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.
Ten thoughts on Old 401(k): What Should You Do?
Lots of good advice here BigLaw. I’ve got a couple old 401ks rolling around that I need to do something with.
More than likely I’ll roll one of them into a traditional IRA and then start doing Roth conversions once our income is a little lower.
The last time I left a company, it’s been ten years, I rolled my 401k to a Roth. It ended up the right timing because of a market collapse and the first time home buyers credit. That being said, to accomplish that I left the money in the old 401k until the right opportunity presented itself. Which really highlights the leaving the old 401k option, but that it has other uses.
Apologies for the amateur question, but what does one do when they want to start backdooring but have a small traditional IRA. I opened one (somewhat stupidly) when I was clerking for the immediate deduction. I had it for 3 years before shifting focus to 401. Now I’d like to start the backdoor process but not be overly penalized now that I’m making $150k more. Thoughts?
Heather – You have a couple of options.
(1) If the balance is small enough, you can just pay the income tax and convert into a Roth IRA. The benefit is that you’ll get that money into Roth protected space where it will grow tax-free and eventually be withdrawn by you tax-free.
(2) If the balance is higher, you have to figure out a way to move the money out of the IRA. If you’re happy with your 401(k) options, the easiest thing to do would be to do a reverse rollover where you transfer your pre-tax IRA balance into your 401(k). Check with your HR department to see if they accept incoming rollovers. Chances are good that they do.
(3) If they don’t or if you aren’t happy with your 401(k) options, your final option is to create a solo 401(k) and then roll the IRA money into that solo 401(k) plan. To create a solo 401(k) you will need a little bit of self-employment income but as far as I’ve seen, nobody cares how much that is. You could literally fill out a few online surveys for $15 and then open up a solo 401(k) account. Just make sure that the solo 401(k) can accept incoming rollovers (unfortunately Vanguard doesn’t).
You only need to have this done by the end of the year in order to avoid the pro-rata rule when it comes to the backdoor Roth IRA.
Excellent advice. Fingers crossed for 2, but will check into 3 as well!
Just noticed the glaring pre-tax mention in #2. That’s simply the money I invested on an above the line basis right? I stopped contributing to the IRA when I stopped getting the deduction so I believe my entire balance (minus gains) is from pretax contributions. Does it all qualify to go to my 401 or will the gains be left somewhere in limbo?
Your pre-tax contributions plus any growth will all be pre-tax. You should be able to roll the entire Traditional IRA into your 401(k) if the 401(k) accepts incoming rollovers.
In my prior biglaw life with my old employer, I previously qualified for and contributed to a Roth 401k. When I left the company, I rolled over all Roth money into a Roth IRA, and all employer contributions into a traditional IRA (approx. $6k). These employer contributions are the only funds held in my traditional IRA.
In my current biglaw life, I no longer qualify for a Roth IRA or a deductible IRA and so have to go the backdoor route. What do I have to do with the employer contributions being held in my traditional IRA before starting the process of a Backdoor Roth? My understanding is this money is non-deductible so I just need to treat it as my backdoor Roth for this year and convert $5,500 of it this year, and the balance next year toward my backdoor Roth contributions. Once all of the $6k is converted, I can start making up the balance toward my $5,500/year max.
Is this correct or can I convert all of it now plus an additional $5,500 in contributions?
401(k) Roths are a little weird in that I think a lot of employers do not match with post-tax dollars. It looks like this is what happened with you. You made your contributions using post-tax dollars to a 401(k) Roth and your employer “matched” your contribution by using pre-tax dollars placed in a Traditional 401(k).
If that’s the case, then the money in your Traditional IRA is pre-tax and was deductible to the previous employer (but that’s a red herring anyway). The point is that now you have about $6K in pre-tax money sitting in your Traditional IRA. Thanks to the pro rata rule, if you make a non-deductible contribution of $5,500 this year and then try to convert $5,500 to a Roth IRA, the IRS will determine that the money you’re converting comes from both the pre-tax Traditional IRA and the non-deductible $5,500 contribution, pro-rata. You’ll have to pay income taxes on the pro-rata portion that comes from the pre-tax Traditional IRA.
To avoid this headache, you can take the actions I described above to Heather to clear the Traditional IRA balance.
Since it’s a small balance, it might just be easier to convert the entire $6K balance to a Roth IRA and just pay the income tax today. Or maybe you can roll into your current 401(k) without much hassle.
Either way, this shouldn’t have any impact on this year’s backdoor Roth IRA. You can convert an unlimited amount of money (as far as I’m aware) from Traditional to Roth, you just have to pay taxes on the conversion. On the other hand, you can only contribute $5,500 a year to your IRA (regardless or whether it’s a deductible or non-deductible contribution).
In sum, I believe the second part of your final question is correct. You can convert all of it now plus an additional $5,500 in contributions.
Thank you for the quick response. I was getting tripped up on the “non-deductible” nature (to me) of the employer contribution in the IRA. Unfortunately even though we have a Vanguard 401k, our plan doesn’t have any of the benefits that would allow me to rollover the balance back into my 401k, or even to take advantage of the mega backdoor Roth. More taxes for me!