Lynn Brenner's Family Finance

When is the Best Time For a Roth Conversion?

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 [email protected].  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved.

 

 

At What Age Can I Move My IRA Penalty-Free From One Bank to Another?

Q: I have traditional and Roth IRAs of my own, and I have also inherited some traditional IRAs. I am currently taking annual distributions from the inherited IRAs based upon my own life expectancy. Here are my questions: 

When I reach age 59 1/2, I understand that I can "move around" all IRAs (traditional, Roth, and Inherited) without any penalty. Is that correct? Is there any special treatment for moving Inherited IRAs from one bank to another? Now that bank interest rates are slowly creeping up, after I turn 59 and a half I'd like to move some IRAs that are invested in CDs currently earning low interest rates. Are there any tax consequences if I do this? Will I have to file anything with the IRS when I move an IRA from one bank to another?

If I have four IRAs in four different banks, is there any rule against moving all of them in the same year?  Is there a limit on the number of times I can move each IRA in one calendar year?

Are there any penalties in "breaking" any of the IRA CDs before their maturity dates?

At what age can I take out some of my own IRA money without penalty? I know that any money I take from the traditional IRAs have to be reported on my tax returns. But am I right that I don't have to report my withdrawals from the Roth IRAs? --DM, via email

A: You don’t have to wait until you’re 59 and a half years old to move the IRAs you own from one provider to another without triggering any taxes or any tax penalty. An IRA owner can do that at any age.

It's not always possible for a beneficiary to move Inherited IRAs, however, as I’ll explain in a moment.

But even though there is no tax penalty, you may trigger a provider's early withdrawal penalty depending on how your IRA is invested.  A prime example is moving a CD before its maturity date. The only time banks waive this penalty -- and not all of them do -- is if you must ‘break’ a CD before maturity in order to take a required distribution from an IRA after you turn 70 and a half years old. 

You don’t have to file anything with the IRS when you transfer an IRA between providers. And there’s no limit to how many times you can move each IRA in a single calendar year – although moving four IRAs several times a year would require a high tolerance for filling out financial services providers’ paperwork.

The best way to move an IRA from one provider to another is in a trustee-to-trustee transfer: You want to move an IRA from Bank A to Bank B. You open a new IRA at Bank B, and then Bank B asks Bank A to transfer your IRA money into the new account.

Alternatively, you can take a check from Bank A and deposit it in a new IRA in Bank B. But in that case, to avoid taxes you must deposit the entire amount in a new IRA within 60 days. (This is called the 60-day rule.)

You can start withdrawing money from your own traditional IRAs without incurring a 10% early withdrawal tax penalty as soon as you turn 59 and a half. But the amount you withdraw is taxable income. (The IRA custodian reports IRA withdrawals to the IRS – so don’t omit it from your tax return in the hope that you can avoid paying taxes on it.)

Your Roth IRA withdrawals are all tax free after you turn 59 and a half and have owned the account for five years. You don't have to report them to the IRS.

Okay, so what about moving an Inherited IRA from one bank to another?

The IRS has no objection to your doing this, as long as you put the new Inherited IRA account in its original owner's name, listing yourself as the beneficiary. But occasionally, the bank’s rules don’t allow IRA beneficiaries to do a trustee-to-trustee transfer; this doesn't happen often, but it does happen. Unlike an IRA owner, an IRA beneficiary cannot use the 60-day rule to avoid taxes on a transfer. In other words, by refusing to allow trustee-to-trustee transfers, a bank with this rule makes it impossible for a beneficiary to move an Inherited IRA without triggering taxes.

Please send your questions to [email protected].  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved

 

Transferring Part of an Inherited IRA to a New Provider? Do It Very Carefully!

Q: I've read your February post on the importance of doing a trustee-to-trustee transfer when moving an inherited Roth IRA to a different provider. I inherited a Roth IRA from my father, and I'd like to transfer the cash portion to another brokerage to invest, while leaving the stocks and bonds at the current brokerage. Can I effectively split the inherited Roth IRA by doing a trustee-to-trustee transfer for just part of the assets? I only want to transfer the cash portion. -- LP via email


A: What you want to do is perfectly legal, but it's a little more complicated than the standard transfer. The real question is, how can you make sure the broker doesn't screw it up?

Your best option is to simplify the process by doing it in stages, says Barry C. Picker , a tax accountant and financial planner who is also an expert on IRAs.

His advice:

First, create two inherited Roth IRA accounts at the current brokerage, one for the stocks and bonds and the other for the cash. Make sure they're both correctly titled -- i.e., in your father's name, with yourself listed as the beneficiary.

Then go to the new broker and open a new inherited Roth -- again with the correct title, in your father's name, with yourself as the beneficiary. Finally, tell the new broker to ask the old broker to transfer the cash account into the inherited Roth account you've just opened. The cash Roth IRA account you're having transferred will have its own account number, which you'll be careful to list correctly on the new broker's form.


Please send your questions to [email protected]. I'm sorry I can't respond personally to every email. Questions are addressed only online.

(c) Lynn Brenner, All Rights Reserved.

Can I Withdraw My Principal From A Roth IRA in Less Than Five Years Without Triggering a Tax?

Q: I really appreciated your timely AARP magazine article "Roth Mania" . I have a question on one of the rules. You wrote: "Roth IRAs allow tax-free withdrawals of earnings after you're 591/2 and have owned the account for five years." Does this five-year rule refer to the principal and the interest earned, or just to the interest earned? -- PS via email
 
A: This rule is often misunderstood!  It applies only to the interest earned.

You can't withdraw the Roth IRA's earnings tax-free until you're over 59 and a half AND have owned the account for five years. 

But you can withdraw your principal anytime without triggering a tax or a penalty.

There is one exception: If you do a Roth conversion and you're under 59 and a half, you'll owe a 10% early withdrawal penalty -- but no income tax -- on converted principal that you withdraw within five years of doing the conversion, says Barry C. Picker, a New York City tax accountant and IRA expert.

If you do a Roth conversion and you're over 59 and a half, you can withdraw the converted amount tax-free and penalty-free at any time; but you can't withdraw earnings tax-free until the account is over five years old. 

The reason you can withdraw Roth IRA contributions tax-free anytime is that you've already paid taxes on them. If I contribute $2,000 to a Roth IRA, for example, I get no tax deduction for the contribution. The $2,000 is included in my taxable income for the year.

But of course, there's a major downside to tapping the account: If you withdraw your principal, the Roth IRA can't earn anything.

Please send your questions to [email protected]. I'm sorry I can't respond personally to every email. Questions are addressed only online.

(c) Lynn Brenner, All Rights Reserved.