After-tax IRA vs. taxable account

I haven't been in exactly this situation before, but can you not roll the 401(k) into a traditional IRA and then do a Roth conversion on it? Even if your income is too high to do a Roth conversion this year, that limit is going away within a couple years. You do eventually get credit for your "basis" or post-tax contributions, but it's kind of complicated if you have other traditional IRA accounts or don't convert everything at once, since the IRS wants to pool all your IRA assets together in determining which fraction is still subject to tax.

FWIW, I'm also in a situation where I'm trying to jigger my investments around between Roth IRA, 401(k), and regular non-tax-sheltered accounts. I've decided that my marginal tax rate in retirement is unlikely to be much different than it is now (maybe 25% bracket instead of 28%, but maybe tax rates will go up by the time I reach retirement age, too), so I've started doing the rollover and Roth IRA conversion on a chunk of old 401(k) money every year as a way of shifting more of my assets to get the most favorable tax treatment.

-Sandra the cynic

Yes, but it doesn't have the same effect. If I roll it all into a traditional IRA, then when I do the Roth conversion I have to prorate the pre- and after-tax parts and pay taxes on the pre-tax parts. But I believe I have the option, when I do the rollover, of taking just the after-tax part out in cash. The trouble is that that's an irrevocable decision -- I can't put that cash back into the IRA later on.

Big Snip

Big Snip

Putting taxed money in an IRA condemns to you to completing an 8606 every year that you put the money into the IRA and every year that you take money out.

Many aggressive savers and investments find them selves with enough income in retirement that they have to pay taxes on their Social Security and possibly find themselves in a higher bracket after RMD takes effect.

I already have some taxed money in my IRA, which dates back to when there were no Roth IRAs and I wasn't eligible to put before-tax money into my IRA. Fortunately TurboTax takes care of the 8606 for me.

This may well be true, but it doesn't answer my original question :-)

It could hardly be a more trivial form. If you put non-deductible contributions into your IRA, you simply take last years basis and add a number to it. Probably the hardest part of dealing with this is making sure to have last year's form on hand when doing this years (or, of course, if you use TTax, making sure that it imports data from last year to this).

You also need to consider taxable/tax deferred ratio and asset allocation/location.

If you have a large 401k and little taxable assets, you may want to put more in taxable and vice versa. Depending on your asset allocation you may not have enough room in your 401k for all your inefficient asset classes so it would probably be a mistake to move it to taxable.

Not sure of the tax rules on the after tax in the IRA upon death, but if the taxable was in equities there may also be a chance for no taxation due to step up rules.

I did this recently via an in-service withdrawal. I rolled over some portion of my 401k into an IRA and also received my after tax contributions in hand. In my case, my 401k funds swamped my after tax savings, overall it was a small amount but it put me a couple of years ahead of qualifying for lower expenses in the taxable US total market index fund.

Dennis

Andrew Koenig wrote:

======================================= MODERATOR'S COMMENT: Please trim the post to which you are responding. "Trim" means that except for a FEW lines to add context, the previous post is deleted.

I am doing the 401(k) to IRA to Roth IRA conversion, but trying to stage it to keep out of the higher tax brackets and be fully converted by 70 so that I won't have to take mandatory distributions. Between pension and ordinary investments, I shouldn't have to touch the IRA money for a few years.

Roth IRAs are "larger" than traditional when you take in account you've already paid taxes. A Roth is always worh $4000, whereas the traitional might be more like $3200 when you take taxes into account.

rick++ wrote on [Thu, 12 Apr 2007 09:24:42 -0500]:

Or even less, 25% fed is a common tax bracket. Add in state and local taxes and it will be under 3K

Sure because you have already paid the tax on approx $5200 to put $4000 in the Roth. With a traditional IRA you compound $4000 and only put $3200 in. Thumper

Thumper wrote on [Fri, 13 Apr 2007 03:57:13 -0500]:

How does that math work?

Well, let's run some numbers. Let's start out assuming you invest the money in index funds that grow at 8% for 20 years and throw off no taxable distributions until you sell them.

Scenario A: $4000 in Roth IRA, plus 28% taxes paid to the IRS up front. => $18,644 after taxes

Scenario B: $4000 in pretax IRA or 401(k), and invest the extra 28% in a taxable account instead of paying it to the IRS. => $18,644 before taxes in IRA => 5,220 before taxes in taxable account

Who knows what tax rates will be like in 20 years, but plugging in some numbers that aren't unreasonable now, assume 25% tax bracket and that capital gains are taxed at 15%. => $13,424 after taxes in IRA => 4,605 after taxes in taxable account => 18,029 after taxes total

OTOH, if you expect to be in the 15% bracket at retirement, the numbers work out to be: => $15,847 after taxes in IRA => 4,605 after taxes in taxable account => 20,452 after taxes total

Scenario C: $4000 in regular taxable account. => $18,644 before taxes => $16,447 after taxes

Anyway, my observations based on this are:

• Pretax IRA or 401(k) is a big win over Roth if you expect to be in a substantially lower tax bracket at retirement.

• OTOH, Roth IRA is a big win over a pretax IRA if you are in a low tax bracket now. It has only a slight advantage if you expect to be in about the same tax bracket at retirement.

• Many people can probably benefit from spreading their contributions between both types of retirement accounts, so that distributions from the pretax IRA/401(k) are taxed at the lower marginal rate at withdrawal and additional income taken out of the Roth is tax-free.

• You should max out both your Roth and pretax 401(k) contributions before investing leftover money in regular taxable accounts. The numbers above for scenario C assume best-case tax treatment, and it's still a big lose.

And, a further observation, based on some additional numbers jiggling:

• Most people are going to want to hold a balanced portfolio including bonds by the time they reach retirement age. You'll end up with more money if you hold asset classes like bonds with lower returns in your pretax IRA or 401(k) plan and load up your Roth with higher-returning asset classes, instead of vice-versa, or using the same asset allocation in both types of accounts.

-Sandra the nerd

snipped a very excellent analysis

Choosing between the pre-tax 401(k) (but deposits that are not matched) I concluded that one needs to look very carefully at the fees within the

Posters here have noted their 401(k) fees are comparable to post tax accounts, yet I keep reading new studies/articles that point toward the higher fees still being charged. JOE

Note that it may be well worth it, even at the higher fees, if one expects to leave that employer (how long is the average length of employment these days?) and roll that money into an IRA.

There are indications that as more of the ripoffs are uncovered, folks are lowering fees. It has happened very strongly in 529 plans and I believe it's happening in 401ks, too (though 401ks don't have quite the same incentive to be competitive that 529s have).

I used to think that too, but I don't any more. Please check my reasoning.

The point is that if you're figuring your asset allocation, you need to look at the after-tax value of both kinds of accounts. So you need to reduce the effective value of your traditional IRA by your marginal tax rate.

Once you've done that, it doesn't matter whether assets are in traditional or roth IRA.

In other words, suppose your marginal tax rate is 25%, and you have $10,000 in a traditional IRA and $10,000 in a Roth IRA. Then your traditional IRA is really worth only $7,500 because that's what you'll have if you withdraw the money and pay taxes on it.

So this was her point, if one account were bound to triple, and the other double, would you not prefer the ROTH do the tripling? I'll "Stick with the Cynic"(TM) on this one. Might want to take another look at this. JOE

I claim that as long as you're reckoning in after-tax money, it doesn't matter.

Here's an example. Suppose I'm in the 25% tax bracket, and I have $7,500 in a Roth IRA and $10,000 in a traditional IRA. Then the traditional IRA is really worth the same as the Roth IRA, because if I withdraw that $10,000, I will have to pay 25% taxes on it and will have only $7,500 to spend.

So by my model, both these accounts are worth the same.

Suppose, now, that I can choose which of these accounts I want to triple. If the traditional IRA triples, it will be worth $30,000. If I pay my 25% taxes on that, it will cost me $7,500, so I'll have $22,500 when I'm done. If the Roth IRA triples, it will also be worth $22,500. So it's a wash.

I would be inclined to agree with you if I were confident that the government won't decide to start taxing Roth IRA distributions in the future. But I'm not. Are you?

I'm not particularly "confident" about anything the government might decide to do about taxes. :-P But I think such a retroactive change to Roth taxation becomes less likely as time goes on and more voters have more of their wealth tied up in such things. I would guess it's more likely that Congress would raise tax rates generally. Something that's also possible is some complete overhaul of the whole tax system; instituting a flat-rate income tax and/or a national GST and/or eliminating a whole slew of special-case exceptions and deductions, for instance. At some point, you just have to recognize that you can't predict the future, and you need to prepare for anything! ;-)

-Sandra the cynic