New Roth conversion eligibility rule and solo-401(k)
Posted by ML on March 23rd, 2007
One of the most exciting developments in terms of retirement savings for high incomer earners in last year’s Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA, signed by President Bush on May 17, 2006) was elimination of the Roth conversion eligibility limit after 2009. In addition, in 2010 only, the extra tax incurred for this conversion can be spread over two years. Currently, married joint filers can convert their traditional IRA into Roth only if their modified adjusted gross income (MAGI) is under $100,000. Somewhat perversely, this provision is billed as a means to increase revenue, since taxes will have to be paid for the traditional to Roth conversion (at the expense of future tax revenue — but that’s someone else’s problem).
Today, joint/single filers with MAGI over $160,000/$110,000 are not eligible for Roth contribution. Phase-in starts at $150,000/$95,000 respectively. Non-deductible traditional IRA is pretty much the only IRA option for these people, assuming they are not self-employed. Many financial advisors are pointing out that the elimination of conversion eligibility limit creates a loophole where high income earners can simply contribute to a non-deductible IRA and immediately convert it into a Roth. The high income earner gets the Roth benefit without additional income tax liability. This plan works as advertised only if there is no other IRA with pre-tax contributions (traditional, SEP etc.). Since the IRS treats all non-Roth IRAs as a single pool of money, it’s impossible to single out the after-tax contribution for Roth conversion if there are other pre-tax contributions. [To calculate the actual income tax liability requires knowing the value of the IRAs and the basis in them. Some might still decide to do the Roth conversion even though they incur extra tax doing so.] However, all is not lost.
It’s a curious fact that although 401(k) plans share many of the characteristics as traditional IRAs, they are not included in the pool of IRAs when considering the characteristics of the withdrawals/conversions. Thus some interesting possibilities present themselves.
- For those intending to take advantage of the new Roth conversion rule and changing jobs between now and 2010, the best thing to do with their 401(k) is to leave them with the old employer or roll-over to the new employer’s 401(k) instead of rolling over to a traditional IRA.
- For those self-employed, consider a solo-401(k) [aka self-employed 401(k)] instead of a SEP-IRA if there is no employee other than the spouse.
- More research needs to be done but the Fidelity solo-401(k) appears to accept roll-over from a traditional IRA. If that were true, one can simply roll-over all IRAs with pre-tax contributions and voila, the trick mentioned above works beautifully!
In conclusion, those above the Roth eligibility limit and planning on doing the conversion should contribute to non-deductible IRAs now. Those having IRAs with pre-tax contributions should explore the possibility of rolling them into 401(k)s. By the way, the bar for establishing a solo-401(k) is not high. Check out these two articles at MyMoneyBlog (link 1, link 2) for more information. I have a sneaky suspicion that several PF bloggers would benefit from this financial maneuver.
Disclaimer: I’m not a tax professional. Make sure you consult with a CPA/financial planner before making any decisions.
More related posts:
Digg it Del.icio.us Reddit Furl BlinkList Newsvine Yahoo MyWeb
March 24th, 2007 at 10:29 am
I’ve been contributing to my non-deductible IRA ever since I became ineligble for the Roth IRA figuring it would be back door into the ROTH at some point. Even without removing the income limit on conversion earnings for many people can vary quite a bit.
That said, what the Govt really needs to is simply the tax law regarding retirments savings. Somebody with big balls needs to say that it’s all non-sense. There’s no reason that different tax vehicles should have different tax treatments. Why is that someone can contribute less tax deferred dollars because their company has a simple ira plan rather than a 401k? It makes not sense. There should be three tax buckets.
1) Tax deductible, tax deferred i.e. 401ks, SEP-IRA, Simple IRA, etc
2) Non Tax Deductible, Untaxed i.e. Roth IRAs
3) Non Tax Deductible, Tax Deferred i.e. traditional non deductile IRA, annuities etc.
Sure there can be limits on eligibility but that should be function of income instead who you work for. Everyone get 15k to put into tax deductile, tax deferred vehicle, another 4k for the Roth, and another 4k for the the tax deferred non tax deducitble. Wouldn’t that be simpler for everyone? As is many people are getting screwed because they work for companies that piss poor retirment options. Teachers are probably the biggest losers in all of this as they’re often sold annuities instead of traditional mutual fund based 403b plan – they should have an option of contributing dollars in a tax deductile IRA plan.
March 24th, 2007 at 7:56 pm
Dong,
I’ve been doing the same wrt non-deductible IRAs as I also foresaw income variability down the line. In fact, most people who aspire to retire early would have opportunity to make such adjustments in the “pre-retirement” years.
The problem with the variety of retirement plans is that they’re sponsored by the employer. My company for example, has a very lousy 401k administrator, but it’s something I’m aware of, and part of my employment contract that I entered into willingly. I don’t see government mandate as the answer.
ML
March 25th, 2007 at 8:28 am
Nice post on TIPRA! I was just discussing this with a client yesterday. He is early 60s, retired, $140k in income and about $2mm in IRAs. He hates the idea of having to take RMDs in 8 years. Rothifying in 2010 is a perfect solution for him.
The difference between IRAs and 401ks is the latter are qualified plans protected by ERISA, IRAs are not. I don’t understand your recommendation for leaving money in 401ks vs. rolling over to an IRA. Also, you cannot move money from a traditional IRA to a 401k plan unless the IRA is designated as a “Rollover IRA”. It’s a bit more complicated that one would think.
March 25th, 2007 at 1:10 pm
ML,
That’s the exact problem – retirement plans are sponsored by the employer and as a result employees end up being screwed by their employers with bad plans not just because the plans are bad (or non existent), but make employees ineligible for deductions. I don’t think the govt need to mandate anything with regards to how plans are setup, but they should give people freedom with their eligibility of deductible dollars. For example if my employer didn’t sponsor a 401k plan, I should still be eligible for 15,000 of tax deductible savings I can put into a personal IRA account – as it is right now I’d be screwed and wouldn’t be able to take advantage of that tax deduction. There’s no reason that people should be eligible for different levels of deducitble savings based on the administrative laziness of their employer. Effectively that’s what the govt has mandated already.
Thc, I don’t want to answer for ML, but I know what he’s referring to. The problem with a IRA conversion is that all IRA monies regardless if it’s deducitble or non-deductible are treated as part of the conversion. For example if you rolled over 9000 from 401k into IRA, and then have 1000 in a non deductible IRA which has 0 gains, and then decided to convert $1000 – it would be treated prorata, i.e. 900 from the rolled over 401k, and then another $100 from the nd-ira. As result you would end having to pay taxes on the $900 from the rolled over 401k instead of just the gains on the ND-IRA. So the best way to avoid that is to ensure that all your non-ROTH IRA money is purely non-deductible instead of mixing deductible dollars into that mix. By not rolling 401k, it makes easy to keep it straight.
March 26th, 2007 at 3:51 am
In the fall I wrote a post on the loophole that will allow everyone to convert to Roth IRAs in 2010. No question that contributing to a non-deductible IRA now is a smart idea for higher income investors who don’t currently qualify for Roth IRA contributions.
Adam
March 26th, 2007 at 12:25 pm
Doug,
Thanks for answering Thc for me. That’s the exact point I was trying to make. Guess I should have included an example in the post.
I also see your point now about the contribution limits. For that matter I would like to see employees free to open a 401k account anywhere, instead of with the single administrator the employer has chosen.
Thc,
Thanks for that clarification on the IRA to 401(k) conversion. I wasn’t aware of the subtlety.
That roll-over IRAs can be converted into 401ks is still positive. It tends to dwarf the size of regular IRAs because they are usually rolled over from 401ks where the contribution limits are higher. The rest of the argument follows from what Doug laid out above.
March 26th, 2007 at 6:20 pm
Carnival of Personal Finance No. 93…
Welcome to the 93rd edition of the Carnival of Personal Finance, and welcome to *Tired but happy*….
May 3rd, 2007 at 1:00 pm
Soungs great. So, the govt gains a windfall in 2010. What is the guaranty they will not change their minds in 2020 and start taxing Roth withdrawals? It IS in their benefit to do so and they have a long history of continuously changing the rules on retirement funds.