A 1285 dollar lesson from my IRA rollover
Tags: Ira Rollover, Lessons Learned, Money, Backdoor Roth, Retirement

TL;DR: If you regularly perform backdoor Roth conversion, there is a big disadvantage of rolling your 401k balance to IRA that is ususally not mentioned. You will be surprised by additional tax bills for your after-tax dollar contribution.

Photo by Nathan Dumlao on Unsplash

I recently left for a new job. After some research, here are my choices of what I can do with my old 401k plan.

1. Leave it in my previous employer 401k plan

2. Roll to the new employer 401k plan

3. Roll to IRA

4. Cash out the 401k

Among all options, one most recommended option is option 3. The pros are:

1. More choices of investment.

2. Fewer accounts to manage and less paperwork during tax seasons.

This is specifically beneficial in the long run. Jumping ship happens every few years. This could potentially lead to many 401k accounts here and there. Keeping track of the username and password would already be a headache, not to mention all the paperwork to track and maintain for tax return.

Fewer accounts could also mean fewer management fees. Some 401k plan charges high plan fees for employees who had left the employer. In contrast, IRA account offered by discount brokerages usually charge little to none management fees if you chose to manage the account by yourself.

The Cons are:

1. Some funds with lower expense ratios are only available in employer 401k plan.

2. IRA assets do not enjoy the same level of asset protection from creditors as 401k plan.

Having weighted the pros and cons, I made the call and rolled over my 401k balance to my IRA account. I’m particularly drawn to the idea of managing fewer accounts and the paperwork.

Here the story begins.

It starts with a pre-tax/post-tax dollar mix

I have been performing backdoor Roth for the last two years. For those who are new to Backdoor Roth conversion, Backdoor Roth allows high earners to put in after-tax dollars to a limit to theirtraditional IRA and then convert to Roth IRA. Having this context, you won’t be surprised that I have a dedicated traditional IRA account to contribute my after-tax dollars.

In order to differentiate the pre-tax dollars and post-tax dollars, I opened a separate account that is dedicated for my 401k pre-tax dollars. This way I thought I could show IRS that these two traditional IRA account are different:

1) one with 100% after-tax dollars that had been converted to Roth IRA through backdoor.

2) the other with 100% pre-tax dollars from my employer 401k plan.

I thought everything was in a good place till last week I came across a post that discusses the “coffee and cream rule” for Roth conversion. It’s like a wakening call that made me realize how naive I had been of rolling my 401k to my IRA.

Coffee and cream rule

“Coffee and cream rule”, also referred to as the “pro-rata rule”, is a rule to determine the proportion of your pre-tax and post-tax funds across all your non-Roth IRA accounts. In this analogy, coffee is your pretax (aka deductible) dollars and cream is post tax (aka. Non-deductible) dollars.

Just like there is no way that you could sip coffee without taking in some cream, when you mix pre-tax dollars and post-tax dollars in non-Roth IRA accounts, you cannot differentiate them by putting them into two separate accounts. As required by the IRS, the legitimate way to discern the two types of dollars is to calculate a proportion of pre-tax/post-tax dollars.

Applying coffee and cream rule

Let me walk you through my case. Early this year I made 6k backdoor Roth IRA contribution. In October I switched job and rolled over 50k pre-tax dollars from my 401k plan to my traditional IRA.

Across all my non-Roth IRA accounts, now I have

Pre-tax dollars = 50,000

Post-tax dollars = 6,000

Percentage of pre-tax dollar = 50,000/56,000 = 89.3%

Applying the coffee and cream rule,

for every dollar I converted to Roth, I have to pay ordinary income taxes for 0.893 cents.

At the beginning of the year, I had performed 6,000 backdoor Roth conversion . As a result, I had to pay income taxes for 6,000 × 89.3% = 5,357 dollars.

My tax bracket is 24%, which translates to 5,357×0.24 = 1,285.68 dollars more in tax this year.

Remember the 6,000 dollars I put in my traditional IRA are my post-tax dollars! I have to pay an EXTRA 1,285.68 more in taxes because I rolled over the 50K pre-tax dollars to my IRA.

It doesn’t stop here

To make the whole thing worse, there is a ripple effect of this one time IRA rollover. Consider the following years that I wanted to keep doing backdoor Roth.

Let’s assume that my contribution for the next 5 years remain the same at 6,000 dollars and my pre-tax funds will not increase in value. For every year I performed a backdoor Roth on 6,000 dollars, I had to pay 1285.68 dollars. This amount would increase if there is a profit for my pre-tax investment.

Had I chosen option 1 or 2, I would be able to enjoy the full benefit of a backdoor Roth by paying zero tax for my post-tax dollars.

Timing of activity doesn’t matter

Another misunderstanding I had is that I thought the order of activities matter. My reasoning is as follows.

My backdoor Roth conversion happened months before the IRA rollover. At the point of IRA roll-over, the amount in traditional IRA is zero and technically I didn’t mix coffee with cream.

Unfortunately, when it comes to the pro-rata rule, IRS calculates the proportion of pre-tax/post-tax funds considering all activities happened in the year. Regardless the order of activities, as long as you put both pre-tax funds and post-tax funds in the same pod within the same year, your coffee and cream cannot be parted.

What are my choices next?

Having accepted the fact that I made a mistake, I tried to search for a solution. The goal is to remove the traditional IRA balance and get a clean slate. Having done my research, I came up with three options.

1. Roll the traditional IRA balance to my new employer 401k plan.

2. Convert all traditional IRA balance to Roth.

3. Stop doing backdoor Roth conversion in the future.

Option 1 is a quick and painless remedy for my mistake. Were I able to complete a reverse rollover by the end of year, I would save myself 1285 dollars for the lesson. However, that is also subject to that my new employer 401k policy accepts IRA roll-over.

For option 2, it’s a painful yet fast way to get back to the clean slate. It also means I will be expecting a much larger tax bill this year that I haven’t planned for.

Option 3 is the worst among the three in the long run. I don’t feel like giving up the chance to invest 6,000 dollars annually with tax-free growth for the next twenty years.

I hope my story helps you make a more informed decision on how to handle your old 401k plan.