Oops: SEP IRA and Backdoor Roth = Pro-rata Rule

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Wealth_Builder
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Oops: SEP IRA and Backdoor Roth = Pro-rata Rule

Post by Wealth_Builder » Tue Jan 23, 2018 1:25 pm

I've made the error of having a SEP IRA and Backdoor Roth contributions during 2017 and have just learned about the pro-rata rule. Is there anyway of avoiding it at this point? Can my SEP IRA be converted into a self-employed 401(k) and rolled over?

Traditional IRA Contribution: $5,500 in January 2017
SEP IRA Contribution: ~$3,000 in April 2017
IRA Back-door Conversion: November 2017

I'm fairly young and new to investing. The contributions aren't huge, but I'm thinking this would result in a tax bill of about $600. See below:
Pro-rata Rule Exercised:
3000/(3000+5500) = 35% of IRA contributions are pre-tax
35% X 5500 = NEW taxable contribution (this would have been tax-free via backdoor) = $1925
Additional Taxes Due: 1925 X 30% (marginal tax rate) = $578

Any chance I can avoid this amount due? :oops:

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White Coat Investor
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Re: Oops: SEP IRA and Backdoor Roth = Pro-rata Rule

Post by White Coat Investor » Tue Jan 23, 2018 3:40 pm

Not an easy fix, especially with the new laws about recharacterization. Best bet is converting the whole darn thing to a Roth IRA. Is the SEP small enough that you can afford to do that?

Edit: Oh, it's only a $3K SEP? Just convert it and pay the taxes on that $3K. Easy peasy. And use a solo 401(k) instead of a SEP going forward. And don't give me crap about having to pay taxes on that $3K. If you make so much you have to do your roth contribution indirectly, you certainly make enough to pay the taxes on a $3K roth conversion.
1) Invest you must 2) Time is your friend 3) Impulse is your enemy | 4) Basic arithmetic works 5) Stick to simplicity 6) Stay the course

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Earl Lemongrab
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Re: Oops: SEP IRA and Backdoor Roth = Pro-rata Rule

Post by Earl Lemongrab » Tue Jan 23, 2018 5:47 pm

I believe that 2017 conversions can still be recharacterized. The new law only applies going forward from 2018.
This week's fortune cookie: "Your financial life will be secure and beneficial." So I got that going for me, which is nice.

niceguy7376
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Re: Oops: SEP IRA and Backdoor Roth = Pro-rata Rule

Post by niceguy7376 » Tue Jan 23, 2018 6:38 pm

Wealth_Builder wrote:
Tue Jan 23, 2018 1:25 pm
I've made the error of having a SEP IRA and Backdoor Roth contributions during 2017 and have just learned about the pro-rata rule. Is there anyway of avoiding it at this point? Can my SEP IRA be converted into a self-employed 401(k) and rolled over?

Traditional IRA Contribution: $5,500 in January 2017
SEP IRA Contribution: ~$3,000 in April 2017
IRA Back-door Conversion: November 2017

I'm fairly young and new to investing. The contributions aren't huge, but I'm thinking this would result in a tax bill of about $600. See below:
Pro-rata Rule Exercised:
3000/(3000+5500) = 35% of IRA contributions are pre-tax
35% X 5500 = NEW taxable contribution (this would have been tax-free via backdoor) = $1925
Additional Taxes Due: 1925 X 30% (marginal tax rate) = $578

Any chance I can avoid this amount due? :oops:
Are you the employer that did the SEP or just an employee of a company that has SEP?
A SEP IRA contribution of 3K is very low amount (since it is a fixed amount or % by employer to all employees) compared to your salary where you were ineligible for the direct ROTH IRA

Spirit Rider
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Re: Oops: SEP IRA and Backdoor Roth = Pro-rata Rule

Post by Spirit Rider » Tue Jan 23, 2018 8:40 pm

Earl Lemongrab wrote:
Tue Jan 23, 2018 5:47 pm
I believe that 2017 conversions can still be recharacterized. The new law only applies going forward from 2018.
This is correct. The OP could recharacterize the 2017 Roth conversion, rollover the SEP IRA to either their primary employer's 401k/403b/457b plan or a one-participant 401k plan and redo the Roth conversion in 2018.

However, I'm with WCI. Move on, pay the taxes on the 2017 SEP IRA conversion and adopt/use a one-participant 401k for 2018.

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Wealth_Builder
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Re: Oops: SEP IRA and Backdoor Roth = Pro-rata Rule

Post by Wealth_Builder » Sat Mar 24, 2018 8:36 pm

Thanks all for the help! So I had a discussion with my accountant this past week and he was beyond confused. :confused

Can we break this down a little further on what steps I'll need to take. For example, if I do nothing, next year when doing a Backdoor Roth IRA, will I hit the pro-rate rule again? If yes, how can I remediate? I guess it has to do with converting/transferring the SEP-IRA, but where do I send it to? Can I roll it into my Roth IRA?

I'm not sure if working with my accountant helps me or confuses me more. . . But Bogleheads can help! :happy

Bfwolf
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Re: Oops: SEP IRA and Backdoor Roth = Pro-rata Rule

Post by Bfwolf » Sun Mar 25, 2018 12:19 am

Here's the suggestion on the table, assuming you are eligible for a solo 401k:

Step 1: Convert the rest of the $s in your IRAs to a Roth. This will incur some more taxes above and beyond the $578 you've calculated as you'll now also owe 35% x $3,000 x 30% = $315 in additional taxes, but this will clear out your SEP entirely, setting you up for success with backdoor Roths in the future.

Step 2: Set up a solo 401k with Vanguard, Fidelity, or somebody else. Use that instead of the SEP IRA going forward.

If you're not eligible for a solo 401k, that changes things.

http://www.irafinancialgroup.com/solo40 ... bility.php

ivk5
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Re: Oops: SEP IRA and Backdoor Roth = Pro-rata Rule

Post by ivk5 » Sun Mar 25, 2018 12:49 am

Wealth_Builder wrote:
Sat Mar 24, 2018 8:36 pm
So I had a discussion with my accountant this past week and he was beyond confused. :confused

...

I'm not sure if working with my accountant helps me or confuses me more. . . But Bogleheads can help! :happy
It definitely behooves you to understand all this yourself and not need to rely on accountant. But if accountant can't follow, I'd find a new one. This is pretty routine stuff.

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Earl Lemongrab
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Re: Oops: SEP IRA and Backdoor Roth = Pro-rata Rule

Post by Earl Lemongrab » Sun Mar 25, 2018 11:24 am

Bfwolf wrote:
Sun Mar 25, 2018 12:19 am
Here's the suggestion on the table, assuming you are eligible for a solo 401k:

Step 1: Convert the rest of the $s in your IRAs to a Roth. This will incur some more taxes above and beyond the $578 you've calculated as you'll now also owe 35% x $3,000 x 30% = $315 in additional taxes, but this will clear out your SEP entirely, setting you up for success with backdoor Roths in the future.
It would be better to roll the SEP into the i401(k).
This week's fortune cookie: "Your financial life will be secure and beneficial." So I got that going for me, which is nice.

Bfwolf
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Re: Oops: SEP IRA and Backdoor Roth = Pro-rata Rule

Post by Bfwolf » Sun Mar 25, 2018 10:54 pm

Earl Lemongrab wrote:
Sun Mar 25, 2018 11:24 am
Bfwolf wrote:
Sun Mar 25, 2018 12:19 am
Here's the suggestion on the table, assuming you are eligible for a solo 401k:

Step 1: Convert the rest of the $s in your IRAs to a Roth. This will incur some more taxes above and beyond the $578 you've calculated as you'll now also owe 35% x $3,000 x 30% = $315 in additional taxes, but this will clear out your SEP entirely, setting you up for success with backdoor Roths in the future.
It would be better to roll the SEP into the i401(k).
Better financially: for sure.

Better in terms of the juice being worth the squeeze: maybe not. This requires the OP to recharacterize the conversion, establish an i401k that accepts rollovers (not Vanguard for instance), rollover the SEP IRA, and then reconvert. Maybe the benefit of doing all this is four or five hundred dollars, if the OP's tax rate in retirement will be half of what their tax rate is now.

I might do what you're suggesting, but I feel confident in my ability to do all those steps without too much fuss. Some people might just convert the remaining IRA $s and be done with it.

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Earl Lemongrab
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Re: Oops: SEP IRA and Backdoor Roth = Pro-rata Rule

Post by Earl Lemongrab » Mon Mar 26, 2018 12:11 am

Not all that much work, and this clears the way for backdoor Roth every year, not just the one.
This week's fortune cookie: "Your financial life will be secure and beneficial." So I got that going for me, which is nice.

Bfwolf
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Re: Oops: SEP IRA and Backdoor Roth = Pro-rata Rule

Post by Bfwolf » Mon Mar 26, 2018 1:02 am

Earl Lemongrab wrote:
Mon Mar 26, 2018 12:11 am
Not all that much work, and this clears the way for backdoor Roth every year, not just the one.
So does the way I suggested. :)

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Earl Lemongrab
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Re: Oops: SEP IRA and Backdoor Roth = Pro-rata Rule

Post by Earl Lemongrab » Mon Mar 26, 2018 1:03 am

Bfwolf wrote:
Mon Mar 26, 2018 1:02 am
Earl Lemongrab wrote:
Mon Mar 26, 2018 12:11 am
Not all that much work, and this clears the way for backdoor Roth every year, not just the one.
So does the way I suggested. :)
If you don't mind paying the tax at current rates.
This week's fortune cookie: "Your financial life will be secure and beneficial." So I got that going for me, which is nice.

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