Backdoor Roth IRA questions

[rtlexx]

I've been doing a little bit of research about the backdoor/stealth Roth IRA. It sounds relatively easy to do, but there are some details that I don't fully understand.

I am a 31 year old physician and recently just graduated from residency. My salary still qualifies for Roth IRA contributions, but in about 1-2 years my salary will no longer qualify. So I'm not in a hurry to try to setup a 'backdoor' contribution, but I want to slowly, carefully, and methodically setup a path towards doing a 'backdoor'.

I currently have a Roth IRA and I am also trying to quickly setup a SEP-IRA (I do a lot of independent contractor physician work) in the next week so I can deduct taxes for 2011. I tried to setup an individual 401k for 2011, but unfortunately the deadline passed several months ago. I do not have an employer 401k. I also don't think that my future potential employer that I will work for in a few months will provide a 401k or any other type of IRA. So I plan on setting up an individual 401k for 2012 since I will still perform some independent contract work from this point forward.

Okay!!! So the question: What type of IRAs can I use to backdoor money into a Roth IRA account without having to pay the 'pro-rata'? Can I move money from an Individual 401k to a Roth IRA without paying the pro-rata? Or is it impossible to entirely avoid paying the pro-rata? I think for traditional IRA/SEP-IRA/SIMPLE IRA, you have to pay a 'pro-rata' to move money into a backdoor Roth IRA? I read this article and it was saying you can convert a SEP-IRA into an indidvidual 401k and then backdoor it into a Roth IRA. Does pro-rata apply to this type of conversion? Unfortunately, Vanguard does not allow SEP-IRA to be converted to a individual 401k. Why is that? Anybody know of any companies that will allow SEP-IRA conversion to an individual 401k? I apologize for throwing out a lot of questions. I've been doing some reading on this subject of 'backdoor' and there are a lot of details involved that I don't fully understand. I just need a step by step foundation game plan to start off on the right foot with. Also looking forward towards the next 30 years, is there a huge advantage of doing a 'backdoor' Roth IRA vs not doing one? Thanks for any advice.

[Cloud]

http://thefinancebuff.com/the-backdoor- ... ow-to.html

[rtlexx]

http://thefinancebuff.com/the-backdoor-roth-ira-a-complete-how-to.html

I read that article a few times through and I kind of understand it. Some details I want to clarify though. Are you able to move some money from a individual 401k into a Backdoor Roth IRA without paying the pro-rata? I guess the answer would ne 'no' if I'm moving pre-tax contributions to a Roth IRA correct? In the near future when I no longer qualify for the Roth IRA contributions, all of my contributions towards an individual 401k or SEP/IRA wil be pre-tax. I don't think I will be provided with an employer 401k plan which would only let me make non-deductible IRA contributions. So I guess I would have to pay pro-rata on all of my backdoor Roth IRA conversions?......Most of you reading through this can probably tell I'm really confused with this process....

[Alan S.]

Anytime you convert pre tax retirement accounts to a Roth IRA, taxes will be due. If your solo K had a Roth option you used, then the Roth rollover would be tax free except for earnings.

If you had set up the solo K instead of the SEP, then you would have avoided pro rating of the non deductible TIRA contributions when you converted them because the solo K is NOT an IRA and not included in the pro rate calculations of Form 8606.

But now that you have the pre tax SEP amount, you have the choice of just converting it over a short period of time and paying taxes on the amount you deducted in 2011 OR using a solo K custodian that will accept a rollover from your SEP and thereby avoid the pro rating. The decision is affected by just how large your SEP contribution for 2011 was.

This is a trade off over the years. If you just accumulate pre tax amounts in a SEP, pre tax solo K or other pre tax plan, you will have a huge pre tax pool you will have to take RMDs from at 70.5. Conversely, having a share of these in Roth assets will avoid these high taxes in retirement, but you will have to pay higher taxes over your working career to fund the Roth accounts. Perhaps your SEP is not so large that you could convert it over a short period of time to jump start your Roth balance, and if so you would not have to roll the SEP into a non IRA employer plan.

Of course, you would continue to make regular Roth contributions as long as your income does not exceed the limits. But after that you can do the back door conversions to replicate having made a regular Roth contribution.

[Duckie]

rtlexx, you have a lot of questions. Here are some answers.

What type of IRAs can I use to backdoor money into a Roth IRA account without having to pay the 'pro-rata'?
-- If the plan has "IRA" in the name the pro-rata rule comes into effect. So Traditional IRAs, SEP IRAs, and SIMPLE IRAs are all a problem when using the "Backdoor Roth" option.

Can I move money from an Individual 401k to a Roth IRA without paying the pro-rata?
-- Rolling assets from a 401k to an IRA and then converting to a Roth doesn't in itself involve the pro-rata rule, although the conversion (not the rollover) is taxable. The pro-rata rule come into effect if you have other non-Roth IRAs.

Or is it impossible to entirely avoid paying the pro-rata?
-- I'm not sure you understand what pro-rata means. It just means when you convert part of your IRA assets to a Roth, the total assets of all of your non-Roth IRAs (some of which may be after-tax) are taken into account when figuring out the taxes.

I think for traditional IRA/SEP-IRA/SIMPLE IRA, you have to pay a 'pro-rata' to move money into a backdoor Roth IRA?
-- Here's an example. Let's say you already have $5K in a Traditional IRA and $10K in a SEP IRA. You want to make a new $5K contribution for this year, but you make too much to deduct it and make too much to contribute to a Roth IRA directly. So you make a $5K non-deductible contribution to a Traditional IRA (either your old one or a new one, it doesn't matter) and immediately convert the $5K to a Roth. If you didn't already have the $5K and $10K, the taxes on the conversion would be negligible. But because of that $15K, most of the conversion is taxable. That's why people who now want to use the "Backdoor Roth" option attempt to get their assets out of non-Roth IRAs, by moving them into their employer's plans.

I read this article and it was saying you can convert a SEP-IRA into an indidvidual 401k and then backdoor it into a Roth IRA. Does pro-rata apply to this type of conversion?
-- You are allowed to rollover a SEP IRA to an Individual 401k. That takes the assets out of the IRA. With zero assets in non-Roth IRAs, you can then do the "Backdoor Roth" for NEW contributions.

Unfortunately, Vanguard does not allow SEP-IRA to be converted to a individual 401k. Why is that?
-- Every company has its own rules. Maybe they don't want the hassle. Maybe it costs too much. Maybe they'll change their minds later.

Anybody know of any companies that will allow SEP-IRA conversion to an individual 401k?
-- Fidelity allows incoming rollovers from SEP IRAs to their Self-Employed 401k plans. See here.

I realize I repeated myself a lot, but maybe one of these explanations will make sense.

[Default User BR]

rtlexxUnfortunately, Vanguard does not allow SEP-IRA to be converted to a individual 401k. Why is that?
-- Every company has its own rules. Maybe they don't want the hassle. Maybe it costs too much. Maybe they'll change their minds later.

As I recall, they didn't think to put it in, and it's a problem to change it now (regulations and such).


Brian

[tfb]

Are you able to move some money from a individual 401k into a Backdoor Roth IRA without paying the pro-rata? I guess the answer would ne 'no' if I'm moving pre-tax contributions to a Roth IRA correct?

Moving money from a individual 401k into a Roth IRA has nothing to do with a backdoor nor the pro-rata. If you are eligible for a distribution from your 401k (59-1/2, plan termination, etc.), you can rollover the distribution to Roth if you want to. There is no income limit. You do have to pay tax if the money is pre-tax.

In the near future when I no longer qualify for the Roth IRA contributions, all of my contributions towards an individual 401k or SEP/IRA wil be pre-tax.

SEP yes, individual 401k no. Vanguard's individual 401k allows Roth contributions. Fidelity's does not. Whether you should make Roth 401k contributions is a different question.

So I guess I would have to pay pro-rata on all of my backdoor Roth IRA conversions?......Most of you reading through this can probably tell I'm really confused with this process....

I think you will have to read that article one more time. The whole point of a backdoor Roth is that you don't pay tax on the conversion (or pay very little). In a backdoor Roth, you are converting an IRA with non-deductible contributions. You are not moving money out of an individual 401k.

[rtlexx]

Thank you very much for your answers everybody. Have a good day.