1

Recently an investment adviser was providing free consultations at my wife's workplace. He advised us to convert some 401K's from previous employers and traditional IRA's to Roth IRA's. He did this based on projections he did that show that with our retirement fund balances and a continuation of contributions at the current rate, we will have enough retirement income that we'll stay in our current tax bracket (25% on the last dollar). Also, our taxable adjusted gross income is well below the top of our current tax bracket, so the conversions would not bump us into a higher bracket if we spaced them out over several years. If we make these conversions at the rate he's advising, we would need to pay the taxes on the converted amount from the 401K principal that is being converted, as we don't have that much money in any other savings.

However, another financial adviser (from our credit union) advised against this, saying it wouldn't be worth the tax hit now and loss of principal. He also pointed out that tax laws could change before we retire. The guy who does our taxes says it's not such an easy thing to decide as the two advisers make it seem.

Our situation: We're in our early 50's and have a child in grade school. Currently my 401K contributions are at the maximum for my age (I'm utilizing the catch-up contribution) - it's a stretch for us financially, but 401K's and Social Security are the only retirement money I expect to have ... and I'm not so sure about SS. My wife has a job that will provide a modest pension and also has 10% going to 401K's. The first adviser is recommending retirement at 62 - that might work for my wife, since she'll have maxed out her pension and has health issues; also she might take on a second career. However, since we'll be paying for college right then, I don't think it's feasible for me (I earn about 60% of our gross income) to retire before 64; more likely, I'd "down shift" to a lower paying job for a few years at that point.

It has occurred to me that we could convert smaller amounts than the first adviser is suggesting. This would be small enough amounts that we could afford to pay the taxes from other monies and keep the entire principal that is being converted.

So, at this point, I'm looking for insight into how to decide if we should do this and how. Are there any calculations I could do that would help with this decision? Is there a movement to change the relevant laws?

  • 3
    Do not withdraw money from your 401k to pay the taxes on a Roth conversion! You will pay taxes and penalites on that money. I recommend avoiding an advisor that makes that suggestion; they're not doing you any favors. If you want a tax-free Roth distribution in the future, consider lowering your 401k contributions and contributing directly to a Roth right now. – Todd Feb 22 '16 at 18:08
3

If you're in the 25% tax bracket, then you probably shouldn't be doing a Roth conversion right now. You'd prefer to do Roth conversions when you can do so at a 15% rate. You could contribute some of your current annual contributions to Roth directly, but even that isn't a great idea except to diversify your holdings.

Odds are you won't be paying 25% average tax rate on your retirement, unless you're doing very well in your retirement account. Odds are you'll be somewhere around 15%. Converting at a 15% rate therefore is fine; basically, you'll have something like this, based on some assumptions (I'm making up dollars, brackets, etc.; obviously these will change):

Total: $90k annual retirement income
25% bracket starts at 75k
---
Withdraw from Pretax IRA up to 75k
Withdraw from Roth IRA 76-90k

Doing this, you pay 0-15% tax on up to 75k, then pay 0 tax after that on the Roth (which you paid 15% tax on already). Therefore, you don't end up paying more than 15% on any single dollar, and you pay less on the total sum. But you also don't really want to be paying 25% on any of it, since that won't really help you out any and could hurt you (will hurt you, if you end up getting some of that 15% bracket income from the Roth).

If you're in the 25% bracket now, then you probably are better off just keeping everything in regular IRA (unless you're expecting to be in the 28% bracket after retirement?). Putting some in Roth isn't a terrible idea, just for diversification's sake, but it's probably going to cost you money unless tax rates rise dramatically (which they certainly could, though not as likely to rise on the 'middle class' 0-100k range). They'd have to double for you to be worse off this way.

And finally: do not ever withdraw from the 401k to pay taxes on a conversion. You're subject to a 10% penalty for doing that (as it's an early withdrawal) and also have to pay taxes on that withdrawal. Ick.

For more information about when Roth makes sense, read site moderator JoeTaxpayer's Blog article on the subject, which explains this in great detail.

  • 1
    The endorsement is much appreciated. Great answer here. If I'd add any though, it would be to embolden "do not ever withdraw from the 401k to pay taxes on a conversion." That line is so important. It would take an otherwise logical conversion while at 15% marginal rate, and effectively tax it at 25%. – JoeTaxpayer Feb 23 '16 at 0:42
  • Agreed and emboldened! – Joe Feb 23 '16 at 15:17
  • 1
    @GreenMatt: What "new rules"? – user102008 Feb 25 '16 at 1:20
  • 1
    I'm not a CPA, but I've not heard of new rules in this regard eliminating that penalty (and I'm not sure why there would ever be, that doesn't make policy sense). None of the major sites mention this; Fidelity for example. Unless you're over 59 1/2, anyway. – Joe Feb 25 '16 at 15:04
  • 1
    The reason sounds entirely specious. They may be referring to backdoor Roth conversions or something similar; that's not what you're talking about here, though. – Joe Feb 25 '16 at 20:48
2

GreenMatt - this is a good question, and a question I have asked about whether to invest in a Roth IRA, or a traditional IRA. This is my take on the picture, I'm not sure about your tax situation and how much you'd have to pay for each conversion you did, whether you have extra money to pay those taxes, etc. In my opinion I don't think it would be a good idea to use your 401(k) principal to pay taxes, but to have the extra money to pay these when rolling over so you don't lose any interest, especially since you're near the "end" of your "snowball" effect with interest in your retirement account.

Here is a resource to consider.

Also, another thing to consider that I don't really see much of on here is inflation. If you're going to be in the same tax bracket as you are now, and if whatever you're contributing to your 401(k) or traditional IRA is NOT bumping you down in the 15% bracket, then I would suggest doing a ROTH IRA. I say this because to me, when I retire, I would have rather paid my taxes throughout the years (I'm 23 and in 25% marginal tax bracket) in a ROTH IRA and pay nothing when I'm withdrawing in 30 years, factors people forget to consider are that the Cost of Living is going to be MUCH MUCH higher for me down the road, and the cost of sending a child to school is going to be much higher as well.

Since your child is young, consider this site for the cost of a college education for your child. This is comparing the average cost of education for someone attending college in 2015 versus 2033 (a child born IN 2015). While this seems drastic, and there could be a lot of different things that happen by that time, it's a decent illustration. While the website provided certainly isn't validated by the DoE, I have read multiple articles about this, and they are all very similar. Again, other things could happen between now and your child's college career, but if college becomes "free" we're paying for it, and if it's not free and raises at historical rates you're paying for it.

I also don't really want to comment on what is going to happen with taxes over the years, I'm not sure where you live (I'm in the U.S.), but IMO I believe they either A) won't change or B) will raise slightly. As far as SS goes, I think it's fair and definitely more than reasonable to not expect SS in retirement. I'm definitely not counting on it.

You must log in to answer this question.

Not the answer you're looking for? Browse other questions tagged .