Most efficient use of SEP IRA, i401k, and backdoor Roth IRAs?

[Jarpee]

I am trying to determine the best way to get as much sheltered money into retirement accounts while still being tax efficient. I am in my final year of residency with 1099 income from a stipend as well as W2 from residency. I am eligible for a employee 401k starting with my job this fall. My wife and I have each maxed out Roth IRAs for the previous 4 years. I just realized while doing my taxes for 2016 that I am now considered self employed. I will actually have 1099 income for the next three years so I will remain self employed at least that long. I wish I would have realized this last year and started a i401k but alas, I did not. I plan to open a i401k for 2017, 2018, and 2019 and contribute the max I can based on my 1099 income while maxing out my 18k employee contribution to my employee 401k. I also plan to max and convert backdoor roths for both my wife and I each year for as long as they let us. My question is whether I should open a SEP IRA for 2016 to get extra money into a tax sheltered retirement account and also a tax break this year. My 1099 net income for 2016 is $30,099 (after tax and deductions) which would let me contribute 25% of that ($7525). My concern is the pro rata tax hit I will take in 2017 when I do my backdoor roth conversion. I think the benefits to doing the SEP IRA for 2016 potentially outweigh the tax hit but I wanted to see what your all thoughts were.

The Vanguard rep I just spoke to thought I should max my 2017 traditional IRAs and convert them prior to maxing my 2016 SEP IRA to simplify the conversion. The only issue with that is I don't have enough cash on hand right now to max both traditional IRAs and a SEP IRA before April, so assume I would need to file for an income tax extension for 2016, which seems like a hassle. Also, is there anyway to rollover my SEP IRA later this year (or next) to my employee 401k? That would take the tax hit out of the question.

I realize I just asked about 20 questions in one thread, sorry.

I very much appreciate any replies and help.

[jfoxcpacfp]

Jarpee wrote:

My question is whether I should open a SEP IRA for 2016 to get extra money into a tax sheltered retirement account and also a tax break this year. My 1099 net income for 2016 is $30,099 (after tax and deductions) which would let me contribute 25% of that ($7525). My concern is the pro rata tax hit I will take in 2017 when I do my backdoor roth conversion. I think the benefits to doing the SEP IRA for 2016 potentially outweigh the tax hit but I wanted to see what your all thoughts were.

Yes, of course you should. There will be no pro-rata tax hit. You will:

• contribute to the SEP for 2016 (you have until 10/15/17),


• set up the SOLO-k for 2017 (you have until 12/31/17), and


• roll the SEP into the SOLO-k (before 12/31/17).

For the back-door Roth, you will:

• contribute to a TIRA (nondeductible) for 2016 (Y=you have until 4/18/17)


• convert in 2017


• contribute to a 2017 TIRA at any time you want


• and so forth.

Read these posts for more details:

What is a SEP IRA and when should I use one?

What is a 401k and when should I use one?

[DMFA]

Another instance of confusing *for* a year and *in* a year.

Pro rata only applies to what the balance of that non-Roth IRA was on December 31.  This is furnished on your form 5498 that your IRA custodian should provide you.  If you didn't have one then, then there's no pro rata taxation.

SEP-IRA is limited to 25% of your *wages*, meaning it can't include your SEP-IRA contribution...so your cap is 0.25 * (wages - contribution), or rate/(1+rate).  Therefore the 25% maximum is actually 0.25/1+.25 = 0.20 = 20%.  When you do the worksheet in IRS Pub 560, p.22-23, you'll see how it comes out.

So yes, SEP-IRA to reduce the 1099 tax hit as much possible.  If you'd had a solo-401(k) prior to 12/31 (since it has to be started in the year it takes effect), you could have made "employee" contributions of up to a total of $18,000 across all 401(k)/403(b)s per person, plus the 20% "employer" contribution.  It will still be a greater amount than you could save into a traditional IRA.

[Jarpee]

How do I determine my "rate" from the "rate table for self employed"? Also if I am trying to figure out how much I can contribute to my SEP but my net earnings can't include my SEP contribution it seems like the cart is going before the horse. Also half of FICA tax needs to be subtracted as well? So if I have 10k net earnings. Lets say FICA is 1k, so employer portion is 500. So that means I can contribute 20% of 9500 (1900) to my theoretical SEP IRA? So the 25% is just for the employee side of things?

I didn't have a 401k for 2016, so could I contribute more to the SEP than the 20% of net earnings minus half of FICA?

I assume I have confused myself, any redirection is appreciated.

[spiritrider]

It sounds like you have the basics. The maximum employer contribution is 20% of net self-employment (net business profit - 1/2 SE tax). Which is 25% of compensation (net-self-employment income - employer contribution). This is using 25% as your "plan contribution rate" in the rate table which results in a self-employment rate of 20%.

To make the numbers cleaner, let's say the net business profit is $10,500, the SE tax is $1,000 and the net self-employment income is $10,500 - $$500 = $10,000. The max employer contribution will be net-self employment income ($10,000) * 20% = $2,000. Note: This is also compensation ($10,000 - $2,000) * 25%.

The difficulty is understanding that the 25% of compensation and 20% of net self-employment income are exactly the same for the self-employed. Contributions for employees are easier at the plan contribution rate (25%) of compensation (W-2 wages). Both the self-employed individual and employees are equivalent (25% of compensation).

[Jarpee]

Thank you, makes sense now. So to max out a SEP, 54k has to be 20% of your net earnings, I assume it isn't like a s401k where 18k can be employee contribution with an additional 20% of net earnings?

[Jarpee]

Final Edit: I deleted my earlier rant because I figured out the calculations and the form for the most part.

Last question: As long as the s401k is set up by 12/31 of the tax year, we are able to contribute to it the next year prior to filing correct?

[omstexan]

I also am late to the party on 1099 income for 2016 and I just formed a new SEP-IRA.  Do I need to complete my TIRA to Roth conversion for 2016 prior to a 2016 contribution to the SEP? TIA.

[spiritrider]

Jarpee wrote:

Final Edit: I deleted my earlier rant because I figured out the calculations and the form for the most part.

Last question: As long as the s401k is set up by 12/31 of the tax year, we are able to contribute to it the next year prior to filing correct?

Click to expand...

If you are a sole proprietor, you have until your tax filing date with extensions to make both the employee deferral and the employer contribution. You must adopt the Solo 401k and make the employee deferral election by 12/31.

An S-Corp shareholder-employee's deferrals must be deductions from payroll with a "pay date" on or before 12/31. The employer contribution can be made up until the corporation's filing deadline including extensions.

[spiritrider]

omstexan wrote:

I also am late to the party on 1099 income for 2016 and I just formed a new SEP-IRA.  Do I need to complete my TIRA to Roth conversion for 2016 prior to a 2016 contribution to the SEP? TIA.

Click to expand...

Review the first reply from Johanna.

Most of the order is not important as long as it all happens before 12/31. The pro-rata calculation is based on your non-deductible basis and pre-tax balances on 12/31. So long as the SEP IRA and other pre-tax balances are rolled over to minimize pre-tax balances before 12/31, there will be minimal taxable income.

The optimal way to accomplish this is to make all the SEP IRA contributions and non-deductible traditional IRA contributions first, rollover the non-deductible basis to a Roth IRA, and then rollover all remaining pre-tax IRA balances to the Solo 401k. This ensures there is no pre-tax balance on 12/31 and the Roth conversion is tax-free.

However, if you have to do the 2017 contribution/conversion after the rollover, it is not really a big deal if you convert shortly after the contribution as there will be minimal taxable earnings. After all, this is what you will do in the future anyway.