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I have two retirement accounts:

  • Traditional IRA funded with non-deductible contributions
  • 401k

I left my job so I want to roll over my 401k into a Rollover IRA, but I've also heard about the benefits of converting a Traditional IRA to a Roth IRA.

Assuming that I want to do both, is the order important? i.e., does it make any difference if I do the backdoor Roth conversion first or the 401k roll over first? Is it ok to do both in the same tax year?

  • Note: money in the 401K can be pre-tax, post-tax, Roth, company match.... – mhoran_psprep May 17 '16 at 23:11
  • What is a "backdoor Roth conversion"? I have only heard of "backdoor Roth" in the context of "backdoor Roth IRA contribution", in which you contribute to Traditional IRA and then convert to Roth IRA to circumvent the Roth IRA contribution income limits. But you are not doing any contributions here. – user102008 May 18 '16 at 19:00
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tl;dr: Please please please do the conversion first.

JoeTaxpayer's answer is correct, but I am of the opposite opinion.

First, there's just about no reason to have post-tax dollars in a Traditional IRA. You'll eventually have to pay tax on the earnings those dollars generate, so it's essentially the same as having that money in a regular taxable account. Meanwhile, if you roll those dollars into a Roth IRA, you get to earn tax-free money on them for the rest of your life (and even after your death)!

Second, even if you did have some reason for keeping those post-tax dollars where they are, the last thing you ever want to do is mix them with pre-tax dollars (from, say, your 401k). As soon as you mix them, all the dollars become subject to pro-rata taxation (as Joe mentioned), so any future decision you were planning to make about what to do with just your post-tax dollars is moot -- you have given away your right to think separately about your pre- and post-tax dollars.

As an example, let's say the accounts you want to combine look like this:

Current 401k pre-tax            : $ 60,000
Current Traditional IRA post-tax: $ 20,000
Hypothetical mixed Traditional  : $ 80,000 (75% pre/25% post)

Annoying consequence (no more post-tax-only dollars!)

In the future you decide you want to move $2,000 from the above account into a Roth. Because you mixed the money, the IRS insists that your rollover consists of:

Pre-tax money : $2,000 * 0.75 = $1,500
Post-tax money: $2,000 * 0.25 = $  500

So now you owe tax (and it's regular income tax, I believe, not even capital gains tax) on $1,500. That was money that you socked away specifically to avoid taxes, and now you've gone and paid taxes on it! Now, there are valid arguments for intentionally moving pre-tax dollars from a Traditional to a Roth like this, but the point is that you shouldn't even have to be having that argument -- you have post-tax dollars in your Traditional IRA that almost certainly belong in a Roth. By mixing your 401k into your Traditional IRA, you can no longer do anything with just the post-tax dollars. The IRS will forever insist that you do these pro-rated calculations.

Really annoying consequence (no back-door Roth for you!)

Say in the future you suddenly realize that a Roth is much better for your financial situation than a Traditional IRA. (Or you might still prefer a Traditional IRA, but as explained in the next sentence it's not available to you.) Unfortunately, because you're covered by a (new) 401k -- or maybe because you earn too much money to contribute pre-tax dollars to either a Traditional or Roth IRA -- you're out of luck. You're simply not allowed to contribute to a Roth.

Most people in this situation can make use of what's called a back-door Roth. They contribute up to the maximum amount per year ($5,500 or whatever it is now) post-tax to a Traditional IRA and then immediately roll it over to their Roth. You can still try this, but guess what? Yep, because you're mixing these new post-tax dollars with pre-tax money in your Traditional IRA, every year your rollover will be tainted with that pre-tax money, diluting the whole point of the back-door Roth. You'll be paying taxes on money you never wanted to pay taxes on, and you'll be leaving post-tax money behind in your traditional IRA.

(If it sounds like I'm annoyed about this situation from personal experience, it's because I am. :)

Bottom line

By doing the conversion first, you never mix pre- and post-tax money, and your money goes where you want it.

Of course, assuming you eventually do roll over your 401(k) into a Traditional IRA, the Really Annoying Consequence above will still plague you, but at least you'll have cleanly converted that first post-tax amount.

  • My answer was based on his wanting to convert from 401(k) directly to Roth. If he did that, the 401 is taxed 100% and the T-IRA, not at all, but, he'd lose the chance to recharacterize, if he went over a marginal rate change. The mixing is a pain, I agree, but leaves that option open. – JoeTaxpayer May 17 '16 at 23:24
  • Thanks, very helpful answer. I'm getting married this year and my wife to be makes a lot of money so I won't be able to do Roth or deductible IRA in the future. I may NOT do the rollover so I can at least do the backdoor IRA on an annual basis. – gaefan May 18 '16 at 13:28
  • @JoeTaxpayer Ah, I see what you mean now. – dg99 May 18 '16 at 15:33
  • @Kekito You may want to consult with a tax accountant about your best course of action. Perhaps a professional knows of a way in which you can change the ownership on your various accounts (especially now that you're getting married) such that you could do the rollover and still leave the non-pro-rata-taxed backdoor Roth option open to you in the future. Also, if your current 401(k) plan sucks, it may be worth the added backdoor Roth limitations to get that money into an account with, say, better investment options and/or lower fees. – dg99 May 18 '16 at 15:37
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What ever you convert from the 401(k) will be subject to tax.

The bigger issue is that there's no "do over" no ability to recharacterize the conversion if when you do your taxes, you realize you need to undo some. I'd suggest transferring from the 401(k) to the traditional IRA first and then convert, just bring aware of the prorata taxation that will be due.

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