A Roth conversion may be a mistake

Photo: 401kcalculator.org 

Q. I’m 55 and I have $587,000 in my 401(k) and just $20,000 in a Roth. Can I convert the 401(k) to a Roth? I want to have as much tax-free money as I can when I retire.
— Considering

A. It’s a very important question.

But we have to start by saying you should not only rely on us, but you should meet with a financial advisor who knows your entire financial situation.

That said, we’ve got some items for you to consider.

Let’s start with the benefits of a Roth IRA.

Although contributions into Roth IRAs are not deductible, Roth IRAs are very appealing because neither earnings nor distributions are taxed, said Andrew Novick, a certified financial planner and estate planning attorney with The Investment Connection and Brookner Law Offices in Bridgewater.

He said for many, it is not that easy to get money into a Roth IRA. For starters, the annual contribution limit is only $5,500 per year, plus an extra $1,000 catch-up contributions for those age 50 or older.

And you can only contribute if you or your spouse has earned income. Then, you can only contribute the maximum amount if your income is below a certain threshold: $117,000 for single taxpayers and $184,000 for joint taxpayers, Novick said.

“Even if you maximized contributions every year since Roth IRAs were first introduced by the Taxpayer Relief Act of 1997, you’d probably only have accumulated about $140,000 today,” he said.

That calculation assumes contributions increased in accordance with the maximum allowed contribution each year, including the maximum catch-up contribution each year, and that the contributions were made at the beginning of the year and earned a reasonable 6 percent return. While a decent sum, it is not enough to live off the income in retirement – even if the income is tax-free, Novick said.

For those looking to build up the size of their Roth IRA faster, you are allowed to convert a traditional IRA into a Roth IRA. Initially, only those with income under $100,000 were eligible to convert, but this restriction was eliminated in 2010 allowing anyone to convert, Novick said. The converted amount will be taxable in the year of conversion, so it is important to gauge the likelihood that your future tax savings will make up for the immediate tax payment before taking action.

Since 2006, Novick said, U.S. employers have been allowed to offer a Roth 401(k), but many still only offer a traditional 401(k).

“A Roth 401(k) works similarly to a Roth IRA in that salary deferrals into a 401(k) are made on an after-tax basis with earnings and distributions being tax-free,” he said.

Employees can defer up to $18,000 of salary per year (plus an extra $6,000 catch-up if age 50 or over) into a 401(k), so this is another way taxpayers can grow tax-free Roth money faster, Novick said.

He said even high income employees can use the Roth 401(k), and starting in 2013, employers could also allow participants in a traditional 401(k) to convert all or part of their account balance to a Roth 401(k) — assuming the employer offers a Roth.

Novick said generally, putting money into a Roth IRA or Roth 401(k) is more advantageous for younger taxpayers because they are probably in a low tax bracket today and expect to be in a higher bracket upon reaching retirement age. Conversely, using a traditional IRA or traditional 401(k) is better for older pre-retirees who are currently in a higher tax bracket but expect to be taxed at a lower rate in retirement.

With that background, you must first determine if you can convert, and then you need to analyze whether you should convert your 401(k) to a Roth IRA.

Novick said if you are no longer working for the employer that sponsors your 401(k), you can convert some or all of your 401(k) into a Roth IRA.

“Pursuant to a 2008 rule change, it is possible to roll your 401(k) directly into a Roth IRA,” he said. “Note that some plan administrators may still require you to complete the old two-step process – first roll over the 401(k) into a traditional IRA and then convert the traditional IRA to a Roth IRA.”

Novick said you can accomplish the conversion either way.

If you are still working for your employer, you may be able to convert some or all of your 401(k) into a Roth 401(k), but only if the employer offers a Roth 401(k) and allows conversions. Otherwise, you’ll need to wait until you separate from service at your employer.

Novick said he can’t imagine a scenario where it would pay to convert your entire $587,000 401(k) all at once.
Assuming you have no other income, you take the standard deduction/exemptions and that the entire 401(k) consists of pre-tax dollars, you are looking at $170,000 of federal tax, which is almost a 29 percent average tax rate, Novick said.

And that doesn’t count state income taxes.

“At age 55, I presume that you are still working and have additional earned income so the tax impact will actually be worse,” he said.

Then you need to consider where you will get the money to pay the tax.

“If you need to use some of the converted amount to pay the tax, then you will never catch up,” Novick said. “Even if you do have other funds to cover the tax, I still doubt you will ever recoup enough tax savings from the Roth to make this size conversion worthwhile.”

He said he’s not opposed to converting, saying for many it is a great financial planning technique. But you’d need a more complete analysis of your situation.

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In the meantime, Novick said, he suspects it would be better for you to wait until you are in a lower tax bracket at retirement to convert, and then, to convert small amounts on an annual basis to optimize your lower tax bracket.

Jerry Lynch, a certified financial planner with JFL Total Wealth Management in Boonton, said converting too much at one time is usually a mistake.

“Let’s say you make $100,000 and are married, and you decide to convert $200,000 of IRAs into Roths,” he said. “Now you are in a 25 percent tax bracket and that conversion is being taxed — part at 25 percent, another large part at 28 percent, and the final part at 33 percent — very bad move.”

The goal should be to only convert in the same tax bracket, Lynch said.

He also questions converting when you’re living in New Jersey.

“Nobody retirees here as it is too expensive,” he said. “Where do they move? Florida, where the tax rate is zero percent.”
So if you plan to retire out of New Jersey, it will probably be better to convert in that state when you retire, but check the tax rates in that state to be sure, Lynch said.

“The concept is great — tax-free money — but there are a lot of details that determine if it is a smart financial move or not,” he said. “The details are very important.”

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This post was first published in April 2016.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.