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Be Careful When Converting

Conversion of St Paul

Conversion of St Paul (Photo credit: Lawrence OP)

When converting from a 401(k), traditional IRA, 403(b), SIMPLE IRA, SEP or 457(b) to a Roth IRA there are some important tax considerations to keep in mind.

First, converting from a tax deferred plan to a tax free plan it’s not always the best idea. Generally, it’s going to make sense to convert if the tax payer believes that he or she will be in a higher income tax bracket in retirement. For example, John, age 28 has a 401(k) and recently left his employer. He’s currently in the 15% bracket but expects to be in the 28% bracket or higher in retirement. It may make sense for John to convert his 401(k) to his Roth IRA.

This makes sense for John because when he converts from a pre-tax, employer sponsored plan like the 401(k) it’s money that has not yet been taxed. If he converts while in the 15% bracket, that money is now subject to tax at the 15% rate, and arguably a lower amount of money being taxed since he’s still young. If he decided to wait until retirement to convert (let’s assume he’s in the 28% bracket) then that money is going to be taxed at 28%, or almost twice the rate if he had converted when he was in the 15% bracket. John has also eliminated future RMDs as Roth IRAs have no such requirement.

Generally, it may make sense to not convert if you expect to be in a lower tax bracket at retirement. The reason is you’d convert at a higher tax bracket today, only to be in a lower bracket in retirement. Thus, you’ve paid a higher than necessary amount of tax on your money.

Second, when converting, pay close attention to you your age and how you choose to “pay” the tax. Let’s look at two examples.

Let’s say John in the example above decides to convert when he leaves his employer at age 28. He’s saved a nice sum of $100,000 in his 401(k). He decides to convert to a Roth IRA at the 15% bracket. He elects to pay the tax himself from outside of the 401(k), that is, he elects to not have any tax withheld from the conversion. He decides he’ll pay the tax from another source when tax time comes around. All is being equal, John owes $15,000 at tax time.

This turns out to be a very wise decision for John. Here’s why.

Let’s assume the same scenario above except that John decides to have the $15,000 withheld from his 401(k) to pay the taxes on the conversion. Remember how old John was? 28. He’s under age 59 1/2 and the $15,000 withheld for taxes is considered an early distribution, and, you guessed it, subject to the 10% early withdrawal penalty. So instead of paying $15,000 in taxes, John pays an additional $1,500 due to the 10% penalty or a total of $16,500.

It pays (either you or the IRS) to consider the tax ramifications of converting to a Roth IRA. Talk to an experienced financial planner and or tax advisor for help.

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  1. Zvi Kedem says:

    Also, if you plan to move to another state after retirement, the “old” state may tax retirement benefits and the “new” one does not. For example, NY and PA. Then it is likely not advantageous to convert to Roth before the retirement.

  2. Jonathan Newman says:

    Hi Sterling:

    Good advice. I have been thinking about this recently. I am considering early retirement at 55.

    At that time my earned income would drop rom the 28% bracket to ZERO. At the time I have no earned income- I am planning to take advantage by converting my 401k to a roth by “filling up” the lower tax brackets (10% and 15% anyway). I will do this for as many years as possible to convert all my deferred money at low rates and avoid the dreaded RMD requirement. I think it will also help me avoid taxes on my eventual social security checks…

    If I can use capital gains to secure “living money” during those years prior to 59 1/2 I can take advantage of 0% capital gins up to something like $72K as well.

    Anything about that sound out of whack to you?

    I would hire a pro (like you) at the time to make sure that I pulled it off without a hitch.

    1. sraskie says:

      Sounds plausible. Give us a call when you’re ready and we can make sure things make sense. Thanks for reading and commenting!

      1. Alberto Ortiz says:

        If we don’t convert as suggested, do we open the door to pay higher taxes at 70 1/2 due RMD.

        Would it make sense to convert in a ladder from 59 1/2 tof 70 1/2 to avoid a higher taxes later?

        1. jblankenship says:

          Possibly (on both of your questions). If you have to take higher RMD, that will increase your income and therefore increase your taxes.

          Converting smaller amounts prior to age 70 1/2 would spread out the additional tax over many years, possibly at lower rates.

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