Quit, Leave, & Roll
The common financial “advice,” patterned after the basic fire safety technique, is to roll your 401(k), 403(b), or other employer sponsored retirement plan into an IRA once you quit and leave your former employer. This is done with the assumption that 401(k) plans are a substandard retirement vehicle in comparison to IRA accounts. The sales pitch to roll out of a 401(k) typically focuses on the limited investment choice and fees charged by the plan and the advantages of having nearly unlimited investment options in an IRA. The other commonly cited advantage to move money out of a 401(k) to an IRA is to consolidate all of the accounts in one place ostensibly for the ease of managing the retirement assets. However, the common, ubiquitous advice usually omits discussion on the overall fiscal state of an investor.
It is important to take into consideration the effect of rolling a 401(k) plan that is largely pre-tax money into a Traditional IRA and its impact on Roth conversions. In this article, we will focus on the advantages of keeping money inside of a retirement plan to facilitate Backdoor Roth IRAs. It is important for investors to take a holistic approach in evaluating options rather than a myopic examination of the individual parts of their overall financial plan. A focus on the individual parts and not taking consideration of the whole can lead to outcomes that are less than optimal. The main goal in financial planning and investing is to maximize the amount of monies available after taxes within an investor’s constraints (risk, time horizon, taxes, etc.). Investors only keep what the government does NOT take.
Starting with the very basics: There are two main types of IRA accounts: Traditional and Roth. Traditional IRAs are funded with pre-tax money, grows tax free, and are taxed when the monies are withdrawn. Roth IRAs are funded with after-tax money, grow tax free, and withdrawals are not taxed. Roth IRAs pay tax today and Traditional IRAs pay tax in the future.
The ability to deduct contributions into Traditional IRAs and contribute to Roth IRAs is subject to income limitations. If an investor makes too much money, the ability to deduct and contribute to IRAs may be restricted. If you or your spouse do not have a retirement plan at work, income limitations do not apply and the full amount contributed to a Traditional IRA is deductible. If you or your spouse do have a retirement plan at work, the ability to deduct contributions is based upon income. The ability to contribute to a Roth IRA is dependent upon income limits as well. The income limits for deduction and contribution eligibility are based upon modified adjusted gross income (MAGI). The tables below are the income limits for 2017:
If a single investor with a retirement plan at work has more than $133,000 of MAGI, the investor will be ineligible to make a contribution to a Roth IRA and will also be ineligible to deduct a contribution into a Traditional IRA. On a positive note, this single investor would still be able to make a non-deductible contribution into a Traditional IRA. Effectively, the Traditional IRA account is funded by after-tax dollars. In this case, the money still grows tax deferred, and when money is withdrawn, only the growth on the non-deductible contribution is taxed. For example, assume the investor only made one non-deductible contribution in the amount of $5,500 with 3% growth.
After 20 years when our investor withdraws from the Traditional IRA, $5,500 will not be subject to tax and $4,433.61 will be subject to income tax. The IRS requires investors to withdraw a proportionate amount of their pre- and post-tax money from the account. If our investor only withdrew $1,000, $550 (55%) has already been taxed and $450 (45%) would be subject to tax. Assuming the investor is in the 25% tax bracket, ~$1,100 and ~$112 would be owed on a full distribution and a $1,000 partial distribution, respectively.
In 2010, the income limits for Roth conversions were removed. This allowed high-earnings the ability to convert Traditional IRAs to Roth IRAs. In the example above, our investor could have made a non-deductible contribution into a Traditional IRA and immediately converted it over to a Roth IRA. The investor would have avoided paying tax on the growth. In this case, since the investor already paid tax on the money in the Traditional IRA, there would be no additional taxes owed on the conversion. This assumes that there was no pre-tax money in the IRA. This is known as the Backdoor Roth IRA: making a non-deductible Traditional IRA contribution and immediately converting to a Roth IRA. The purpose of the Backdoor Roth IRA is to avoid taxes on the growth of the post-tax contributions.
The Backdoor Roth IRA is an excellent way for high earners to reduce their future tax obligation by avoiding tax on the growth of non-deductible contributions. However, like anything in life, there is no free lunch. The IRS does not allow for investors to only convert post-tax money. Similar to the pro-rata distribution rule for Traditional IRAs with non-deductible (post-tax) contributions, the IRS requires a proportionate amount of pre- and post-tax money to be converted. For example, our investor has a Traditional IRA that has non-deductible contributions, deductible contributions, and growth with the balances below:
If our investor converts $10,000 from the Traditional IRA to a Roth IRA, a proportionate amount of pre- and post-tax money must be converted.
Post-Tax --> $10,000 x 15% = $1,500
Pre-Tax --> $10,000 x 85% = $8,500
The investor would have $8,500 subject to income tax on the Roth IRA conversion.
Backdoor Roth IRAs have the most value when there is no pre-tax balance in a Traditional IRA. If there is pre-tax money present in an IRA, this would be a taxable event. It is important to note that balances in Traditional, SEP, and SIMPLE IRAs are used to calculate the amount of money subject to taxation on a Roth Conversions. Balances inside of 401(k), 403(b), and other retirement plans are excluded from this calculation. Please see IRS Form 8606 for details.
Stop, Drop, But Don’t Roll!
Investors can close the door on the tax efficiency of the Backdoor Roth IRA by transferring their 401(k) into a Traditional IRA. If investors keep their money inside of their 401(k) plan, this maximizes the value of the Backdoor Roth IRA by minimizing the pre-tax balance (taxable portion) of the Traditional IRA. If the 401(k) plan is rolled into a Traditional IRA, it may not make sense to do a Roth conversion due to the pro-rata rule.
According to Fidelity’s most recent analysis of 401(k) balances, the average 401(k) balance was $92,500 at the end of 2016. If this average 401(k) balance is rolled into an IRA and a non-deductible contribution is made, then ~95 cents out of every dollar converted is subject to tax. This increase in the pre-tax portion of the Traditional IRA increases the cost of a Roth IRA conversion, effectively closing the Backdoor Roth IRA.
In the table below, we explore a low, moderate, and high growth return for a 60% stock and 40% bond portfolio. Each year, a non-deductible contribution of $5,500 is made into a Traditional IRA. The column, % Post-Tax, is the proportion of the account that would not be subject to taxes upon withdrawal.
The value of the Backdoor Roth is derived from the tax savings on the growth of the non-deductible (post-tax) contributions if left in a Traditional IRA. For example in the 5% return scenario after 20 years, the account has a balance of ~$205,000. 44% would be subject to tax and 56%, the non-deductible contributions, would not be subject to tax. Assuming that the investor is in the 25% tax bracket in retirement, this would result in a total of ~$22,550 (~$90,200 x 25%) to be paid in taxes. These taxes could have been avoided by converting the post-tax contributions over to a Roth IRA every year.
The table above outlines the tax savings from the same three growth scenarios above assuming a 25% tax on a withdrawal from the account. This table also assumes that there were no pre-tax monies in the IRA thus avoiding any taxes on the converted amount.
As we can see from the two tables above, the growth on post-tax monies is significant over time, and utilizing the Backdoor Roth IRA can result in large tax savings. Even in the low growth scenario, after 20 years, this could result in tax savings of ~$11,000. This tax savings represents ~11% of the total balance in the Traditional IRA.
Prior to rolling money from a 401(k), 403(b), or other employer sponsored retirement plan to an IRA, we would urge investors to contemplate the impact on their overall financial situation. Rolling a retirement plan into a Traditional IRA increases the pre-tax (taxable portion) balance, which will increase the tax liability of a Roth conversion. This will likely close the door on the Backdoor Roth IRA. At a minimum, investors should analyze the cost of leaving money in the retirement plan with the tax savings offered by the Backdoor Roth IRA.
While we realize the emotional impact of leaving an employer, either voluntarily or forced, we would like investors to stop before taking the normal course of action with retirement plans: Quit, Leave & Roll. Stopping to think and contemplate options and possible outcomes prior to taking action can help improve outcomes.
Adam Hoffman, CFA, CAIA
- Department of the Treasury. (2017). “2017 IRA Deduction Limits – Effect of Modified AGI On Deduction If You Are NOT Covered By A Retirement Plan At Work.” Retrieved from IRS.gov. 2017 Trad IRA Deduction Limit - No Retirement Plan
- Department of the Treasury. (2017). “2017 IRA Deduction Limits – Effect of Modified AGI On Deduction If You Are Covered By A Retirement Plan At Work.” Retrieved from IRS.gov. 2017 Trad IRA Deduction Limit - Retirement Plan At Work
- Department of the Treasury. (2017). “Amount of Roth IRA Contributions That You Can Make For 2017”. Retrieved from IRS.gov. 2017 Roth IRA Income Limits
- Department of the Treasury. (2017). “Publication 590-A”. Retrieved from IRS.gov. Publication 590-A
- Fidelity. (2017, February). “Fidelity Retirement Analysis: 401(K) Balances, Contributions, and IRAs End 2016 At Record Levels”. Retrieved from Fidelity.com. Fidelity Retirement Analysis
Disclosure: I am/we are long VTI, VXUS, VCSH, VCIT, VMBS, VFIIX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Peak Capital Research & Management's clients are long the following positions in either Vanguard ETFs or Mutual Funds or utilizing a similar iShares ETF. Broad US Index, Broad International Index, short-term corporate bonds, intermediate-term corporate bonds, and GNMAs.