Worth setting up IRA for moonlighting income?

[Tuxedo]

We are a dual physician family.  My wife is employed, maxing out her tax deferred retirement.  I'm in the military, maxing out my Roth TSP.  I have some moonlighting income from 2016 on a 1099.  Might be an ongoing thing for the next few years or it might never happen again.  Is it worth it to set up an IRA to make a tax-deferred contribution (I figure the max I can contribute will be around 1K in the form of an employer contribution)?  Or should I just throw an extra 1K in our taxable Vanguard account?

IRA seems preferable to 401k based on the record-keeping requirements but I'm certainly open to advice as far as this goes, too.

[DMFA]

It's too late to set up a 401(k) for 2016.  You should already be doing IRAs every year for you and your wife, in addition to your employer plans.  Are you doing taxable instead of doing IRAs?

You can't do "employee" contributions to a 401(k) since you've met that with the $18,000 to your TSP per IRC 415(c).  Your "employer" contributions would be limited to 25% of wages -or- 20% of net profits (revenue minus expenses minus half of self-employment tax), which is actually the same number.  On $1,000, that would probably only be about $150 or so.

You can't deduct your traditional IRA contributions because your income is too high and you have an employer plan (TSP).  You should use it for a "backdoor" Roth IRA imo, which is probably the way you should be doing IRAs every year, assuming you and your wife are MFJ with AGI > $184,000 or MFS and don't currently have any pre-tax IRA holdings (just IRA, not 401(k), 403(b), TSP, etc).

1. Make a traditional IRA contribution for 2016


2. Convert it to Roth a few days later


3. File form 8606 with your 2016 taxes.  It should read $1,000 on lines 1,3,4,14 and zero on all others (esp lines 15 and 18, since those are the taxable amount), assuming you contribute that much (imo you should max it for both)

If you really, really want the tax-deferred instead of post-tax on the money, you can still start a SEP-IRA for 2016.  I don't like those because they hinder your ability to do the "backdoor" Roth due to taxability of otherwise non-deducted money due to the "pro rata" rule.  However, you can still start an indie 401(k) and roll 2016's SEP-IRA money into it, as long as you have 1099 income in 2017.

One more piece of (unsolicited) advice, if you're in 33% bracket or higher, consider switching form Roth TSP to Traditional and taking the tax break now instead of later.  I say *consider* because there are still advantages to keeping that much Roth space, although Roth TSP still has RMDs, though you can roll over to a Roth IRA...however the TSP has several huge advantages, especially since index investing is the way to go anyway, in its inexpensive funds (ER 0.029%) and unique fixed-income holding in the G-Fund (prob not for you at this point).

[Tuxedo]

DMFA wrote:

You can’t do “employee” contributions to a 401(k) since you’ve met that with the $18,000 to your TSP per IRC 415(c).  Your “employer” contributions would be limited to 25% of wages -or- 20% of net profits (revenue minus expenses minus half of self-employment tax), which is actually the same number.  On $1,000, that would probably only be about $150 or so.

Sorry for not being clearer.  Gross is 6K.  I figure net will be around 5K.  20% of net profits is where I got the 1K figure from.

One more piece of (unsolicited) advice, if you’re in 33% bracket or higher, consider switching form Roth TSP to Traditional and taking the tax break now instead of later.  I say *consider* because there are still advantages to keeping that much Roth space, although Roth TSP still has RMDs, though you can roll over to a Roth IRA…however the TSP has several huge advantages, especially since index investing is the way to go anyway, in its inexpensive funds (ER 0.029%) and unique fixed-income holding in the G-Fund (prob not for you at this point).

I have gone back and forth over whether to do Roth vs. traditional TSP.  Current strategy is to max out my Roth while I can; once I'm out of the military, we'll be limited to backdoor Roths at most. 

 

I haven't been able to wrap my head around the whole pro-rata rule and we do have some IRA holdings which is one thing that has made me a little hesitant to do backdoor Roths. 

[DMFA]

Then what I'd do is:

• contribute your 2016 IC earnings to SEP-IRA


• Roll the SEP-IRA over to an indie 401(k) in 2017 (along with your 2017 IC earnings)


• Further roll in your other pre-tax IRAs into that indie 401(k)

..and you're green-lighted to do all the backdoor Roths you want, including for 2017, since you will have zero in pre-tax IRAs on 2017-12-31 for your 2017 conversions.  The best way to understand the pro-rata rule is not to have to worry about it!  Just note that Vanguard doesn't accept incoming rollovers; go with Fido, Schwab, TD, E-trade, etc for it.  I like Fido, but if you're already at one of those other institutions,

I max my Roth TSP, my wife maxes her pre-tax 403(b), and we each did $5,500 in backdoor Roth on 3 January this year.  If your retirement accounts don't bring you to your retirement savings/investments goal of 20-25%, then you should supplement them with backdoor Roth IRAs.

[ENT Doc]

I agree with DMFA about the Roth TSP to Traditional.  I funded the Roth TSP for 2 years, maxed out.  Changed to the Traditional this year after our marginal rate got bumped to 28% after moonlighting (although I probably should have been doing the Traditional TSP in a 25% bracket too).

 

A point about the employer portion of the 401k contribution for locums.  Since they don't typically consider you an employee you are left paying the employer and employee portions of the FICA (15.3%).  This all affects the employer contribution maximum, which is 20% of net earnings (total wages - deduction for self-employment tax).  This isn't straight forward and isn't as simple as saying 25% of the number on your 1099.  This is the arrangement in a more standard employer and multiple employees 401k set-up.  As a self-employed individual, you need to look at the Long Schedule SE, which goes through how to get the deduction amount (50% of your self-employment tax).  This employer contribution ($1K est. in your case) shouldn't have any bearing on how much you put in a traditional IRA.  As DMFA stated, you can't deduct this.  You should be able to deduct the employer portion (line 28 of 1040) of your 401k as calculated above.  I would suggest starting an i401k, putting in your employer portion, deduct this, and on a completely separate note put in $5,500 to a traditional for you and your wife and do a backdoor Roth conversion.  You don't want to just put money into a traditional IRA, especially when you can do a backdoor Roth.

As far as the TSP is concerned, their expense ratio went from 0.029% to 0.038% this year.  I like the ability to roll it over to a Roth IRA where I don't have RMDs.  RMDs from the TSP will follow a pro-rata rule as well, so it's not like you can pick and choose which funds (Roth vs traditional TSP) you take out to maximize tax efficiency.  Just some things to think about.

DMFA, please correct me if I'm wrong here.

[ENT Doc]

That SEP IRA is a good idea if you haven't set a 401K up yet.  You'll still get the same employer contribution/deduction as if you had the 401k.

 

As far as the traditional rollover to the 401k, I think you have to take both the pre-tax money AND ANY growth from both pre-tax and non-deductible amounts out in the rollover, right?  I think you only want the non-deductible money from prior tax years in the traditional before you do a Roth conversion.  Another point - make sure you do the whole SEP to 401k thing before the end of the year.  Otherwise you get hit with the pro-rata rule for that Roth conversion.

[DMFA]

ENT Doc wrote:

As far as the TSP is concerned, their expense ratio went from 0.029% to 0.038% this year.  I like the ability to roll it over to a Roth IRA where I don’t have RMDs.  RMDs from the TSP will follow a pro-rata rule as well, so it’s not like you can pick and choose which funds (Roth vs traditional TSP) you take out to maximize tax efficiency.  Just some things to think about.

DMFA, please correct me if I’m wrong here.

Click to expand...

You're correct.  Expenses for 2016 were 0.038%, up from 0.029% in 2015.  They had been hovering around 0.03% for a few years.  Expenses for many funds are moving targets as opposed to setting fixed ERs in case the actual operating expenses are lower, so no additional cost is passed onto the investors.

I was surprised to see a 31% relative increase, though (but it's just a 0.009% increase, 90 cents per $10,000).  That's still better than every fund except for some institutional-class index funds like VFFSX, which is basically free, and FXAIX, which is 0.015% which is in my wife's 403b offering.

A common choice for Roth TSP is to hold enough to hold your G fund (since you can't get anything truly like it elsewhere) and roll the rest into a Roth IRA to avoid RMDs.

Which pro rata rule are you referring to?  Having to withdraw only an amount, and having that drawn from both Trad/Roth and from all funds equally?  Yeah, that's a pain.  According to the info on RMDs and the withdrawal form, it doesn't specify from where the withdrawal is supposed to come.

[ENT Doc]

I guess I was referring to two different situations.  First, the TSP.  I believe when you take RMDs from the TSP it follows a pro-rata rule.  If you have 1/2 your money in a Traditional TSP and 1/2 in the Roth TSP you'll take a combined RMD and get hit with ordinary income tax on 1/2 of your required withdrawal.  Thought I saw this in the TSP RMD tax form.

The second pro rata rule I was referring to was in regards to doing a Roth IRA conversion from a Traditional IRA that has both pre-tax and non-deductible money.  Some of what is in the Traditional IRA will be growth as well.  In order to avoid the pro rata rule I thought you needed to move all of the pre-tax money AND any growth from the traditional to a 401k. Then, you could move any current/prior non-deductible money to the Roth IRA.  Is this accurate to the best of your knowledge?

[DMFA]

ENT Doc wrote:

I guess I was referring to two different situations.  First, the TSP.  I believe when you take RMDs from the TSP it follows a pro-rata rule.  If you have 1/2 your money in a Traditional TSP and 1/2 in the Roth TSP you’ll take a combined RMD and get hit with ordinary income tax on 1/2 of your required withdrawal.  Thought I saw this in the TSP RMD tax form.

The second pro rata rule I was referring to was in regards to doing a Roth IRA conversion from a Traditional IRA that has both pre-tax and non-deductible money.  Some of what is in the Traditional IRA will be growth as well.  In order to avoid the pro rata rule I thought you needed to move all of the pre-tax money AND any growth from the traditional to a 401k. Then, you could move any current/prior non-deductible money to the Roth IRA.  Is this accurate to the best of your knowledge?

Click to expand...

Yeah.  Roll all the pre-tax Trad IRA money to 401(k) and post-tax Trad IRA money (the backdoor contribution) to Roth.  This irons out on Form 8606.

[ENT Doc]

Thank you.  The growth needs to be put in the 401k as well, right?

[Tuxedo]

Thanks for the input.  Can you walk me through why I should be doing a traditional TSP rather than a Roth?  I had been doing both initially but the switched to adding to the Roth only and stopped traditional TSP contributions (on the assumption that tax free growth was better than tax-deferred growth...I realize reasonable minds might differ on this).

 

I didn't realize having money in a traditional TSP would change how the Roth TSP is handled for tax purposes.  And I don't understand it.

[ENT Doc]

From page 1 of "Important Tax Information About Your TSP Withdrawal and Required Minimum Distributions" (pdf can be found by googling this):

"Your entire TSP account is subject to the required minimum
distributions. When you have traditional (non-Roth)
and Roth balances in your account, any withdrawals will
be paid pro rata (i.e., proportionally) from each balance.
Also be aware that if you receive a payment from an account
that has both taxable and tax-exempt contributions,
your distribution will be paid proportionally from taxable
and nontaxable amounts."

So this is only for withdrawals - not for adding to a Traditional vs Roth TSP.  When you take a withdrawal from the TSP it appears that you take it pro rata, meaning that it is proportional to the amounts in Tradition and Roth.  So if you take out $20,000 and you have a 50/50 split of Traditional/Roth you'll be on the hook for $10,000 of that for tax purposes.

Why Traditional vs Roth TSP?  As a dual physician family you're probably pushing the 28-33% tax bracket.  When you put the money in a Roth TSP you miss out on $6000-ish opportunity cost of investing elsewhere.  If on the margin is your back-door Roth, this is very costly.  If in a taxable account this is still costly.  Look at it on the flip side.  Max out the traditional instead with $18,000.  You'll not pay $6,000ish in tax that you now invest elsewhere.  This whole "you pay tax on the entire thing though" argument doesn't hold up to most situations.  I even heard Dave Ramsey telling someone the other day that in a 33% tax bracket you should be putting money into a Roth 401k - even said it for a 50% tax bracket situation!  That's ludicrous.  This article sums things up better than I ever could:

https://thefinancebuff.com/case-against-roth-401k.html

[DMFA]

Tuxedo wrote:

Thanks for the input.  Can you walk me through why I should be doing a traditional TSP rather than a Roth?  I had been doing both initially but the switched to adding to the Roth only and stopped traditional TSP contributions (on the assumption that tax free growth was better than tax-deferred growth…I realize reasonable minds might differ on this).

 

Click to expand...

• Roth: made with already-taxed money (not deducted), grows tax-free, withdrawn tax-free


• Traditional: made with not-taxed money (reduced salary or deducted), grows tax-free, withdrawn at marginal income rate (prob 25%)

Obviously, ceteris paribus, tax-free growth is better than tax-deferred growth, but that doesn't take into account today's deduction for tax-deferred accounts.  Roth is taxed now (made with post-tax dollars) and never again, and traditional is deducted now and taxed later.  So the tax break you get now could be worth more than the tax break you could get later.

The argument for using Roth above 25% levels is that to take a 28+% hit now and no tax on anything it grows, vs taking a 28+% deduction now to take whatever hit on the compounded gains later, is that there will be more money grown not subject to tax.  However, that doesn't account for what you might do with the tax you don't pay now.

Say you're in the 33% bracket, and have $18,000 to invest, either in traditional or Roth.  You will let it grow 30 years at 6% and withdraw it in retirement, into the 25% bracket.

• Roth: pay $6,000 taxes on it now, equal $103,383, after growth, minus today's tax for net of $97,383.


• Traditional: pay no tax now, still equals $103,383 after growth, after 25% income tax at withdrawal = $77,537.
  
  
  
  • However, if you'd also invested the $6,000 in taxes you didn't pay, growing at the same rate, in a taxable acct (since you should be maxing your backdoor Roth IRA anyway), will grow to $34,461, assuming 15% LTCG tax on the gains will be $30,192 for a total of $107,728.
  
  
  
  


• You end up with an additional $10,345 after-tax by doing traditional.

Extrapolate the same numbers to the 28% bracket today, retiring to the 25% bracket.

• Roth: pay $5,040 now, for 30-yr amount (less today's taxes) of $98,343


• Traditional: $77,537, plus the $5,040 into taxable = $25,361, so total $102,898


• You end up with an additional $4,555 after-tax by doing traditional.

This, again, all assumes the following:

• You invested everything you didn't pay in taxes.  Obv this might easily not be the case, but if you're not funding a Roth IRA (backdoor or not), then that tax savings would be extremely well-put there.


• You retire into the 25% bracket.
  
  
  
  • If you can manage to retire into the 15% bracket, the tax-deferred accounts would become worth more since they'd be subject to less taxes
  
  
  • However, you'd have to reduce your taxable income, which would be done by having less in tax-deferred accounts in the first place, meaning either putting more into Roth or paying tax on a conversion to get your RMDs down to that number...  (this part is complicated)
  
  
  
  


• The tax code and rules governing retirement accounts stay the same.

Tuxedo wrote:

 

I didn’t realize having money in a traditional TSP would change how the Roth TSP is handled for tax purposes.  And I don’t understand it.

Click to expand...

It doesn't, really.  If you take out $1,000, and it's half in Trad and half in Roth, then only $500 is taxable income.  It's just a matter of whether you paid taxes on what was contributed or what's being withdrawn; you don't do both.  The government's gonna get theirs, but at least in this instance, they're not gonna double-dip.

The issue with the pro-rata rule vis-à-vis gains on non-deducted traditional IRA contributions is explained by Form 8606.  This is why, specifically for pre-tax IRAs (not 401k, 403b, or TSP), you're best off keeping pre-tax and already-taxed contributions separate by rolling all the pre-tax into indie 401(k) and the post-tax into Roth IRA.  [Your bank should be keeping track of the basis of what has and hasn't been taxed.] This will make sure that anything you have put into an IRA that wasn't deducted (on which you've already paid tax) doesn't get taxed again as part of a pre-tax to Roth IRA conversion.

[jfoxcpacfp]

I'm in the stuff-everything-you-can-in-a-Roth-today camp.

Contribute to a SEP with your 2016 IC income, contribute to a nondeductible IRA for 2016, set up a SOLO-k for 2017, roll your SEP into it, and then convert your 2016 n.d. 2016 IRA to your Roth (back-door). Continue with SOLO-k contributions as needed and back-door Roth contributions.

[spiritrider]

jfoxcpacfp wrote:

I’m in the stuff-everything-you-can-in-a-Roth-today camp.

Contribute to a SEP with your 2016 IC income, contribute to a nondeductible IRA for 2016, set up a SOLO-k for 2017, roll your SEP into it, and then convert your 2016 n.d. 2016 IRA to your Roth (back-door). Continue with SOLO-k contributions as needed and back-door Roth contributions.

Click to expand...

With just $1K to contribute to the SEP IRA, I wouldn't bother rolling it into the Solo 401k. I would convert it to the Roth IRA along with the non-deductible traditional IRA contribution.

I would roll the SEP IRA contribution to the traditional IRA or vice versa. Then you would only have to do one Roth conversion. Or even easier, you can make the traditional IRA contribution to the SEP IRA account, if the custodian allows it and you identify it as such. Then you just have the one Roth conversion. The deduction and the taxable income cancel each other out.