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Investing Blog Roundup: 401k Rollovers

Marketwatch editor Jonathan Burton kindly invited me to write a guest article this week. It just went up this morning. I hope you find it helpful:

Investing Articles

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  1. Forrest Pruitt says:

    Hi Mike,

    In bullet #2, of our Marketwatch article, “4 Reasions not to roll over an old 401k” you mention “the percentage of the conversion that is NOT taxable is calculated as your net nondeductible contribution, divided by the sum…
    Can you confirm this info with some numbers for me?

    For example:
    If someone has a pre-existing SEP-IRA ( I’m assuming all pre-tax, a.k.a. deductible contributions) with an account value of $50,000.

    And he wanted to contribute $5,000 this year to a NON-deductible Traditional IRA, then convert immediately to a ROTH (the “back door ROTH method”)… The IRS will tax him as follows?

    $5,000 divided by $50,000 = 10%

    $5,000 x 10% = 500 (portion of contribution/conversion that is NOT subject to taxation)
    $5,000 x 90% = 4,500 (portion of contribution/conversion that IS taxed)

    Did I compute this correctly? If I did, it seems to be a “raw’ deal as one will have already paid income taxes on the $5,000 contribution, then to have to pay taxes on 90% of the $5,000 conversion amount..

  2. Hi Forrest.

    Almost. The fraction would be $5,000 divided by $55,000. (The denominator includes both the end of year IRA balances and the amounts converted.)

    The idea is that if the entire $55,000 were converted, $50,000 of it (that is, 91%) should be taxable, because tax has only been paid on $5,000 so far.

    If an amount less than $55,000 is converted, it’s treated on a pro-rata basis, as if 91% of the amount converted comes from the deductible portion and 9% comes from the nondeductible portion.

  3. Forrest Pruitt says:

    Ok, Mike, I think I understand… (Reference is made to my previous post and your response):

    Then, someone would have to pay taxes on 91% of the contribution/conversion amount ($5,000), which thus means:

    $5,000 x 91% = $4,550 (taxable amount which will be subject to further taxation at the individual’s federal & state marginal tax rates).

    And just to confirm, this pro-rate conversion tax computation applies to SEP-IRAs as well?

    Again Mike, this seems a bit “harsh” since you will have paid regular income taxes on the $5,000 contributionfor this year…only to pay taxes on the majority (91%) of the conversion…. Do you agree ?

    Thanks again Mike!

  4. Yes, that 91%-taxable rate would apply whether it was money from the SEP that was converted or money from the traditional IRA.

    And, generally speaking, I prefer to withhold my opinions on tax law (other than my opinion that they’re far too complicated, IRA-related rules most certainly included).

  5. Forrest Pruitt says:

    I agree. The tax code is quite complex. Mike, thanks for making sense of it all for the rest of us Non-CPA folks!
    Happy New Year!!!

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