Frontloading Roth-converted SEP IRA contributions

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Dioremius
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Frontloading Roth-converted SEP IRA contributions

Post by Dioremius »

Suppose you wish to maximize Roth contributions/conversions in a given tax year, and in particular accelerate Roth contributions/conversions planned for future years into the current tax year.

Why? Perhaps you expect to be in a higher tax bracket in future years; or are eager to get another year of tax-free growth; or some other hypothetical scenarios.

There are all the usual things to maximize Roth:
* Maximize Roth IRA contributions, or backdoor Roth IRA contributions+conversions
* Maximize employer 401(k) Roth contributions and mega backdoor Roth contributions+conversions
* Roth-convert your existing traditional IRA balances and, if allowed, 401(k) employer plans

Suppose, moreover, that you're a sole proprietor with a SEP IRA plan. Then you would also:
* Maximize your SEP contribution (limit: 20% of net profits, maximum $58,000), and convert it into a Roth IRA before the end of the tax year

But if I'm reading things right (warning: I'm not an expert and haven't tried any of this): you don't have to stop there. You can intentionally overcontribute to your SEP IRA, Roth-convert immediately, and pay the 10% excise tax.

In general, this can get complicated and expensive. The excise tax on overcontribution ("nondeductible contributions to qualified plans", Section 4972) is 10% on the excess amount, reported on Form 5330 and due by July 31st of the next year. Then, "If you contribute more to a plan than you can deduct for the year, you can carry over and deduct the difference in later years, combined with your contributions for those years" (see Pub 560 for examples). Put differently, the excess amount eats into your SEP contribution limit for the subsequent tax year. So if your original excess amount was too large and/or you contributed too much to the SEP into the next year, then you may again have excess contributions in that next year, and pay the 10% excise tax again on the newly-calculated excess, and so forth, until the excess is fully absorbed into the annual limits.

But consider the simple case. Suppose your SEP deductible limit is constant because you're hitting the $58,000 annual cap. Now, suppose you make a SEP contribution of 200% your SEP deductible limit, Roth-convert it immediately, and avoid making any SEP contribution in the following year. You end up with the full contribution of 200% * $58,000 in the Roth IRA, and no deferred compensation, just as if you contributed and converted the maximum deductible amount separately in each year... but earlier. You'll pay an excise tax 10% tax on the frontloaded $58,000 (just once, because the excess amount will be fully absorbed on the second year).

Similarly, if you contribute and immediately Roth-convert 300% your SEP annual deductible limit (assumed constant), and don't make further SEP contributions in the next 2 years, then you've effectively frontloaded those 2 years, at a cost of a total excise tax of 15% of the total frontloaded amount (10% in the next year, and then 5% in the year after because half the excess was already absorbed).

This excise tax is a lot to pay just to accelerate the Roth contribution... but consider this against the tax savings of tax-free growth in the Roth account.

Note this risk: if your business's net income drops in those future years (and with it, the 20%-of-net-income limit), you may be unable to fully absorb the carried-over excess as planned, and thus end up paying an annual 10% excise tax for additional years.

Is this correct and legit?

Also, if it really is the $58,000 cap you hit (lucky you, your sole proprietorship must have x5 that net profit!), then another approach would be to offload some of the business work to your spouse (as W-2 salary, or 1099 contractor), or bring them in as a partner (perhaps as Joint Qualified Venture). That would utilize the spouse's SEP IRA limit. But consider the effect on employment tax (especially if you're already past the Social Security $142,800 taxable income limit but your spouse isn't).
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