The other day I was chatting with a friend discussing the Backdoor Roth IRA. As anyone who has made a backdoor Roth IRA contribution knows (or, at least, I hope they know), you can’t have any existing IRAs holding pre-tax money on December 31st of the year you make the backdoor Roth IRA contribution without being subject to the pro-rata rule.
If you do, when you convert your non-deductible Traditional IRA contribution to a Roth IRA, you’ll be forced to convert both the non-deductible portion and the pre-tax portion from your other IRAs on a pro-rata basis, therefore paying tax as you convert pre-tax money into post-tax money (something that you don’t want to do and is easy to avoid).
This friend had an old 401(k) from a previous job that he had moved into a Rollover IRA, so we got into a discussion of what you can do with your old 401(k) upon leaving a job. In particular, what could he do to keep his backdoor Roth IRA options open.
There’s really only a few options when you leave your job:
Roll old 401(k) into traditional IRA
This is probably the most common thing to do, but probably not the best option for a high earner given how it complicates the Backdoor Roth IRA.
The benefits of rolling your old 401(k) over to a Traditional IRA is that you can roll it into a company of your choosing, allowing you to invest in index funds that either weren’t accessible in your company’s 401(k) plan or allowing you to invest in funds with lower expenses.
Keep in mind that if you’re rolling a 401(k) that has pre-tax and Roth money, the pre-tax money will go to your Traditional IRA and the Roth money will go to your Roth IRA. My understanding is that if your Roth 401(k) is qualified (holding period of 5 years and your age is at least 59.5) then all of your Roth 401(k) gets added to your Roth IRA basis. On the other hand, if your Roth 401(k) is not qualified, your contributions are allocated to your Roth IRA contributions and any earnings in your Roth 401(k) are allocated as Roth IRA earnings.
This isn’t likely to be a major point for many people since all qualified Roth IRA withdrawals will be tax-free. It seems like it would only come into play if you tried to withdraw Roth contributions before you turned 59.5. Essentially, there’s no magic trick that lets you roll an entire Roth 401(k) to a Roth IRA and then access the entire Roth balance in 5 years (you’ll have access to the contributions in 5 years, but not the earnings until you’re 59.5). I didn’t find a direct IRS source for this, but Alan S. is usually just as good.
However, since most lawyers are or should be interested in doing a backdoor Roth IRA, rolling your 401(k) balance to a Traditional IRA is probably not a good option.
Roll old 401(k) to new work 401(k) (reverse rollover)
To preserve the Backdoor Roth IRA option, you can do a reverse rollover if you’ve already put the money in a Traditional IRA (i.e. a reverse rollover moves money from the Traditional IRA to a new 401(k)). This presumes that your new 401(k) will accept incoming rollovers.
The other option is just roll your old 401(k) directly to the new 401(k). This could be an existing 401(k) that you have or could be a 401(k) plan at your new place of employment. Again, the only thing that matters here is making sure the receiving 401(k) plan allows incoming transfers.
Set up a solo 401(k)
If you have any self-employment income at all (I’m told as little as $100 should do it), you can open a Solo 401(k). If that Solo 401(k) accepts incoming transfers, you can then transfer the old 401(k) to the new Solo 401(k). This could be a good option if you don’t like the fees or investment choices at your new job’s 401(k) or if there’s no “new job” and you still want to preserve the option for the Backdoor Roth IRA.
Do nothing with your old 401(k)
If your old 401(k) plan worked fine, had low fees and good fund options, then you could always keep your old 401(k) plan intact. As long as there’s a reasonable balance in the account, my understanding is most 401(k) plans allow you to keep the money. Just check with the 401(k) plan agreement to make sure. I could also see using this if your 401(k) has access to some type of unique fund.
Convert old 401(k) to Roth
It’s also possible to convert your old 401(k) into a Roth IRA. Obviously, you’ll be paying huge taxes on the conversion, but it’s possible that this is the best decision for you. Perhaps you’re leaving Biglaw and taking a 1 year sabbatical traveling the world where you’ll be earning no money? In a low income year, doing a conversion could make sense since the income you’ve generated by doing the conversion would first fill up the lower tax brackets and therefore be taxed at a lower effective rate.
Notice that I didn’t include the option to “cash out” the 401(k) on the list. That’s never an option or at least shouldn’t be an option. You want to keep that money sheltered, so leave it in a 401(k) or put it in an IRA.
Joshua Holt is a practicing private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He spends 10 minutes a month on Personal Capital keeping track of his money. He's also exploring real estate crowdfunding platforms like Fundrise which are open to both accredited and non-accredited investors.