How Rolling Over Your 401(k) to an IRA Can Increase Your Tax Bill
By Jeffrey Levine, IRA Technical Expert
Follow Me on Twitter: @IRAGuru4EdSlott
Last week, we published a Special Report on the Back-Door Roth IRA. This week, we explore how a simple 401(k)-to-IRA rollover could dramatically change the tax impact of that transaction. Here’s how…
Remember the movie Ghostbusters? Spengler repeatedly warns the other Ghostbusters “Don’t cross the streams!” Well, one trap you can step into with regards to the Back-Door Roth IRA strategy – or any Roth IRA conversion for that matter – is when you “cross streams” by rolling plan money into an IRA in the same year you make a Roth IRA conversion. When an IRA is converted, only IRA assets are taken into consideration for the pro-rata rule. Plan assets have no effect. For example, let’s say you have an IRA worth $5,000, of which the $5,000 represents non-deductible contributions. Now let’s imagine that you also have a 401(k) worth $495,000 (all pre-tax). If you convert the entire IRA, you will not owe any tax, since the plan assets are excluded from the IRA pro-rata formula, and your IRA was all after-tax money.
But now let’s say you change jobs mid-year. Believing you’d be better off in an IRA than with your 401(k), you roll your 401(k) to an IRA. Bang! You just increased your tax bill for the year by several thousand dollars. Why? Because it’s the end of year IRA balance that is factored into the pro-rata calculation – not the balance on the date the IRA is converted.
Now, since the 401(k) funds are not excluded from your IRA pro-rata calculation, they have to be added back in. And instead of only owing tax on none of your $5,000 conversion, you will owe tax on $4,950. Here’s how…
The denominator for calculating the pro-rata rule now changes from $5,000 to $500,000 (your $5,000 Roth IRA conversion plus your $495,000 401(k) to IRA rollover). This makes the $5,000 of nondeductible IRA contributions a much lower percentage of your total IRA balance. That results in the tax free percentage of the $5,000 conversion going from 100% to only 1% ($25,000/$500,000 = 5%)! This will significantly increase the taxable amount of your conversion. Now the tax-free part of the conversion is only $50 (1% of the $5,000) as opposed to the $5,000 (100% of the $5,000) that would have been tax free without the later 401(k) rollover. How can you avoid this mistake? Simply wait until January 1st of the following year to roll the funds over. That way, you’ll have a $0 year-end balance. Of course, if you want to convert your 401(k) to a Roth IRA too, this would be a non-issue and both conversions could be done in the same year without any adverse tax consequences.