In general, I like the idea of 401k’s and IRA’s, I just wish the rules were more consistent and simple, and for some, I wish there weren’t hoops to jump through.
For example: let’s say your AGI is above the threshold to allow you to contribute to a Roth IRA. Well, there is a legal way still available, called the backdoor Roth IRA conversion.
The idea is basically, you open a traditional IRA and deposit the money, say $3000 into your traditional IRA and then immediately do a Roth IRA conversion. Since the money you put into the new traditional IRA has not earned anything, when you do a Roth conversion, there are no tax consequences
….Well, almost no tax consequences…You see, the big assumption is that you do not have any other IRA accounts opened. If you do have any other IRA accounts, than technically when you converted that $3000 to Roth, you took a distribution across ALL your IRA accounts, not just the one that you opened. From the IRS perspective, an IRA distribution is not from a specific account, it’s from your entire IRA amount across all accounts…
…However, the IRS treats IRA and 401k differently.
If you had a 401k account, and no IRA accounts, then you could do the backdoor roth IRA conversion, since you will only open 1 traditional IRA to do the backdoor roth ira conversion. Again, IRS treats your 401k diferrently from IRAs, even 401ks that were from your previous employers…..
There are two huge implications of this 401k and IRA distinction from the IRS.
1. If you ever rolled over a 401k from a previous employer to a Rollover IRA, you just eliminated your ability to do a backdoor Roth IRA. Because the moment you converted your 401k to a Rollover IRA, now you have an IRA account that will be counted as part of any distribution you take converting any IRA money into a Roth IRA,and your pay taxes on that distribution, even if you are taking out (say $3000) exactly what you just put in.
2. If you have other traditional IRAs and want to do a backdoor Roth IRA, then what you could do is you could rollover your IRAs into your existing employer’s 401k plan, if they allow that. Then, for the purposes of the IRS, you have no other IRA accounts, and therefore can do a backdoor Roth IRA conversion. But there are drawbacks to doing thiss.
1. You would be limited to the fund selection(s) and fees of your current employer’s 401k plan
2. This assumes your current employer even allows a rollover from elsewhere into your current plan.
Why is it this complicated, I have no idea… But again, yes another first world problem.
Morale of the story. If you want to do a backdoor Roth IRA, don’t ever rollover a previous employer’s 401k account into a IRA… Either keep the 401k or roll it into your existing employer’s 401k plan.
