governmental or 401a? I actually don’t recommend 457 non-governmental plans for my clients. Even though the maximum is high, there are several problems:
1) You can not roll it into a qualified plan (pretty much into anything, including an IRA or a 401k plan).
2) Distributions are taxable. Even though you can take them over several years, it is still a bad deal because you have no control over the amount and the timing. Yes you can hold the assets there, but this just prolongs the inevitable huge distributions at the wrong time.
3) Investment choices are usually very bad.
4) No protection from creditors. So having a lot of assets in such plans is a mistake.
There is really nothing wrong with a municipal bond, except if it is an inappropriately sold bond (usually very long term ones, and potentially higher risk) pushed by brokers for a big undisclosed spread vs. selected to fit your specific financial situation. And a single bond is not a good idea – a bond portfolio with a particular goal and investment strategy would be more appropriate.
Annuities can be appropriate in some situations (especially during retirement and distribution phases), not sure they are in yours. I prefer retirement plans, low cost index funds and individual municipal bonds, and Vanguard is the best place for that.
Yes, insurance brokers don’t tend to act in fiduciary capacity or do holistic planning. My bias is towards flat fee work (vs. asset-based or sales). I really feel bad for all the docs who have a lot of financial choices to make but who do not get the right type or the right level of advice for their situations (because asset-based advisers don’t want them for lack of assets, and insurance brokers don’t have the right advice).
2) Unless you hold the assets there until the “right time.”
3) I’ve seen some Vanguard funds in 457s.
4) You have GREAT protection from YOUR creditors. Unfortunately, you have no protection from your employer’s creditors, since it’s technically still their money.
That said, you have to weigh these downsides against a big tax break. That’s a big deal in the top bracket.
Some non-governmental 457 plans actually make full distributions within some time after termination. Sucks to have your entire amount distributed in one year and taxed at a highest bracket (something that we are trying to avoid, so it becomes a wash). The maximum contribution to a non governmental 457 is actually $18k, but to a 457f it can be unlimited, but subject to forfeiture.
The distribution rules would be pretty important to understand BEFORE contributing.
You know Konstantin and I are different people, right? I think your “451” is a 457. I’d use even a non-governmental one if I were in the highest bracket, but I can understand why some people might not want to.
You need a new adviser, BTW. You accidentally hired a salesman instead.
Yes I know you and Konstantine, as well as Dr. Khan, are different people. I’m keeping that in mind when I continue on my planning here. This is my first time asking a question here and don’t quite know how the reply thread works, sorry.
I will say keep doing more and more taxable. Gives you flexibility.
1) Max out 401 k, since he is employed, he probably wont get full 52K
2) Max out 457, all comes out pretax
3) Backdoor Roth
4) Keep doing taxable, this way you can eliminate retirement cliff
I believe the only way he’d get to the 52K is contributing after tax money to the 401K, which then leads back to the MEGA backdoor Roth concept. Again, it isn’t a 457, it is a private 451 through the hospital that has no contribution limits. Not a guaranteed investment and somewhat risky, but it’s a very large and mature hospital system and is very unlikely to go under in the next 10-12 years. It appears to function on withdrawal much as a 401K, though I’m not sure if there are any restrictions on rolling it to an IRA of some type upon retirement from the company.
Another question is about rental property. We currently have one and I was wondering if you could establish an EIN with self-employed status and then add a SEP IRA, or something else with myself being the self-employed landlord? I know it’s a little off topic, but I recall reading about SEP IRA’s and conversion to Roth as well??
No, you cannot contribute to a retirement plan using passive income. It must be earned income. “Being the landlord” is still probably passive income, but look at the rules, they’re pretty specific.
I’d love to learn more about this 451. Mind scanning some of your literature from it and sending it my way? Or sending me a link. It’s pretty odd that I hear about a retirement plan I know nothing about. Is it insurance based? I can’t even google anything about it. Seriously, I know about 401(k)s, 403bs, 457s, 401(a)s, 529s etc etc, but not 451s. Very interesting.
I don’t know what a 451 is. I do know what a 457 is. There really are NO contribution limits? Kind of odd for a retirement plan. Most 457s have a $17.5K limit. Can you explain how your plan works?
In order for your husband to do a mega backdoor Roth, his 401(k) (or one of his other retirement accounts) must 1) allow for post-tax (not Roth) contributions and 2) allow for in-service rollovers. If those two aren’t allowed, no Mega Backdoor Roth. A Roth 401(k) is different and is the employee contribution for the 401(k). It’s limited to $17.5K and replaces $17.5K of tax-deferred money…maybe not the best idea for someone in their peak earnings years.
You have $118K in a single municipal bond? Wow! Hope that municipality doesn’t go bankrupt. If that were me, I’d probably sell it if I could do so at a reasonable expense and invest it in a municipal bond fund at Vanguard. Also, why would you have money in a money market fund right now? Might as well leave it in your checking account. At least go over to Ally Bank and make 0.9% on it.
My husband has a 401K as well as ability to contribute to a separate 451 (I’m sure I’m naming this right). It is offered to physicians (high-income earners) only who work for the hospital. The hospital is a non-profit, I believe it is privately held by them. It has mutual funds within it. There are no contribution limits. It sounds to me as if it is like a self-insured plan that a hospital would have although it is mutual funds. He was offered this 3 years ago and we declined as it sounded quite risky. You have to contribute for 5 years before withdrawal of any kind.
We are checking into his 401K to see if it will meet both of those requirements to do a mega backdoor roth. Although that sounds somewhat risky, it seems less risky to me than dumping a lot of money into the prior fund I was talking about. And to be clear, that $52K limit is both employee and employee contributions, correct? He is over 50 so I believe his max contribution is either $21 or $23K I cannot recall. I don’t believe they match 100% so he may still have some room there.
I don’t believe our Municipal bond is a single bond, it is a bond fund. However it is through the aforementioned insurance agent/”financial planner”. If we review our situation and determine we might benefit from more municipal bonds we will be purchasing them from Vanguard. From what I understand a municipal bond functions somewhat in the same way as a roth. Gains are not taxable as they are post tax $$. Also I believe they are not subject to creditors and can be passed to heirs. I might be wrong on that last point.
Thanks for the clarification on the landlord “passive income”. I think that would have just made filing taxes much more difficult (and expensive) anyways. We’re just trying to figure out what all of our options are.
We have money in a money market account because we are in the middle of a kitchen remodel and want to be able to access in the next 2 months in the event we haven’t saved enough in our checking account. If we have budgeted appropriately it will be rolled into an investment at Vanguard most likely.
We try to review every 3-6 months, but based on this past round of gaining new knowledge I believe we are going to re-organize all of our investment information and make an appointment with a fee for service financial advisor. I know Vanguard offers broker advise, but I’m not sure that is enough with all of this.
Thanks WCI for all the great information and links to more!!!
back to the 451-We started contributing this past year. You can choose a dollar amount, a percentage of income, etc. to contribute. We chose at this point to only contribute bonus compensation as it would be a smaller amount over the next year. It is a tax deferred plan and decreases our AGI, but like I believe you said earlier it–I don’t believe it’s subject to creditors, but it is subject to the hospital systems creditors………
It sounded risky to us the first couple of years, but in looking at our options, it seemed like the only other thing we could do at the time to put away more money into a tax deferred investment.
451 is a non-governmental 457 – I believe they are the same thing. And you have to be very careful how the money is distributed on termination, the rules can be different depending on the plan.
Sounds like a good idea to see an advisor. Doesn’t mean you have to use him forever. The highest yield is the first year anyway.
A municipal bond IS NOT like a Roth IRA. While interest is federally tax-free, only some bonds are state tax-free. Plus, capital gains from it aren’t tax-free. While the fund you’re in might not be a very good one, I think even a bad fund is a better idea than a single bond.
Yes, the $52K limit ($53K for 2015) is both employee and employer. But just because employee + match does not equal $52/$53K doesn’t mean you are allowed to contribute more. And even if you can, it doesn’t mean it can be deducted. If it can contribute more and defer it, great. That’s basically a 401(k)/Profit-sharing plan. It you can contribute more and then roll it out of the plan where it can be converted, great, that’s a Mega backdoor Roth IRA. If you can contribute more but not roll it out, that’s not very useful. Most people, however, simply can’t contribute more.
WCI-does the after tax contribution have to be rolled outside of the plan to a Roth IRA if it is held in a separate account and there is a roth option inside of it? From what you were saying it sounds like it can’t even be held with the same 401K company (Fidelity)? Maybe I’m misunderstanding.
BTW I looked at the 451 and it has an annual distribution over 5 years, therefore we need to be wary of how much is placed there as it will be taxed upon distribution. Maybe that’s a tool to use in early retirement i.e. age 65-70??
I would still love to know what a 451 is. I have a feeling its basically private 457, though I have never heard it being referred that. Amber can you tell us more about what a 451 is?
Dr. Khan: A 451 is a non governmental 457, which is a deferred compensation plan. Contributions can be very high ($50k is not unusual) and the money can not be rolled over into any other plan but another 451. You get distributed upon termination, anywhere from 2-10 years.
Amber: The problem is, what happens if your husband changes jobs? Because he surely can not keep the money in there if he goes to work elsewhere. It gets distributed potentially over a short period of time.
I’m actually working on a full blown simulation of whether a 457/451 plan is worth it based on various parameters. Right now my gut says that in the distribution phase you’ll pay the full tax on all contributions plus investment growth, whereas if you invested after-tax, you wouldn’t even pay capital gains until later on, so depending on your contribution, rate of return and distribution time, you might end up paying tax on a much higher income, thus throwing you into the higher bracket, making this plan a very bad deal. Also, most of these plans have crummy investments, and typically have brokerage windows (which are great for ETFs, and sometimes for mutual funds, though that can get expensive for a multi-asset class portfolio of mutual funds).
It just depends on the rules of that particular 401(k). Read the plan document and ask the plan administrator. I agree that 457/451s should be tapped first in retirement.
WCI,
Did you mean to say that the $52k limit is a per employee number as opposed to employer?
No, $52K limit is per employer. If you have two unrelated employers, you get two $52K limits. The $17.5K limit, however, is per person, no matter how many employers.
Thank you WCI for the very useful info! I didn’t know much about the backdoor Roth IRA option.
Here’s my situation:
– 50 years old
– I max out on deductible contributions to 401k and Keogh ($57,500 this year)
– Taxable income for 2013 was $177k
– I have accumulated ~ $96k in a non-deductible IRA i.e. an account containing only non-deductible contributions (cost basis ~ $57k) plus gains
– I have a deductible IRA (rollover of 401k from prior employer) worth ~ $170k, which I MAY be able to rollover into my current employer’s 401k
Not sure the backdoor Roth IRA option makes sense for me because the tax to pay on the earnings would be quite significant.
Any suggestions?
I agree the taxes are significant. I would still try very hard to do it because a Roth is so much better than a non-deductible traditional IRA. You’ve got $39K in gains, so perhaps $13K in taxes. Consider that $13K a retirement contribution, because that’s how it will act.
Hi WCI,
I recently opened up a traditional IRA but have not funded it yet. Is it too late to do a Backdoor Roth conversion for 2015? Am I better off waiting for January 2016? And how would filing the tax paperwork be affected by this? I remember you said the paperwork is easier when you open the account and convert the funds in the same year. Thanks.
Hi, Liz, Hope you don’t mind my 2 cents. It is not too late to convert according to the calendar but it may be too late for the conversion paperwork to be submitted. You should check with your advisor or financial institution. I believe we told clients that TDAmeritrade needed forms submitted by 12/22.
I don’t know your tax bracket but I presume your TIRA will be nondeductible. In that case, the main consideration is to wait a few days between funding your TIRA and converting to a Roth to avoid the appearance of a “step transaction”. Otherwise, it really won’t matter which year you convert as there will be no tax consequences and you are not limited on the amount you convert. You have until 4/18/16 to contribute $5,500 to your IRA for 2015. Hope this helps.
Thanks, Johanna.