Youll Owe Taxes On The Money Now But Enjoy Tax
Thomas J Catalano is a CFP and Registered Investment Adviser with the state of South Carolina, where he launched his own financial advisory firm in 2018. Thomas’ experience gives him expertise in a variety of areas including investments, retirement, insurance, and financial planning.
If you’ve been diligently saving for retirement through your employer’s 401 plan, you may be able to convert those savings into a Roth 401 and gain some added tax advantages.
Converting Roth 401 To Roth Ira
Rolling over your Roth 401 into a Roth IRA can be beneficial because of greater investment flexibility with an IRA. Typically, individual IRA accounts have wider investment options than Roth 401. Sometimes your options in a 401 are limited to mutual funds or a few different index funds.
The 5-Year Rule
One thing to keep in mind is the 5-year rule. If you roll a Roth 401 to a Roth IRA, its the time clock on the Roth IRA that counts. For example, imagine youve had a Roth 401 for 10 years and a Roth IRA for five years. If you roll your Roth 401 to that Roth IRA the clock is reset to the time youve had the Roth IRA. In this case, its five years, so youre good. If that Roth IRA was only active for three years, then youd need to wait two more years before you could withdraw earnings tax-free.
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How You Would Pay For The Conversion
A Roth IRA conversion has a cost, which is the income taxes on the amount you convert. It generally makes sense to use taxable assets rather than proceeds from a converted account to pay the tax cost of a Roth IRA conversion. This is because, all things being equal, the rate of return is generally higher for a Roth IRA because no taxes are due for any gains in a Roth IRAand taxes reduce the returns you achieve. Consequently, it usually makes sense to pay for a conversion with the assets that will earn a lower after-tax return . This is particularly true for those under age 59½, because, for them, paying for a conversion using proceeds from a qualified account could also result in a 10% tax penalty and further reduce the potential benefit of converting.
Consider this hypothetical example: Elaine is 62 and has $100,000 in a traditional IRA and $25,000 in a brokerage account. Her current marginal tax rate is 25% and she expects it to remain there. What would she have after 5 years if she converts her traditional IRA to a Roth IRA and uses proceeds to pay the taxes? How would that compare with using money from her brokerage account to pay for the conversion?
Pay conversion taxes from a taxable account, so more of your money is tax-free
Read Viewpoints on Fidelity.com: Answers to Roth conversion questions
Any evaluation of a potential conversion should include input from a financial advisor, along with a tax and/or estate planning attorney.
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A Conversion May Affect Government Programs
If you participated in government healthcare programs or others that depend on your income, its vital to note that a conversion could affect your eligibility in those programs or their cost.
The Roth conversion is viewed as taxable income in the year it occurs, says Keihn. This means that it could affect your eligibility for Obamacare or financial aid or your childrens financial aid. If you are on Obamacare or completing a FAFSA application, it is important to factor that into the decision of how much to convert, if any.
People who are two years from receiving or are receiving Medicare benefits need to know that their Medicare premium most likely will go up two years after they convert to a Roth IRA, says Gilbert. Medicare has a two-year look-back to determine premiums and in the year you convert, your income will be higher than other years. But this is a one-year spike that will then decrease the following year.
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A Roth Ira Can Be A Great Way To Save For Retirement Since The Accounts Have No Required Minimum Distributions And You Withdraw The Money Tax
Tax-free income is a dream of every taxpayer. And if you save in a Roth account, it’s a reality. Roths are the youngsters of the retirement savings world. The Roth IRA, named after the late Delaware Sen. William Roth, became a savings option in 1998, followed by the Roth 401 in 2006. Creating a tax-free stream of income is a powerful retirement tool. These accounts offer big benefits, but the rules for Roths can be complex.
Here are 11 things you must know about utilizing a Roth IRA as part of your retirement planning.
Should You Convert To A Roth 401
If your company allows conversions to a Roth 401, you’ll want to consider two factors before making a decision:
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The Difference Between A Roth Ira And Tax Sheltered Accounts
Roth IRAs are already taxed investment accounts. This means the money you put into the account has already had taxes taken out, so when you withdraw from the roth in the future you do not need to pay tax.
In contrast, 401k and traditional IRA account contributions are not taxed by federal income tax . You will pay taxes when money is withdrawn in the future. In the meantime, you receive a tax break for contributions you make each year.
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Our reporters and editors focus on the points consumers care about most how to save for retirement, understanding the types of accounts, how to choose investments and more so you can feel confident when planning for your future.
Consider Converting Over A Period Of Years
Experts such as Victor advise careful planning to minimize the tax hit that comes with a conversion. Individuals could space the conversion out over many years rather than convert the full amount in one year. By doing so, they may be able to avoid jumping up to a higher tax bracket and paying more on each incremental dollar of converted money.
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How To Not Lose Money On A Roth Ira Conversion
If you want to do a Roth IRA conversion without losing money to income taxes, you should first try to do it by rolling your existing IRA accounts into your employer 401 plan, then converting non-deductible IRA contributions going forward.
The bonus annuity route should only be considered if the 401 option isnt available to you. In either case, be sure to first consult your tax advisor, since the penalties for making a mistake on a Roth IRA conversion can be steep.
Readers: What conversion methods have you tried when attempting to avoid losing money on a Roth IRA conversion?
So You Want to Learn About Investing?
The 38% Medicare Surtax
The amount you convert from a traditional IRA to a Roth IRA is treated as incomejust like all taxable distributions from pretax qualified accounts. Therefore the conversion amount is part of your MAGI, and it may move you above the surtax thresholds. This may cause you to incur the additional Medicare surtax on your investment income.
For more information on this, read Viewpoints on Fidelity.com: 6 key Medicare questions
But, once your money is in a Roth IRA, the shoe is on the other foot. Because nontaxable withdrawals from a Roth IRA aren’t part of your MAGI, a Roth IRA conversion may potentially enable you to limit your exposure to the Medicare surtax down the road.
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How Do You Convert To A Roth Ira
The actual process for converting a 401 or traditional IRA to a Roth IRA is simple. In fact, its so straightforward that you can create problems before youre aware that youve done so.
Here are the three basic steps to convert your retirement account to a Roth IRA:
If you manage your own funds, you should be able to find steps to do a Roth conversion on your investment platforms site, says Kerry Keihn, financial advisor at Earth Equity Advisors in the Asheville area, noting that each institution has a slightly different process or forms.
Within a couple weeks and often sooner the conversion to the Roth IRA will be made.
When it comes time to file taxes for the year you made the conversion, youll need to submit Form 8606 to notify the IRS that youve converted an account to a Roth IRA.
How To Reduce The Tax Hit
If you contributed more than the maximum deductible amount to your 401, you have some post-tax money in there. You may be able to avoid some immediate taxes by allocating the after-tax funds in your retirement plan to a Roth IRA and the pretax funds to a traditional IRA.
Alternatively, you can choose to split up your retirement money into two accounts: a traditional IRA and a Roth IRA. That will reduce the immediate tax impact.
This is going to take some number crunching. You should see a competent tax professional to determine exactly how the alternatives will affect your tax bill for the year.
The Build Back Better billpassed by the U.S. House of Representatives and currently being considered by the U.S. Senateincludes provisions that would eliminate or reduce the use of Roth conversions for wealthy taxpayers in a few ways.
If passed in its current form, starting in January 2022, employees with 401 plans that allow after-tax contributions up to $58,000 would no longer be able to convert those to Roth IRA accounts. Further limitations would go into effect in 2029 and 2032, including preventing contributions to IRAs for high-income taxpayers with aggregate retirement account balances over $10 million and banning Roth conversions from pretax retirement accounts for high-income taxpayers.
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Benefits Of Converting A 401 To A Roth Ira
- Youll lock in a zero future tax liability. By voluntarily converting your 401 to a Roth IRA now, youll pay taxes now, but youll also give your money an opportunity to grow completely unrestrained by taxes for the rest of your life.
- IRAs tend to be more flexible. Since an IRA is an independent retirement account, you dont necessarily have to be in any sort of formal employment relationship to open one Money in an IRA is free of the common restraints that typically come with the standard 401 plan youll find at your employer.
- Youll be free to invest in what you want. Most 401 plans have set investment menus that youll need to choose from with IRAs, youll have significantly more choice in terms of how you can invest your money.
There are also some major costs involved with converting your 401 to a Roth IRA.
Roth 401s As An Alternative
A Roth 401 combines the employer-sponsored nature of the traditional 401 with the tax structure of the Roth IRA. If your employer offers this type of plan, youll contribute after-tax money to your account and you wont owe taxes when you start receiving distributions. If your employer offers a match, though, that money is in a traditional 401 plan. So if you choose to convert it, you will owe taxes on it the year you do so.
If youre looking to do a rollover from a Roth 401 to a Roth IRA , the process is quite simple. All youll have to do is follow the same steps as if you were rolling over a traditional 401 to a traditional IRA. The tax structure is staying the same. If youre looking to convert your Roth 401 into a traditional IRA, youre out of luck. Unfortunately, this isnt possible, since you cant un-pay taxes on the money in your Roth 401.
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What To Know About Roth Iras And Roth Conversions
A Roth individual retirement account offers advantages a traditional IRA does notlike the potential for your savings to grow tax-free and not having to take required minimum distributions.
Well help you understand the benefits Roth IRAs offer, your options for including a Roth IRA in your retirement savings strategy and what to consider when evaluating your needs.
You Want To Leave Heirs Tax
A Roth conversion could also make sense if you want to leave your heirs tax-free income. This way could be particularly beneficial if you intend the money to go to someone other than a spouse, where the IRA inheritance rules are special and more advantageous.
Under the SECURE Act if you leave your traditional IRA to someone you are not married to, they have to withdraw all the funds from that account in 10 years, says Keihn. Depending on the size of the account, this can have significant tax consequences.
But the Roth IRA gets your heirs out of the tax consequences, says Keihn. While the 10-year rule would still apply in this case if your non-spouse beneficiary inherited your Roth IRA, your beneficiary would not have to pay income taxes on the withdrawals, she says.
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