Why You Should Not Rollover Your 401(K) Into A Traditional IRA

Why You Should Not Rollover Your 401(K) Into A Traditional IRA

If you’re leaving your job for a new employer, it’s important to address whether or not to roll over your 401(k). The wrong decision could cost you. One of the most common questions you have encountered is “What should I do with my 401(k)?” This article will explain in detail under which scenarios, you should not rollover your 401(k) to a Traditional IRA.

A lot of times, the most straight forward response to this question is “You should roll it over to a Traditional IRA!” You probably have heard it so many times that you might have already done it yourself. I don’t blame you for that. It’s what almost every other financial expert would recommend you to do. There is nothing inherently wrong with this advice.

What Should You Do With Your old 401(k)?

So should you just go ahead and roll over our 401(K) money into an IRA? Is it the right choice for you? Is there any scenario where it might not be the best thing to do?

I recently ran into an interesting situation with a colleague of mine. They are double income family and their household income is well over the MAGI limits for a Roth IRA contribution. If you are personal finance buff, you’d just say, “Go ahead and do a Backdoor Roth IRA contribution. What’s the big deal?” Well, he is aware of that. What could possibly stop him doing a Backdoor Roth IRA contribution? It turns out he had just landed himself in a tricky situation there.

Roth IRA Contribution Limits 2019 vs 2018
Courtesy – rothira.com

Why You Should not Rollover Your 401(k) To A Traditional IRA

Like many others, he had listened to the good old advice of “Don’t leave your money with your previous employer’s 401(K). Always roll over it to an IRA.” So he had rolled over his previous 401(K) contributions to a Traditional IRA (TIRA). All this while he was lucky (or rather didn’t feel the need to do a Backdoor Roth IRA) since their MAGI was within the IRA limit to allow for a direct Roth IRA contribution. So he never felt his hands tied up. He just went about his business and did the direct Roth IRA contribution year after year. No brainer!

But things took a rather interesting turn in 2018. Although he maxed out all his retirement accounts last year, he had a different challenge. In spite of maxing out both of their 401(K) contributions, their MAGI was over the limits mandated by IRS to allow for a direct Roth IRA contribution. This naturally made him look at Backdoor Roth IRA as the only way out. Little did he know, it wasn’t going to be a cake walk.

What If You Already Have Money In A Traditional IRA?

For the most part you are good. For e.g. If you don’t intend to ever do a Roth IRA contribution, you shouldn’t even bother about this. But you are not an average investor. You know better and you don’t want to miss an opportunity to grow your money tax free! If there is anything I can to keep the government’s hands off of my money, I am all ears.

Courtesy – GIPHY

However the situation my colleague found himself in, can be very tricky. On one hand his income was very good. Yayy!! But on the other hand, he had landed himself into a slippery zone with rolled over money in a Traditional IRA. Even though they both maxed out their 401K contributions, they still didn’t meet their targets of saving 20% of their income towards retirement. I feel once you earn that much, it’s almost a basic requirement to save at least 20% of your gross income towards retirement. Anything less, would simply mean you are not saving enough and need to look at your spending habits. This is the absolute minimum I would recommend anyone earning that much to do.

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What Is Pro-rata Rule?

So back to my friend’s story. He contacted Vanguard, to inquire about the Backdoor Roth IRA option. If you are not familiar with a Backdoor Roth IRA, check out this article – Vanguard Backdoor Roth 2019: a Step by Step Guide. My colleague was well versed with this. What he didn’t know was this little known rule called – Pro-Rata Rule. A quick summary of the pro-rata rule is

The pro-rata rule is the formula used to determine how much of a distribution is taxable when the account owner holds both after-tax and pre-tax dollars in their IRA(s).

Depending on how much money is there in your Traditional IRA, this can be a big deal since you are now looking at triggering some taxes due to this Backdoor Roth IRA contribution. What could have been a non-taxable event, now becomes a taxable event? Ouch!!

Having pre-tax money is a Traditional IRA can make the typical Backdoor Roth IRA more than a simple 2 step process. like the one below. Let’s check out an example of what happens when you do a Backdoor Roth IRA in this scenario.

E.g. Let’s say you have $95,000 in your Traditional IRA, all of which is pre-tax, i.e. you could have made a deductible IRA contribution over the years or have simply rolled over 401(K) from a previous employer. If you make a $5,000 nondeductible (after-tax) contribution to a Traditional IRA, your total IRA balance will be $100,000 and $5,000 of which will be after-tax.

Thus, only 5% ($5,000 / $100,000 = 5%) of your Roth IRA conversion will be tax-free. If you convert $5,000 from your Traditional IRA to a Roth IRA after making your nondeductible contribution, just $250 would be tax free ($5,000 x 5%), while the remaining $4,750 ($5,000 – $250 = $4,750) would be taxable.

Note – If you have multiple IRAs with pre-tax dollars, your total IRA amount will be the sum of money in all of those accounts, even though your convesion may be happening from just one of them.

As you can see, you ended up paying taxes on 90% of your contributions unnecessarily. In fact, you ended up paying taxes on the amount twice since this amount is already after-tax money. Double Ouch!!

Clearly, the conventional advice, “You should never leave your money in a 401(K) with an employer especially after you leave your employer. You should roll over the money to an IRA” is not necessarily appropriate all the time. I do acknowledge that it’s good 90% of the time but if you ever land yourself in a high tax bracket, you are going to trigger a taxable event.

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What Is A Backdoor Roth Contribution?

A backdoor Roth IRA allows you to get around income limits by converting a Traditional IRA into a Roth IRA. The amount of money you can contribute to a Roth IRA is normally limited, but a backdoor Roth IRA has no limits on the amount of the conversion.

Contributing directly to a Roth IRA is restricted if your income is beyond certain limits, but there are no income limits for conversions. If you are one of those (fortunate) people who is a high-income earner and loves the benefits of a Roth contribution, I have 2 specific suggestions for you that can work very well for you. This should be tackled after you have maxed out your Traditional 401(K) contribution limits and still haven’t reach your target savings goal.

1. Move the pre-tax portion of Traditional IRA to your current 401(K) and convert remaining to Roth IRA

This would be the most ideal thing to do since it makes ways for all future Backdoor Roth IRA contributions to go smoothly without hiccups. There are 2 requirements for this option to work favorably.

  1. Your current employer 401(K) must accept conversions from a Traditional IRA. Some 401(K) plans don’t allow this. So please check with your employer before you do this.
  2. Depending on how much money is left after step#1 you may have to pay as taxes for the conversion you make to a Roth IRA. Follow the above example to compute the tax liability this conversion may result in. If you are looking at a lot of money, I would recommend you break up the conversions to multiple years and follow the example I stated above and stick with partial conversions.

2. Look For An After Tax 401(K) and max it out

An after-tax 401(K) is basically a 401(K) plan offered by some employers which allows you to make contributions to a 401(K) plan after you reach the IRS limits mandated for a Traditional 401(K). This can be such a massive wealth builder since the limits are nearly 3 times the Traditional 401(K) limits ($56,000 in 2019). Any money contributed towards after-tax 401(K) grows tax-deferred and provides an excellent way to quickly build up retirement savings and still enjoy the benefits of a 401(K). If you have this option, I wouldn’t even bother doing a Roth IRA contribution. What makes this plan all the more attractive is that you can convert the non-deductible portion of the after-tax 401(K) plan into a Roth IRA completely tax-free!! Woooohooo!!

So imagine if, instead of contributing $600 per year to a Roth IRA you instead contribute effectively up to $37,000 per year in after-tax 401(k) contributions? Not only will you accumulate a fortune, it will also produces income to you on a tax-free basis in retirement. This is the ultimate wealth builder. Go for it!!

In the end I feel every advice you receive should be weighed in before acting up on it. If you ever find yourself in a situation like this, make sure you explore some of the options I have listed above. Good Luck!

2 thoughts on “Why You Should Not Rollover Your 401(K) Into A Traditional IRA”

  1. A couple of years ago I rolled over my prior employer 401k to my traditional IRA and then shortly afterwards learned about the pro-rata rule and the limitations it would mean on Roth conversions. DOH! Not sure if I can roll a portion of my IRA to my current 401k but it is probably something I should check out. I am assuming my current brokerage company would be able to tell me what is pre-tax vs. after tax contributions?

    Great message on understanding the impact of a financial move before jumping into it!

    • Absolutely. This is one thing I feel there is a very high probability people will run into it after several years when they find themselves in higher tax brackets in their career and can’t do direct Roth IRA contributions.

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