Q: I'll be retiring sometime in 2012. I'd like to take all or a part of my 401(k) and roll it into a Roth IRA. What would I have to pay in taxes to begin with? Could I remove a portion of the Roth IRA tax-free in an emergency? I'll be 64 in 2012. --DH via email
A: The amount you transfer from your 401(k) to a Roth IRA is added to your taxable income for the year in which you do the conversion. If you rolled $100,000 into a Roth in 2011, for example, your 2011 taxable income would shoot up by $100,000.
Financial planners say it's often less expensive to do a Roth conversion the year after you retire than while you're still employed.
Your taxable income will be smaller because you'll no longer be earning a salary. What's more, you may be able to claim high deductions from the previous year. (The 2010 state and local income taxes that you paid in 2011 are deductible on your 2011 federal return, for example.) If your deductions exceed your income, you may not even owe any taxes in your first year of retirement, says Robert Schmansky, a Pittsburgh financial adviser. As a result, you might be able to withdraw money from a tax-deferred account like a traditional IRA or a 401(k) plan -- whether you need it to live on or want to roll it into a Roth IRA -- without triggering a tax bill.
Make an appointment with a tax accountant who can crunch your numbers and advise you on the best way to time your Roth conversion. (One question to discuss with him or her is whether it makes sense for you to do a single conversion, or a series of small annual conversions. Depending on your tax situation, several small conversions may be less expensive.)
As for your second question, yes, the money in the Roth IRA will be accessible tax-free in an emergency. In fact, you'll be able to take a tax-free distribution of the entire amount you rolled into the Roth IRA after you do the conversion.
This important point is often misunderstood.
The rule is that you can withdraw Roth IRA earnings tax-free after you are 59 and a half years old and have owned the account for five years. What people usually don't understand is that in an ordinary Roth IRA (not a converted IRA) your principal -- i.e., the amount you contributed -- is not subject to that requirement. You can withdraw principal at any time, regardless of your age, without incurring a tax.
The reason is very simple: You've already paid taxes on that money.
In a converted Roth IRA, there is a penalty on funds withdrawn within five years of the conversion -- but only if you're under 59 1/2 years old. In your case, it wouldn't apply, says Barry C. Picker, a Brooklyn tax accountant.
Here's an example. You roll $100,000 from your 401(k) plan into a Roth IRA. Let's say you're in the 15% tax bracket when you do the transfer, so it costs you $15,000 in taxes. We'll also say you can pay that bill from another account, so you're able to deposit the entire $100,000 in the Roth IRA. (If not, you'd only be able to roll $85,000 into the Roth account.)
The very next day, you could take your entire $100,000 deposit out of the Roth IRA tax-free.
But of course you hope you won't have to do that ... because the Roth conversion only makes financial sense if your earnings in the account ultimately exceed the $15,000 tax you paid to do the transfer. That's very unlikely to happen if you must start emptying the Roth account right away.
Please send your questions to Lynn@LynnBrennersFamilyFinance.com. I'm sorry I can't respond personally to every email. Questions are only addressed online.
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