401(k) to Roth IRA conversion questions

[bluewater]

I am a 30 year old beginning investor who is trying to make sense of my retirement planning options.

I currently have $34,000 in an employer-sponsored 401(k), and have no other IRAs or retirement accounts. I am switching jobs at the end of the year, and am deciding whether the convert the 401(k) into a Traditional IRA or Roth IRA.

My wife and I file taxes jointly and exceed the income limits for Roth IRA contributions (barely), but I am aware of the “backdoor” method for Roth IRA contributions. I am concerned about properly following the backdoor method and avoiding unnecessary taxes and fees. Does the following procedure work?

1. Convert existing 401(k) to Roth IRA. In order to avoid underpayment of estimated taxes, fill out Form 1040-ES and pay taxes on converted amounts.

2. Set up Traditional IRA account and contribute yearly maximum.

3. Every year, convert prior year’s contributions to Traditional IRA to existing Roth IRA. Pay taxes on pre-tax contributions and earnings for converted funds. Does the year-long wait period avoid application of the IRS step transaction doctrine?

Am I missing any steps? Are there other potential taxes or penalties in this method?

Even if this method works, is there a reason to consider the Traditional IRA route? I realize the primary factor is the projected income tax bracket when I want to withdraw funds, but are there other factors.

Thanks in advance.

[Bob's not my name]

What's wrong with leaving the 401k where it is? Is it a bad 401k without a single low cost fund?

Can you roll the 401k into your new employer's plan?

About three quarters of posters here misunderstand the Roth IRA income limit. If your gross income is over $220,000 you are probably correct that you will not be able to make direct Roth IRA contributions.

... but if your gross income is over $220,000 then you are in 28% bracket (31% next year), maybe with a state tax to boot, or in the AMT with an effective 32.5% rate and a state income tax to boot. Since your total marginal rate is therefore 31-42%, I don't know why you would choose to volunteer more income for taxation.

[bluewater]

Thanks for the response. The problem with my former employer's plan is that it charges former employees $160 dollars per year for maintenance fees. I suppose I could roll over the 401k to my new employer's plan however, I would like to diversify investments by having both pre-tax and after-tax accounts.

I was surprised to hear about the income limit. I thought that $188k was the limit for 2013. Thanks for that info. How much can I contribute to a Roth IRA per year with a combined AGI (with my wife) of around $192k?

Thanks again

[Bob's not my name]

The MAGI phaseout is $178,000 - $188,000. Your gross income should be about $40,000 higher than your MAGI, so I'm confused by your response. Is your gross income not over $220,000?

Also "tax diversification" is oversold. Don't pay a colossal tax penalty to get it. You get it willy nilly because you are not eligible for deductible TIRA contributions, so Roth IRAs are your only choice.

[bluewater]

Sorry for the confusion. My MAGI is $192K. Therefore, I don't believe I can make Roth contributions without using the "backdoor" method that I described in my initial post. You are correct that I'm in the 28% bracket. The only good news is that I'm in a state with no income state.

Just to boil it down, you would recommend that I roll my 401(k) into my new employer's plan, correct? This is preferred compared with the options of rolling the 401(k) into a traditional IRA or leaving the 401(k) with my former employer (and getting hit with annual fees)? Additionally, am I correct in saying that the converting the 401(k) to a Roth IRA is not worth tax hit I would take next year?

Thanks again for bearing with me.

[Bob's not my name]

Yes on all.

A few further comments on your income level. Working backward and forwards from your MAGI:

$232,000 gross income
- $1,000 FSA contribution (guess)
- $4,000 pre-tax health, dental and disability insurance premiums withheld from your pay (guess based on national median)
- $35,000 401k contributions
--------------------
$192,000 MAGI
- $7,800 two personal exemptions
- $10,000 standard deduction (this goes down next year with the return of the marriage penalties; perhaps you itemize and deduct more than the standard)
-------------------
$174,000 taxable income

Your taxable income is in the middle of the 31% bracket next year. If you itemize, your itemized deductions will start to phase out above about AGI $174,500, another marriage penalty and tax increase returning next year. This adds about 1% to your marginal rate, so 32% is your effective bracket. With no state income tax, you are probably safe from the AMT. The AMT's bite will be reduced in any case with the return of higher tax brackets (a notable oversight of the Bush tax cuts was that the AMT rates were not similarly reduced, so getting caught by the AMT was both more likely and more painful).

With $232,000 gross income you should escape the ACA taxes that start next year. Your wages subject to the 0.9% ACA tax are (in my nominal stack above) $227,000, below the $250,000 threshold for married taxpayers, but you may be hit by this new marriage penalty in a few years because it's not inflation-adjusted. Your MAGI is well below the $250,000 MAGI threshold for the new 3.8% ACA tax on investment income, so you should be safe from that new marriage penalty for a long time (it's also not inflation-adjusted). If you and your spouse both have FSAs available to you and have low medical expenses, you should not be affected by the new FSA limit introduced by the ACA, but watch to see if the IRS drops the use-it-or-lose-it rule, which will make contributing to an FSA an easier decision, especially for couples with kids in their future.

[mbres60]

One thing to think about: How good is your new employer's 401k? If it is not very good (doesn't offer funds you would want and/or high expense ratios) then I would put it in an IRA where YOU have control of it and your pick of funds from almost anywhere.

[retiredjg]

What seems clear to me:

-you should not roll/convert your current 401k into Roth IRA at 28% just to be able to do back door Roth IRA contributions in the future

-you should not leave your current 401k where it is unless it is huge and the $160 a year is less than a drop in the bucket and the choices are very low cost

-you should roll your current 401k into the new one if (and only if) the new one has some good low cost choices

What is not clear to me:

-the choices in your new 401k - if there are not a couple of low cost choices, you would be better to roll your old 401k to tIRA and skip the back door idea for yourself (although your spouse might still be a good candidate)

-whether your wife does not work or simply doesn't contribute to a 401k, 403b, 457, SEP, or SIMPLE IRA

-if your wife might be eligible for deductible contributions to tIRA