Mechanics of Backdoor Roth IRA with accumulating Traditional IRA funds

[pistolpete]

I'm hoping you guys can clarify something for me. As of the current moment, I only have a Roth IRA. I'm single.

In the near future, let's say I'm self-employed, my private practice is a professional corporation, and I make $350,000 per year. My financial goal is to put away 25%, or $87,500, into retirement each year.

I contribute the max $53,000 to my solo 401k. I contribute  $5,500 to my Roth IRA. I contribute $3,350 to a HSA. That's a total of $61,850. That leaves $25,650 of savings to be invested.

If I save $25,650 in a traditional IRA, when I go to do a backdoor Roth IRA next year, what happens? Because of the pro-rata rule, I'd be paying taxes on 25,650/31,150= 82% of the amount each year, right?

I guess I'm not seeing how you guys manage to put away $5,500 via the backdoor Roth method each year without getting hammered by the pro-rata rule. Am I missing something?

[Docbeans]

That would be a problem, wouldn't it?

Fortunately, you wont have that problem because you are allowed to contribute only a max of $5,500 (for 2016) in a Roth/Trad IRA in a yr.

So, after the $61,850, you would put the rest in a taxable account, not a TIRA.

Also, in the first place, you wouldnt be able to put $5,500 in a Roth directly because your income is too high. So, you put the $5.5k in a TIRA and convert it into a Roth. This process is called the Backdoor Roth.

Good luck!

[pistolpete]

Ahh, gotcha. So the pro-rata rule applies only to Traditional IRA's, and not taxable accounts?

Would there be a more tax-efficient way to invest the $25,650 than in a taxable account?

Thanks!

[Docbeans]

pistolpete wrote:

Ahh, gotcha. So the pro-rata rule applies only to Traditional IRA’s, and not taxable accounts?

 

Click to expand...

Exactly.

pistolpete wrote:

Would there be a more tax-efficient way to invest the $25,650 than in a taxable account?

Thanks!

Click to expand...

1. Get another unrelated source of earned income and open another tax-advantaged account.

2. Employ spouse in your business, if applicable, and open solo 401k for her/him.

3. Invest in tax-advantaged securities, such as low-turnover index funds or muni bond funds, etc- depending on your goals/asset allocation.

4. If saving for college is a goal, 529 is an option. If no kids at present, make yourself the beneficiary and switch later. No taxes saved now, but later when expense used for education.

[DMFA]

The way we do Backdoor IRAs completely untaxed (well, untaxed again, since it's post-tax money) is to have ZERO holdings in TIRA, SEP-IRA, and SIMPLE-IRA.  Convert them and pay the taxes on them, or better yet, not to have had them in the first place.  Nothing else counts toward the pro-rata conversion rule other than non-Roth IRAs.

The separate income stream to enable an additional 401k will get you the most dollars in there.

The 529 offers another tax-advantaged option, with the caveat that it's used on education.  Some states give you a state income tax deduction.  Upside is that they're easily transferable - downside is that if they're not used for education, it's taxed at income plus 10% penalty.

Tax-managed securities in a taxable account are a great option once you've maxed out your tax-advantaged space.  You can simply buy a fund that calls itself "tax-managed," like Vanguard's Tax-Managed Balanced Fund (VTMFX, 50/50), or the large/mid (VTCLX) and small-cap (VTMSX) US stocks.  Municipal bonds are tax-exempt.

If you're a resident, you will need to manage your student loans appropriately, too...if you've got them.  Also, does your current residency program have a 403b or 401k?  Are you contributing to that as well as your Roth IRA?

[pistolpete]

Thanks for the great answer. It seems my best bet to maximize my retirement savings will be to work for an employer for a year or two as I build up my private practice on the side. This was my plan all along anyway. That way I can have multiple employer contributions to separate 401k's. The employer I'll most likely be working for this summer offers a 401k and a 457b, which I'll max out in addition to the HSA and Backdoor Roth. I have no traditional IRA as of yet so the backdoor Roth will work perfectly. Once I transition to full time private practice, I'll max out my solo 401k as noted above and put the rest in a taxable account. Once I hit 40 and have a higher income I'll look into a cash balance plan.

No kids yet, but I could definitely start a 529, even though in my state it's not a tax deduction. Oh well. I also learned today that the homestead exemption in my state isn't much of an exemption.

I plan on paying off all my loans in about 5-6 years.

My current strategy is to save 20% for retirement, put 25% away for loans, and 35% for taxes, while living on 20% of the remainder, per year, over the next 4-5 years.

My residency does not offer a 403b or 401k, so I'm only contributing to a Roth IRA as of right now.

[rb6p]

Just wanted to say that docbeans is giving you great info.  Agree with all of above.

[jfoxcpacfp]

Excellent advice above except for one correction: if you are 100% owner of 2 businesses, you can contribute no more than $53k total to your SOLO-k. That is because, as 100% owner, your businesses are treated as one. it's not where the income originates, but who owns the businesses. If you own < 80% of the business, then you can have a separate 401k with separate limits. Of course, then you wouldn't qualify for a SOLO-k. T

The suggestions to hire your spouse and to have some W2 income at a job where you would qualify to participate in a qualified plan are good ones.

I disagree with letting the tax tail wag the growth of wealth dog if you can grow your portfolio more than enough to pay the additional tax liability with investments that aren't simply driven by tax concerns.

A taxable account has many benefits.