Consider the following… Even if you make too much money to contribute to a Roth IRA, you’ll soon be able to make a non-deductible contribution to a Traditional IRA and immediately convert it into a Roth IRA. In other words, the removal of the income limit for conversions effectively removes the income limits for contributions.
Or does it? As it turns out, there’s a relatively nasty “gotcha” associated with these conversions. More specifically, if you have any tax-deferred money in an IRA (Traditional, SEP, or SIMPLE) you’ll have to factor those in when determining the tax status of your conversion. Here’s a snippet from Fairmark.com that explains the problem quite well:
“For example, if you happen to have a traditional IRA with $96, 000 of money from a 401k rollover (zero basis) and you make a $4, 000 nondeductible contribution to a new IRA, thinking you can convert it to a Roth at little or no cost, youâ€™ll be wrong. You have to add the two IRAs together to determine the taxable amount, and in this case your conversion will be 96% taxable.”
Bummer. This is actually a significant problem for me, as I have a relatively large SEP-IRA that is chock full of tax-deferred dollars. Thus, if I were to stash $5k in non-deductible contributions in a Traditional IRA with the intention of converting it to a Roth, the majority of the conversion would wind up being taxable.
The Solo 401(k) solution
The good news is that there’s a workaround, though it’s moderately inconvenient. Because this “pooling” of tax-deferred funds applies only to IRAs, I can actually set up a Solo 401(k) and roll my SEP-IRA funds into it. I’ll then be free to set up a dedicated Traditional IRA to receive non-deductible contributions that will get converted straight into the Roth with no nasty tax implications.
I actually mentioned this possibility back in October of 2007, and then promptly forgot about it. A few weeks back, I was reminded of it when I ran across a post talking about this strategy over on TheFinanceBuff. Time is now running short, but I should still be able to pull it off before the end of the year.
The downside of this strategy
Probably the biggest downside for me is that I’ll have to leave Vanguard (at least temporarily) to make this happen. The reason for this is that Vanguard doesn’t accept IRA-to-401(k) rollovers. Thus, I’ll likely wind up moving the money to Fidelity.
That being said, Vanguard does, however, accept 401(k)-to-401(k) rollovers, so I could ultimately move the money back in. Is this a deal breaker? Not really, though I’ve grown quite fond of Vanguard over the years.
Other concerns (though not big ones in my book) are that:
- You have to start filing a Form 5500-EZ with the IRS every year once your 401(k) account reaches $250k in value. With a SEP-IRA, there is no such reporting requirement.
- With an IRA, you can withdraw money at any time for any reason. Sure, you might have to pay a penalty, but you can do it. With a 401(k), you have to meet specific hardship guidelines before you can touch the money.
Like I said, not major issues, but still something to consider. In the end, I’m leaning toward doing it, though I’m still not 100% sure. Thoughts?