401k vs Maxing Roth via Mega backdoor

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martiboy
Posts: 7
Joined: Fri Aug 03, 2018 9:03 pm

401k vs Maxing Roth via Mega backdoor

Post by martiboy »

Hi
I'm 34M and am working in the US on an H-1B visa. My employer matches upto $5k worth of 401k Contributions. Since I am from a backlogged country, I cannot expect to live in the US long term. There are a few other threads (viewtopic.php?t=316008) that suggest not letting the 401k get too big especially since estate taxes are an issue for non-immigrants.

I see two options:

1. Contribute $5k to get the match from employer and put the rest $66k - $10k in after-tax and convert to Roth (MBR). I can withdraw the amount after 5 year period if I decide to leave the country.
2. Contribute the full $22.5k + $5k employer match. Bite the 10% penalty when I decide to leave the US. It would be a call at that time to decide how much to withdraw and how much to leave until 59.5

My effective tax rate is likely 18%+ for just Federal taxes and bound to increase with time. To me option 2 make sense if I could time the withdrawal after leaving the US in the first few years if I am in a low tax bracket (or tax rate + 10% penalty < 18%). Option 1 isn't bad, its better than not contributing beyond match as the earnings would be tax-free.
What would you suggest?
TedSwippet
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Re: 401k vs Maxing Roth via Mega backdoor

Post by TedSwippet »

martiboy wrote: Mon Mar 20, 2023 6:51 pm My effective tax rate is likely 18%+ for just Federal taxes and bound to increase with time. To me option 2 make sense if I could time the withdrawal after leaving the US in the first few years if I am in a low tax bracket (or tax rate + 10% penalty < 18%).
Are you sure you are making the right comparison here? Money paid into a 401k is pre-tax and so effectively saves tax at your marginal tax rate, not your effective tax rate.

Beyond this, check how 401k withdrawals are treated by your local country tax (India?). The treaty, if any (this one?), may give some clues. In particular, some treaties reserve tax rights on pension to residence country only, and this provides an arguable case that a treaty such as this protects against not just US tax but also the 10% US early withdrawal penalty. This can sway the decision about when to cash in the 401k, assuming you're not going to retain it until age 59.5 when early withdrawal penalties fall away.

Finally, taking your numbers at face value, if your withdrawals are US taxable (that is, no treaty get-out) once an NRA living outside the US, then the lowest ECI tax bracket for NRAs is currently 10%, and it's payable on the very first dollar of US source income -- no personal exemption or standard deduction allowed. Worse, the FDAP tax is a flat 30%, and this can apply to the earnings proportion of a 401k/IRA withdrawal. That seems to give an absolute minimum early withdrawal US tax rate of 20%. That needs to be below your current marginal rate.
martiboy wrote: Mon Mar 20, 2023 6:51 pm Option 1 isn't bad, its better than not contributing beyond match as the earnings would be tax-free.
Roth earnings are only tax-free after age 59.5 (and five years after opening the Roth). Otherwise, they're taxable, and if under age 59.5 also subject to the 10% early withdrawal penalty, though again a treaty might override this standard US tax treatment.
Topic Author
martiboy
Posts: 7
Joined: Fri Aug 03, 2018 9:03 pm

Re: 401k vs Maxing Roth via Mega backdoor

Post by martiboy »

TedSwippet wrote: Tue Mar 21, 2023 4:03 am Are you sure you are making the right comparison here? Money paid into a 401k is pre-tax and so effectively saves tax at your marginal tax rate, not your effective tax rate.
That seems to give an absolute minimum early withdrawal US tax rate of 20%. That needs to be below your current marginal rate.
You are correct about me being wrong about the tax rate. On the treaty, its difficult to interpret and I haven't seen anything concrete online on the treatment of 401k for people moving to India, and it might be safer to assume it doesn't exist. Given my tax bracket is in the 24% to 32%, I think traditional 401k is the winner if I'm able to do early withdrawal at 20%. Please point out if you think otherwise.
Remaining things I'd need to worry about is:
1. Making sure this isn't double taxed by the Indian government, I believe the tax treaty helps here.
2. There would likely be some hassle with withholding at 30% in the US and getting an IRS check refund to India. I can only hope that improves with time. Is there a better way to deal with this? Maybe some broker that would let you set the withholding rate in my favor.
Lazerr
Posts: 41
Joined: Fri Aug 12, 2022 2:41 pm

Re: 401k vs Maxing Roth via Mega backdoor

Post by Lazerr »

Tax treaty tables make me think the US should not tax pension distributions, except for maybe the 10% early withdrawal penalty. In that case, putting US pre tax money into retirement accounts rather than post tax seems like the way to go.

I have my company 401k at Schwab and they seemed to be aware that there is a Form W-8BEN and tax treaties for US nonresidents. I am still with the company, so I cannot test if they actually honor the treaty rate, but based on my communication with them, I would expect they do.
TedSwippet
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Joined: Mon Jun 04, 2007 4:19 pm
Location: UK

Re: 401k vs Maxing Roth via Mega backdoor

Post by TedSwippet »

martiboy wrote: Tue Mar 21, 2023 2:05 pm You are correct about me being wrong about the tax rate. On the treaty, its difficult to interpret and I haven't seen anything concrete online on the treatment of 401k for people moving to India, and it might be safer to assume it doesn't exist.
Except that it does exist. While you can pretend that it does not, the assorted tax authorities (IRS, Indian) will nevertheless expect you to use it.

For example, Article 20 paragraph 1 restricts tax on US pensions withdrawals by US nonresident aliens living in India to only India. If you 'voluntarily', or accidentally, nevertheless pay US tax on these withdrawals, India is under no obligation to let you off or allow you a tax credit for the US tax you paid. The treaty says India has to allow you a tax credit for US tax, but only US tax that you cannot avoid paying -- Article 25, paragraph 2(a). Potential double-tax, then.

That is, you don't get to choose which country gets the tax on your pension withdrawals. The treaty does the choosing for you, and you need to follow it. I do agree though that treaties are hard to follow. There are multiple grey areas, and often even professionals disagree. As a case in point, the US/India treaty says that only India may tax your US pension, but it does not say anything about when or how. Best case, India will tax only withdrawals when made, but the treaty doesn't seem to stop India taxing gains inside a US pension annually if it wanted to. So now you have to fully understand the general Indian tax laws on non-Indian pensions as well as the treaty.
martiboy wrote: Tue Mar 21, 2023 2:05 pm Given my tax bracket is in the 24% to 32%, I think traditional 401k is the winner if I'm able to do early withdrawal at 20%. Please point out if you think otherwise.
Maybe. A moderate case at 24%, but a fairly strong one at 32%. Even stronger if you need to factor in any additional state tax on top of these numbers.
martiboy wrote: Tue Mar 21, 2023 2:05 pm Remaining things I'd need to worry about is:
1. Making sure this isn't double taxed by the Indian government, I believe the tax treaty helps here.
But you stated earlier that you will assume the treaty doesn't exist!
martiboy wrote: Tue Mar 21, 2023 2:05 pm 2. There would likely be some hassle with withholding at 30% in the US and getting an IRS check refund to India. I can only hope that improves with time. Is there a better way to deal with this? Maybe some broker that would let you set the withholding rate in my favor.
When it comes to payments made to folk outside the US, US brokers are pretty much stuck with the withholding rates specified by the IRS. You will almost certainly not find one who will let you set a different rate.

As for receiving a refund ... often a hassle, but one possible avenue is a Wise (or Revolut, or similar) multi-currency account. These give you a standard-looking US bank facet -- ACH and so on -- and so can usually function as any normal US bank account. Having a refund deposited that way avoids difficulties with paper checks.
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Hyperborea
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Re: 401k vs Maxing Roth via Mega backdoor

Post by Hyperborea »

TedSwippet wrote: Tue Mar 21, 2023 4:03 am and this provides an arguable case that a treaty such as this protects against not just US tax but also the 10% US early withdrawal penalty.
This seems correct from the standpoint of the US tax treaties but do you know of any institution that will not take the 10% early withdrawal penalty? Any case law? Private letter rulings?

Thanks
It’s not just that facts don’t seem to matter anymore. It’s that it doesn’t seem to matter that facts don’t matter.
TedSwippet
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Re: 401k vs Maxing Roth via Mega backdoor

Post by TedSwippet »

Hyperborea wrote: Wed Mar 22, 2023 3:09 am
TedSwippet wrote: Tue Mar 21, 2023 4:03 am and this provides an arguable case that a treaty such as this protects against not just US tax but also the 10% US early withdrawal penalty.
This seems correct from the standpoint of the US tax treaties but do you know of any institution that will not take the 10% early withdrawal penalty? Any case law? Private letter rulings?
No (to all three of your questions!). Basis is nothing more than the opinions of a few firms that have been posted in the past.
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