Question From A Reader – Should You Convert Your 401k To A Roth IRA?

by Hank Coleman

Last week, I received a question from a reader…

I am 56 1/2 years old and have a 401k with my employer. I plan on retiring in about 5 years (maybe sooner). I am wondering if rolling over my 401k into a Roth IRA and paying the taxes now is a good idea, given that taxes appear to be going up in the next few years. My 401k balance is only about $140K and my current Roth IRA only has about $3K. (I also have a state retirement). Any advice would be helpful.

First off, thanks for the question. I really appreciate it. If anyone else has any other questions, feel free to email me and I will dissect them on here (or email you back if you just want help that way).

There are several things that you should think about when converting your 401k to a Roth IRA. You should consider thinks like converting to a Traditional IRA, how you will pay your taxes, and whether or not taxes are really going to increase in the future.

No Income Limits On Conversions

There has been much hoopla made about changes in the tax law that has lifted the income restrictions in 2010 to allow anyone regardless of income level to convert a Traditional IRA into a Roth IRA. One thing to keep in mind is that you will have to rollover your 401k into a Traditional IRA and then convert that Traditional one into a Roth IRA. It is one extra unneeded step but a must.

How Will You Pay Your Taxes?

If you are converting a 401k retirement plan into a Roth IRA, you will owe taxes on the money you are investing in the Roth. You are going from a before tax dollars plan to an after tax dollars retirement plan. You should usually only convert your retirement accounts if you do not tap your 401k or Traditional IRA to pay the conversion tax. You will lose a lot of future earnings if you do that. Also, if you pay for the tax bill out of the proceeds from your 401k plan, you could be charged with the 10% penalty for early withdraw if you are not 59 ½ years-old. You should pay for your taxes out of your savings or other non-retirement investments.

Are Taxes Going Up In The Future?

If you believe you are in a lower tax bracket now than you will be at retirement, it could make sense to pay taxes now rather than later. This is the same argument as to why young workers should invest in a Roth IRA before they invest in a 401-k retirement plan or Traditional IRA. Many people think that taxes are going up in the future, both long and in the short term, because of the political climate in America. If you will be in a higher tax bracket in the future, paying taxes now will save you money.

Note – Remember to have your investment mutual fund company or your employer to make out the check to your new Roth IRA company directly. Don’t handle the money yourself. If you take too long depositing the money, you could find yourself getting charged the 10% penalty for early withdraw. Be careful.

Roth IRAs do not have mandated required minimum distributions like a Traditional IRA has. You can therefore use them as a great tool for estate planning by passing them on to your heirs. In general, the longer you plan to keep funds invested in your Roth, the more beneficial it becomes to convert. Roth IRAs are a great investment vehicle. Many consider them to be the best way to save for retirement, and the amount of money you save in taxes alone should entice people to consider a traditional to Roth conversion.

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{ 2 comments… read them below or add one }

fern August 22, 2010 at 3:49 pm

For the same reasons as outlined in your post, doing a Roth IRA conversion while you’re unemployed is an excellent option. If you’ve been long-term unemployed or underemployed like me, this is a good year to do that conversion becus you’ll likely be in a lower tax bracket.

Note that whatever amount you convert will be considered income, and that amount itself could bump you into a higher bracket.

Jim Barlow August 30, 2010 at 8:57 pm

do you think refinancing a home loan and using some equity to convert a 401k to a Roth IRA is a good idea

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