Should I consolidate my IRAs or move them to my 401(k)?

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Q. I have several retirement accounts and I have a Vanguard Roth IRA. I have three other traditional IRAs at different companies. And I have a Vanguard 401(k) at my new job. Should I put them all in one IRA or into my 401(k)? Should I also get a backdoor IRA to help with my taxes?
— Investor

A. Let’s start with whether you should consolidate your three traditional IRAs.

The way you have your accounts set up now, you’re subjecting yourself to three separate annual custodian fees — typically $35 to $50 annually — unnecessarily, said Matthew DeFelice, a certified financial planner with U.S. Financial Services in Fairfield.

He said at the very least you should combine these three accounts into one IRA, but from there, your decision gets more complicated.

You certainly have an option of rolling the traditional IRA money into your Vanguard 401(k) plan at your new job, but there are pros and cons, DeFelice said.

“Keeping the funds in an IRA allows you to invest in anything you want instead of being limited to the investment options available in your plan,” he said. “While it is likely that fees are higher in a managed IRA account than your employer’s retirement plan, the benefits of oversight, appropriate attention to risk management, and updating asset allocation as personal circumstances change throughout your life can outweigh cost differentials in the long run.”

Besides the obvious reason of making life simpler by having it all in one place or potentially having lower expenses, there are some situations where rolling the funds into your 401(k) might make sense, he said.

401(k)s can be more flexible than IRAs if you are between the ages of 55 and 59 ½, DeFelice said.

“With an IRA, you must wait until age 59 1/2 to take distributions without being subject to an early withdrawal penalty taxes — assuming the normal exemptions don’t apply),” he said. “With a 401(k), if you hit age 55 or older and retire, you can start taking withdrawals without penalty.”

Then, IRAs do not allow loans, but some 401(k) plans do.

If your 401(k) plan allows loans, you could potentially roll your IRA into the 401(k), increasing the amount of money available to you via 401(k) loan, he said. Check with your plan administrator to learn about your plan rules before you submit a rollover.

“It should be noted that just because it is possible to borrow from your 401(k) doesn’t mean it’s a good idea, he said. “Raiding your retirement funds for short term cash needs can hurt you in the long run.”

On the backdoor IRA, DeFelice said they’re not for everyone. And if you make the move, how much money you have in IRAs in general — instead of your 401(k) — would make a difference.

For 2020, if your modified adjusted gross income (MAGI) is higher than $139,000 if you’re single or $206,000 if you’re married filing jointly or a qualifying widow or widower, you cannot contribute to a Roth IRA, he said. But these income limits don’t apply to backdoor Roth IRA contributions, which can be used by high income earners to get money into a Roth.

“You would make a non-deductible after-tax traditional IRA contribution and then simultaneously convert that money into a Roth IRA,” he said. “However, the IRS requires you to follow the pro-rata Rule, which basically considers all your traditional IRA money as one account.”

He offered this example.

Let’s say you make a $6,000 non-deductible after-tax IRA contribution with the intent to convert it to a backdoor Roth IRA and avoid the tax on the conversion. Let’s say the total balance in your three IRA accounts is $60,000. As a result, the pro-rata Rule requires you to include these funds as part of the calculation for taxes owed on the conversion.

You must add up all your non-Roth IRA funds ($60,000) and add up all of your non-deductible IRAs ($6,000) to determine the percentage of after-tax dollars involved. In this scenario ($6,000/$60,000 = 10%).

“This is the percent that would be tax free on the conversion,” he said. “Meaning the other 90% would be taxable. Your attempt to convert $6,000 of a non-deductible IRA just resulted in 90% of that transaction being taxable.”

So by moving the three IRAs into your 401(k), you effectively neutralize the pro-rata rule, DeFelice said.

“Assuming you have no other IRAs — traditional, SEP or SIMPLE — shifting that pre-tax IRA money to your 401(k) leaves you with only new post-tax money contributions to your IRA, which simplifies things substantially for a backdoor Roth,” he said. “It’s important to realize that this would only need to be done if you earn more than the income limits for Roth IRAs – otherwise you can simply make a direct Roth contribution of the $6,000 and save yourself the hassle.”

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This story was originally published on July 29, 2020.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.