It’s common for financial advisors to recommend rolling your 401k over into an IRA when you leave a company. There are many sound reasons why you should – consolidating accounts, better investment availability, costs, and more control over your account to name a few. However, that doesn’t mean a Rollover IRA is always the way to go.
Here’s one good reason...
If you expect your income to exceed Roth IRA contribution limits but still want to get the benefits of tax-free growth from a Roth IRA, you’ll need to consider backdoor Roth conversions. In short, making nondeductible IRA contributions then converting them into a Roth IRA, giving you access to a Roth IRA even though you make too much money to directly fund one. If that sounds like blatantly taking advantage of loopholes, it’s not. The Congressional Conference Report of the Tax Cuts and Jobs Act of 2017 specifically gives this set of actions the green light in the footnotes of page 289: “Although an individual with AGI exceeding certain limits is not permitted to make a contribution directly to a Roth IRA, the individual can make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA."
What does this have to do with not rolling a 401k over into an IRA? The IRA aggregation rule, which essentially treats all of your non-Roth IRAs as one when taking distributions. That would be fine except for the fact that specifying what money to withdraw (pre-tax vs post-tax) isn’t allowed. Instead, distributions are prorated based on the proportion of pre and post-tax dollars in all of your non-Roth IRAs. What this means for Roth conversions is even if you have a completely separate IRA with only nondeductible contributions in it, if you have pre-tax money in other IRAs, your Roth conversion will be partially taxable.
Say you have a $54,000 IRA you rolled over from an old employer (all pre-tax money), and you want to make a nondeductible contribution of $6,000 this year and convert that to Roth. Your total non-Roth IRA balance is $60,000 and $54,000 (or 90%) of it is pre-tax money. 90% of your $6,000 Roth conversion, even if your pre and post-tax money were in separate accounts, would be taxable and only the remaining 10% tax-free. It’s particularly painful when you remember that both your $6,000 contribution AND 90% of the $6,000 conversion are taxed this year. In the long run, everything ends up being taxed once, but it sure feels like double taxation now.
Aside from rolling a 401k over into an IRA, what are your options?
You can keep your existing 401k account, consolidate it with your new company’s 401k plan, or take taxable distributions. These options may or may not be available or viable for you; for example, your new company may not accept rollovers into their plan, or if you aren’t eligible for qualified distributions you’d face an additional 10% tax penalty when making a taxable withdrawal. Claire Boyte-White’s What Happens to a 401(k) After You Leave Your Job on Investopedia is a solid primer on figuring out what to do with an old 401k.
In general, I lean toward account consolidation and not leaving a trail of stray accounts behind. Therefore, unless there’s a specific reason why your old 401k account is preferable, I’d lean towards trying to combine it with your new 401k. This turns two accounts into one, and you leave behind the old plan completely. All of this depends on your specific situation of course. Your new company’s 401k plan might suck, and you only want to contribute enough to get your company's match. Maybe you don’t even have a new 401k plan, or you’re starting your own company. Those could be reasons to leave your old 401k account as is.
Wait. I already have a large IRA...
If you're reading this because you want to do backdoor Roth conversions, but you already rolled a 401k into an IRA, have a SEP or SIMPLE IRA (these are also counted for the aggregation rule), or made pre-tax IRA contributions before, all is not lost. If your current company's 401k allows incoming rollovers, you can get rid of your pre-tax IRAs by rolling them into your 401k. You open the door for backdoor Roth conversions but remove the IRA benefits of flexibility and control.
Remember, this is just one reason why rolling your 401k into a Rollover IRA might not be the right move. There are also great reasons to have a Rollover IRA, and other factors in your life might complicate the decision. Just because you want to take advantage of backdoor Roth conversions doesn’t mean Rollover IRAs are off the table. You should evaluate your situation as a whole before making a decision on one piece of it.