In preparation for converting my non-deductible IRA contributions to Roth IRA in 2010, I’m rolling over the pre-tax portion of my traditional IRA to my solo 401k. I set up the solo 401k last year primarily for this purpose — to provide a harbor for my pre-tax IRA money so I won’t get taxed proportionally on my Roth conversion. After the rollover, I should have only one small IRA, consisting of my non-deductible contributions plus or minus market fluctuations from now until I convert in January 2010.

I have my solo 401k with Fidelity. When I called them about the rollover procedures, to my surprise, the rep actually discouraged me from doing so. To his credit, he made valid points. He knew what he was talking about. Fidelity trained them well.

He said the 401k has more restrictive rules on withdrawals. Before I reach 59-1/2, I can withdraw from a traditional IRA for any reason. I just have to pay tax and the 10% early withdrawal penalty. Not that people should do that but that option is there. If I put the money into the solo 401k, I have to qualify for specific hardship events before I’m allowed to withdraw and pay the tax and the 10% penalty. Fidelity’s solo 401k plan does not allow loans.

He also said rolling over money in an IRA to a solo 401k will get the solo 401k closer to an IRS reporting threshold. When a solo 401k plan’s assets reach $250,000, the plan administrator will have to file a Form 5500-EZ with the IRS every year. I can avoid the extra paperwork for more years if I don’t rollover IRA money into my solo 401k.

I would agree with him if I’m not preparing for the Roth conversion. I decided the benefits of low taxes on Roth conversion outweigh the restrictions on withdrawals and the extra paperwork.

The actual rollover consists of two steps. Because I’d like to keep the assets in my IRA, I would transfer in-kind to a new Fidelity Rollover IRA as a bridge. After that’s done, Fidelity needs a letter from me as the administrator of my solo 401k to accept the rollover from my Fidelity Rollover IRA. Then the bridge rollover IRA will be closed. Fidelity will not charge the usual $50 IRA closing fee.

I initiated the partial rollover online with Fidelity last Wednesday. I mailed the transfer of assets form on Thursday. By Tuesday, the rollover is completed. Four business days. Fidelity did a very good job.

With the rollover, I said goodbye to Vanguard Brokerage Service. Vanguard is a great mutual fund company, but its brokerage service is substandard. In order to avoid complications with the rollover, I wanted to change my dividend reinvestment election from automatically reinvest to taking the dividend in cash. I got this nice message when I tried to do so:

Vanguard Brokerage Service is saying their computers for processing dividend reinvestment elections go off their shift at 5 p.m. Eastern time. I honestly cannot think of any reason why computers work only a day shift.

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Software picked, likely related articles at The Finance Buff:

• The Origin of Solo 401k
• Solo 401k For Part-Time Self-Employment
• Alternatives to a High Cost 401k Or 403b Plan

Non-Deductible IRA Or Taxable

After you enter your assumptions, the spreadsheet will calculate how much you will have in a non-deductible IRA and how much you will have in a taxable account, after all taxes are paid. Of course the calculated result will depend on your assumptions. So play with some what- ifs. For example under this set of assumptions,

a non-deductible IRA beats a taxable account after all taxes even for a tax efficient fund which only distributes dividends. In the above scenario I assumed the laws will stay as we know now. In other words, capital gains will be taxed at 20% and dividends will be taxed as ordinary income, because under the current laws the special 15% rate for long term capital gains and qualified dividends will go away in 2011. If the fund isn’t so tax efficient and its distributions are 2.5% instead of 2.0%, a non-deductible IRA’s advantage goes up.

A common argument against the non-deductible IRA is that it converts capital gains into ordinary income. While true, as the actual calculation demonstrates, if the investor has a long timeframe, the benefits from tax deferral can overcome the higher tax rate on withdrawal.

Another thing that comes up whenever a non-deductible IRA is mentioned is tax form 8606. If you make a non-deductible IRA contribution, you have to file this form. It’s a very simple form. Mine has only 3 numbers on it. In the ages of computers, tax software does the calculation and produces the form. Filing Form 8606 is really a non-issue.

The non-deductible IRA is already better than a taxable account for me (use the spreadsheet with your own assumptions and see if it’s better for you). The possibility of converting it to Roth makes it even better. Under the current laws, a traditional IRA can be converted to a Roth IRA in 2010 and every year thereafter without any income limitation. The spreadsheet calculation does NOT include the effect of such conversion. If there are no changes to the laws and a traditional IRA is allowed to be converted to Roth with no income limit, a non-deductible IRA’s advantage over a taxable account will be much larger.

I have IRAs with both pre-tax and after-tax money. My current plans for taking advantage of the Roth conversion are:

• In 2008, establish a Self-Employed 401(k) Plan (aka "solo 401k"). All I need is a little bit of self employment income, which I already have. Otherwise washing the neighbor’s car for $5 should count. Fidelity offers a no-fee solo 401k .
• In 2009, roll over from my Traditional IRAs to my solo 401k everything except non-deductible contributions. This is crucial because otherwise the pre-tax money in the Traditional IRA will also be taxed during the Roth conversion. The solo 401k provides a safe haven for the pre-tax money.
• In 2010 and every year thereafter, make a new non-deductible contribution to Traditional IRA. Convert the entire Traditional IRA to Roth.

Even if the Roth conversion option goes away, a non-deductible IRA is still not bad by itself. It’s well worth the effort for me.

Elsewhere on the Internet:

• Fairmark: Conversion Rule Changes
• Bogleheads Wiki: Non-deductible Traditional IRA

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Software picked, likely related articles at The Finance Buff:

• TFB’s Stumbles: Week Ending March 28, 2008
• Alternatives to a High Cost 401k Or 403b Plan
• Solo 401k For Part-Time Self-Employment

If the plan has a match, you contribute enough to get the full match. That’s a no-brainer, because the match will more than compensate for the high costs and hidden fees. But then what? Any additional money you contribute to the plan won’t get any more match. Or perhaps the plan doesn’t have a match to begin with or your employer contributes to the plan regardless whether you contribute or not.

In these cases, should you still contribute to the high cost 401k or 403b plan even when there is no [additional] match? I made a spreadsheet to compare the alternatives.

1. Roth IRA. If you are eligible, contributing to a Roth IRA is a good alternative to a no-match 401k or 403b. Because a Roth IRA is under your own control, you can buy low cost funds in your Roth IRA. The lower your costs, the more investment returns you get to keep.

2. Non-Deductible IRA. If you are not eligible for contributing to a Roth IRA, you are still eligible to contribute to a non-deductible Traditional IRA. The contributions are not tax deductible but the investments grow tax deferred inside the IRA.

Under the current law, there is an opportunity to convert a non-deductible Traditional IRA to a Roth IRA in 2010 and thereafter. This 2010 Roth conversion issue is beyond the scope for this post. See Should I Contribute To A Non-Deductible IRA? Part 1, Part 2 on My Money Blog for more information. For the purpose of this post, I assume the non-deductible IRA is going to stay as-is and not converted to Roth.

3. Taxable Account. Another alternative to a high cost 401k or 403b plan is investing in a regular taxable account.

If you buy tax efficient stock funds, the majority of your returns will come as unrealized capital gains which are not taxed until you sell. When you do sell, under the current laws, the long-term capital gains are taxed at a more favorable rate than ordinary income.

4. Contribute to the plan and then rollover. The alternatives are not necessarily better than contributing additional money to the 401k or 403b plan even if the cost is high and there is no match. This is true especially if you are not going to work for this employer for very long.

When you leave your employer, you can rollover the balance in your 401k or 403b plan to your own IRA. Then you will be able to use low cost funds. You just have to hold your nose and pay the high cost until you are liberated from the plan. A key input is how many years you will have to pay the high cost.

Finally, here is the spreadsheet that compares these options:

alternatives to high cost 401k or 403b plan

You will need the estimated tax rates, investment return, extra cost in the plan, how many years you will be in the plan and how many years you have until withdrawal. It then calculates “advantage over 401k” for each alternative. If the result is positive, it means that’s a better option. If it’s negative, it means it’s still better to contribute to the high cost 401k or 403b plan and wait for the rollover.

In many cases you will find that Roth IRA is better than a high cost 401k or 403b but the other two options are not. For example, under this set of assumptions,

we get

In this example, a Roth IRA is 7.2% better than a high cost 401k or 403b plan; a non-deductible IRA is 16.9% worse; and a taxable account is 19.9% worse. That’s why you often hear about the rule of thumb: 401k for the match, then Roth IRA, then back to 401k.

If you are not eligible for Roth IRA, the spreadsheet also indirectly compares a non-deductible Traditional IRA with a taxable account. In our example if you max out the 401k and you still have money to invest for retirement, you should do the non-deductible IRA before you invest in a taxable account because a non-deductible IRA is not as bad as the taxable account.

Feel free to plug in numbers applicable to yourself and see how the alternatives play out for you.

Notes:

1) Front-end load is often waived for 401k and 403b plans. Please verify with plan administrator.

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Software picked, likely related articles at The Finance Buff:

• A Non-Deductible IRA Is Worth It For Me
• Overhyped: The Smartest 401k Book You’ll Ever Read
• Retirement Plans Galore: 401(a), 401(k), 403(b), 457, SEP, SIMPLE

I searched on the Internet for a calculator that implements the strategy outlined in my previous post 401(k), Roth IRA, then Back at 401(k). But to my surprise I couldn’t find any. There are calculators for 401(k), calculators for Roth IRA, but not one that combines them together. So I had to make one myself. If the inline frame doesn’t display well, you can download it. It’s simple HTML, with calculation done by JavaScript. Please let me know if you see any problems with it. Also let me know if you find a better one elsewhere.

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Software picked, likely related articles at The Finance Buff:

• 401(k), Roth IRA, then Back at 401(k)
• Commutative Law of Multiplication
• Carnival of Personal Finance #96

Resist the urge to buy the latest computer or other gadget as soon as it comes out. Wait three months and the price will be lower.

Three months! Gosh, stop buying those crap altogether! That’s why most people can’t contribute the maximum amount to their 401(k) and Roth IRA. I guess if Money said wait three years it would cause an outcry and slow down the economy by 1 percentage point, so it settled with waiting three months.

What I really want to comment on is Rule #6:

All else being equal, the best place to invest is a 401(k). Once you’ve earned the full company match, max out a Roth IRA. Still have money to invest? Put more in your 401(k) or a traditional IRA.

Except for the last part “or a traditional IRA” (I’ll get into that later), this is the sequence I recommend as well. If your employer offers a company match, that’s practically a part of your compensation package, you should contribute enough to earn the full match, no matter what. Otherwise it’s like you are not claiming a part of your salary. Match formula vary by employer. Most typical I’ve seen is 50% match up to 6% of your salary. So if you contribute 6%, the employer matches 3%. In that case, you should contribute at least 6%. Enough said.

Rule #12 also says

If you’re not saving 10% of your salary, you aren’t saving enough.

I’d make it 15%. After you earned the full match in your 401k, if you qualify*, you should open a Roth IRA at Vanguard and contribute $4,000 to it. Why not just use the 401(k)? Because you typically get a better deal in a Roth IRA at Vanguard than what you can get in your 401(k), unless you work for a very large company and they have knowledgeable people in charge of your 401(k). Put it into the Vanguard LifeStrategy Moderate Growth Fund, the TFB Award winner for the Best Mutual Fund for Investing More Than $3,000, and you are done.

If you are trying to save 15% of your salary, full match in your 401(k) plus $4,000 probably won’t make it. Now put the rest into your 401(k). Forget about the “or a traditional IRA” part in Rule #6. That’s not possible. Traditional IRA and Roth IRA share the same annual limit. If you contributed the maximum $4,000 to your Roth IRA, you can’t put anything into a traditional IRA.

I will make a calculator for this strategy if I can’t find one on the Internet.**

* See this post about Roth eligibility limits by JLP at AllFinancialMatters.

** UPDATE: I couldn’t find one so I created a calculator for this myself.

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Software picked, likely related articles at The Finance Buff:

• Calculator for 401(k), Roth IRA, then Back at 401(k)
• Commutative Law of Multiplication
• Roth 401(k) for People Who Contribute the Max