Roth IRA Two-Step (Advanced)

by Joe on May 14, 2012

A small recap – last week, we discussed The Roth IRA Two-Step, the ability to deposit money to a traditional IRA and immediately convert the funds with no tax due. In effect, a ‘back-door’ to the Roth for those whose incomes exceed the limits for a Roth deposit.

Since nothing in the tax code is simple, there’s a catch. First, you must understand, IRA = Individual Retirement Arrangement. The “A” is important here. When it comes to the Traditional IRA, you have one IRA, regardless of the number of accounts it’s spread over. Got that? I spell this out because if you have any existing Traditional IRA and it contains pretax deposits, the conversion also contains pre-tax money in the same proportion as the entire IRA. Sorry, you can’t just say “Take the $5000 I just deposited and convert that exact $5000 to Roth.” Well, you can say it, but it ain’t happening that way.

But. There’s a way to taxologically (don’t look it up, my friends at TurboTax made up the word) shield the pretax money from this transaction. Legally. As you may know, you can transfer existing IRA money into your 401(k), and by default, only pre-tax IRA money can go into the 401(k), so it follows that the remaining funds are post-tax, and you can convert to Roth with no tax due.

“But, Joe,” you might say, “you’ve warned how many are getting 401(k)o’ed, that 1% and higher fees really destroy wealth over the years, and now you tell me to think about putting my low cost IRA into my high cost 401(k)?” Wow, great question, and I’m honored that you’ve been paying attention. I have two words for you. Individual 401(k). If you or your spouse have any side income, any income you should be claiming on a schedule C,  there is no expense to setting up the Individual 401(k) even if that income is minimal or only lasts a year. I happen to be a Schwab customer and their site gives you the details about their Individual 401(k). What’s great is that there are no fees other than for trades, so, in effect, it looks just like your IRA. If at some point down the road, you wish to convert it to Roth and pay the taxes, you’d need to transfer it to your IRA, but for now, those who have put away money into their traditional IRA now have a way to isolate their pretax money and make use of the Roth IRA.

Let me illustrate the value in this transaction. Jane (my wife) and I have $100,000 in post-tax IRA money saved over the years. If we save $12,000 (it’s $6,000 per year if you are 50 or older) for the next 12 years, and gain 8% per year, the combined total will be just under $480K. The deposits add to $244,000 and $236,000 in gains. Even if this money were all cap gains at 15%, that’s over $35,000 in tax we will have saved. Not bad for a bit of paperwork each year.

Any questions on this strategy? Do you have any post-tax IRA money you’d like to convert at no cost?

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