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Well, I was going to give you a link where Brightscope rates 401(k) plans, so you could check the ratings for yourself, but their website doesn't seem to be working tonight. If it happens to come back up, here's the link: https://www.brightscope.com/ratings/

The Brightscope site is working again https://www.brightscope.com/ratings/#

I did check ratings, and I had remembered my prior employer's plan rating incorrectly - it was an 80. Joel's current employer (the plan he likes to brag about) is an 88. And my current temp/contracting employee has a 65 rating. So still not terrible, but it does get downgraded for high fees, even though they aren't as high as some.

AJ
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In what scenario would it be a bad idea to convert from a deductible traditional IRA to a Roth IRA
When your tax rate in retirement is lower than your tax rate now.
(which probably will be the case for many/most people - including you I would guess when you get to 32% bracket)

when you can pay the current tax bill with outside funds?
irrelevant IMO
Those outside funds would be invested (possibly at least partly within a Roth) if not used to pay taxes.

Since the current year tax consequences are a 6 figure impact, I am stressing about this decision.
Is there a reason it has to be done in 2018?
If it were me, and I'd decided to convert a large amount I would spread it out over multiple years, trying to stay mostly in my current bracket or maybe go one bracket higher.
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So I have been creating spreadsheets to crunch the numbers and using online calculators to verify, and I can’t find a reasonable scenario where I wouldn’t be ahead to convert my large (to me) deductible Traditional IRA to Roth. I am in the fortunate situation where I could pay the tax bill for the conversion from proceeds from a taxable stock account. Even considering that it bumps me to the 32% tax bracket in 2018 it still seems to be the best decision for maximizing my future after tax income along with the added benefit that it gives me more flexibility. Am I missing something?

Unless you are going to be in the 32% bracket in future years, I would suggest instead doing multiple partial conversions over enough years to keep you in the 24% bracket for all of the conversions.

Since the current year tax consequences are a 6 figure impact, I am stressing about this decision. I have met with numerous financial planners over my 20 year investing career and am always disappointed in their lack of insight. Seems like I usually pay for someone’s advise that is less knowledgeable than me. So I’m asking this board if anyone has experience with this. In what scenario would it be a bad idea to convert from a deductible traditional IRA to a Roth IRA when you can pay the current tax bill with outside funds?

If, in the future, you will be in a lower bracket than 24% without doing the conversion, it would be a bad idea to do the conversion at 24% or higher.

Unless you want to convert the entire account* so that you can take advantage of the back-door Roth contribution, or are building up more traditional accounts through contributions to a current 401(k), I would suggest that you may want to keep some of the account in traditional form. While you will be required to take RMDs once you reach 70 1/2, under both the current tax rules, and the rules that the old rules that are currently scheduled to return in 2026, you can still have a fairly substantial taxable income without bumping into rates higher than 24% - 25%, so paying rates as high as 32% now in order to completely avoid taxes later doesn't make sense.

*Another way to eliminate a traditional IRA so that you are able to do back-door Roth conversions would be to roll some/all of the traditional IRA into your current 401(k). So, if you want to do a back-door Roth conversion for 2018, you could do a partial conversion of your IRA - low enough to keep you within the 24% bracket, and then roll the rest of the IRA into your 401(k) before the end of 2018.

AJ
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AJ,

You brought up something here that I hadn't thought about. Will research this but can you explain how this helps on tax and RMD's
Scenario, I have a Rollover IRA from a previous employer. If I were to roll it back to my 401K and then retire in 2019, is there any benefit to doing this?

Mike
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You brought up something here that I hadn't thought about. Will research this but can you explain how this helps on tax and RMD's
Scenario, I have a Rollover IRA from a previous employer. If I were to roll it back to my 401K and then retire in 2019, is there any benefit to doing this?


A couple of possibilities:

If you have earned income in 2018 and/or 2019 that puts you over the limit for making Roth IRA contributions, then rolling the IRA into the 401(k) before the end of 2018, so that you have no pre-tax/Traditional IRAs as of Dec 31, 2018) will allow you to make back-door Roth contributions for 2018 and 2019. The back-door Roth contribution is where you make a non-deductible contribution to a traditional IRA, and then convert it to a Roth. If you have any gains between when you make the contribution and do the conversion, you will have to pay taxes on the gains. But if you just make the contribution to a money market account and convert shortly after the initial contribution, there probably won't be enough gains to be taxable.

Because of the pro-rata rules that the IRS imposes on conversions, this back-door strategy only works if you have no other traditional IRAs, including, but not limited to, rollover, SEP or SIMPLE IRAs. If you do have other IRAs with pre-tax contributions and/or gains, then you have to pay taxes based on the overall percentage of pre-tax monies in the total of your IRAs.

The back-door Roth strategy doesn't really help with RMDs, but it does allow you to put more money into Roth accounts, which are tax free.

The other way that rolling an IRA to a 401(k) can be an advantage is - if you leave service from the employer sponsoring the 401(k) in or after the year you turn 55, and the 401(k) plan allows it, you can take distributions from the 401(k) without having to use 72(t)/SEPP (Substantially Equal Periodic Payments) and without being subject to a 10% penalty. Putting more money into the 401(k) then provides a larger balance to draw from between the year you turn 55 and when you are 59 1/2 and can access your other tax-advantaged accounts without penalties. Using more of your tax-deferred accounts, rather than taxable accounts, during this timeframe will decrease amount of tax-deferred money that will be subject to RMDs.

Another way that having more money to draw from in a 401(k) can be helpful with taxes is that all 401(k) withdrawals (not conversions) are required to have withholding, and you can specify a higher percentage of withholding. Combined with the fact that withholding is considered by the IRS to be equally across the year, you can do conversions into Roth accounts across the year without having any withholding, and then, in December, have a withdrawal that is 100% withholding to cover the taxes on the conversions (and any other taxes you may owe). This will help avoid underpayment penalties, but will allow you to hold onto your money until December.

One caution is - if your 401(k) charges high fees and/or has poor investment choices, these advantages may not be worth it.

AJ
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AJ, Thanks much. I won't be able to even consider it then as I couldn't empty both IRA's as one already has funds from my present 401K. Thanks for the detailed reply.

Mike
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aj485,

You wrote, One caution is - if your 401(k) charges high fees and/or has poor investment choices, these advantages may not be worth it.

Let me elaborate on your statement as I've done this analysis several times in the past. And it's pretty simple to explain as well.

A retirement account only saves you taxes on the reinvested realized earnings. In other words, capitals, dividends, interest, etc. But in an average year that's probably around 2-4% of assets. If you were in say a 25% blended (capital gains and qualified dividends get better treatment in a taxable account) tax bracket, your frictional costs associated with using a taxable account vs. a tax-advantaged retirement account is between 0.5% and 1.0%/year.

That's real money over say a 30 year investment horizon. But often small to mid-sized employers charge employees fees in this range for 401(k) plans, which can completely eliminate the tax advantage. This is one of the reasons many people tell you to contribute to get the company match, then contribute to an IRA, then come back and reconsider the 401(k) plan.

But if you intend to stay at a job and the retirement plan is costing you 2.0%/year of assets, there is absolutely *NO* advantage to using that plan compared to simply making taxable investments. At 1.0%/year, the math is a little harder because you can always roll your funds out when you leave your employer so even though you might lose a little on the front-end (during accumulation), you should gain it back during retirement.

I've actually been stuck in a plan where the average combined expense was 2.0%/year. I contributed the max, but the only way I could convince myself to do it was by investing only in a "low-cost" S&P 500 index fund and telling myself there was no way I'd be there more than a few years. As it was, I think I was paying about 1.5%/year.

Anyway, I think plans that cost >= 0.5%/year are still the norm. Usually only large-cap and public sector employers offer better. That makes rolling in (and usually locking up) previous employer plan assets a very questionable proposition given that you might be paying these additional expenses on a six figure portfolio just to gain a tax advantage on future gains on a $5,500 contribution. For the math to work, the additional expenses charged by your employer's plan usually needs to be less than 0.1%/year more than what you are paying in an IRA.

Yeah. The math usually just doesn't work for most people ... even if they have the income.

And more thing: I am assuming your employer's 401(k) plan has investments that can match your returns outside of their plan. Often that's not a valid assumption.

- Joel
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Anyway, I think plans that cost >= 0.5%/year are still the norm.

I guess my employer's plan is pretty good. I thought it was just average for the sector or slightly better than average overall.

I can invest in VIIIX (S&P500 index) with a 0.02% exp ratio or a managed growth fund with 0.38% expense ratio.
I think my most expensive fund I own in it is a managed low-price stock fund that has a 0.45% expense ratio.
If I look at going with a similar fund outside of my 401k like FLPSX it'd be 0.67%
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I guess my employer's plan is pretty good. I thought it was just average for the sector or slightly better than average overall.

Well, I was going to give you a link where Brightscope rates 401(k) plans, so you could check the ratings for yourself, but their website doesn't seem to be working tonight. If it happens to come back up, here's the link: https://www.brightscope.com/ratings/

I can invest in VIIIX (S&P500 index) with a 0.02% exp ratio or a managed growth fund with 0.38% expense ratio.
I think my most expensive fund I own in it is a managed low-price stock fund that has a 0.45% expense ratio.
If I look at going with a similar fund outside of my 401k like FLPSX it'd be 0.67%


That does sound like a pretty good plan. The large company that I retired from recently has a better than average rating - 86 or 87, I think, and the index fund expense ratios are in the 0.01% - 0.06% range, target date funds with a 0.08% ratio, and managed funds between 0.22% and 1.06% - which are generally lower than similar funds outside of the plan. Additionally, there are administration fees that get taken out up to once a quarter that are generally in the 0.002% - 0.003% range. (Last year, those fees were only taken out 3 out of the 4 quarters, though.) I still have money invested in my 401(k) there.

On the other hand, the 401(k) at my current consulting gig (handled through a fairly small temp/contracting agency) has index funds with expense ratios of 0.04% - 0.16% (so, 2.5 - 4 times as high), target date funds from 0.56% to 0.74% (so, 7 - 9.25 times as high), with managed funds from the 0.2% - 1.0% range (so, about the same). However, the administration fee, which will be charged every quarter, is in the 0.02% range per quarter (0.08% per year) - which is 8 - 13 times as much as my old employer's plan, if you consider my prior plan only charged me for 3 out of 4 quarters last year. Compared to Joel's example, these expenses are lower, so it's still not a bad plan - but they are significantly higher than my prior employer's plan.

That said, because I'm not planning on being in this gig for long, I decided that the benefits of being able to put more money into tax deferred/tax free accounts was worth the extra expense ratio. However, as soon as I can after my gig is over, I plan on rolling the money to my Vanguard IRA to get out of paying those expenses. (I can't roll money into my prior employer's 401(k), because I no longer work there.)

AJ
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Well, I was going to give you a link where Brightscope rates 401(k) plans, so you could check the ratings for yourself, but their website doesn't seem to be working tonight. If it happens to come back up, here's the link: https://www.brightscope.com/ratings/

The Brightscope site is working again https://www.brightscope.com/ratings/#

I did check ratings, and I had remembered my prior employer's plan rating incorrectly - it was an 80. Joel's current employer (the plan he likes to brag about) is an 88. And my current temp/contracting employee has a 65 rating. So still not terrible, but it does get downgraded for high fees, even though they aren't as high as some.

AJ
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