How and Why I Rolled Over 401(k) Funds to a Roth IRA

Actually I didn’t do this exactly as I’ll explain later. First I’ll discuss the “why”.

As I discussed in this post, you should have some of your retirement funds in tax-deferred savings such as traditional IRA or 401(k) funds. This is because some taxable income is not actually taxed. The taxable income on which you pay no taxes at all is that which is less than your personal exemption and standard deduction. The standard deduction amount is increased slightly for someone 65 or older. This adds up to almost $10,000 for a single person over 65 in 2007, and this amount is indexed annually for inflation.

However, the effective tax rates for a retiree can quickly escalate once taxes are paid. If other income including withdrawals from tax-deferred savings added to 50% of your Social Security benefit exceeds $25000 for a single person, you begin paying taxes on $.50 of Social Security for each $1 of additional other income. With even more income, you pay taxes on $.85 of Social Security for each $1 of additional other income. This can effectively turn a 15% tax bracket into 22.5% or 27.75%, and a 25% bracket into 37.5% or 46.25%. It would be terrible to pay 46.25% taxes on money you deferred at 25%. Also, the $25,000 threshold for testing whether or not some of your Social Security is not indexed for inflation which will result in more and more people paying more taxes on Social Security benefits.

Once you reach the age of 70 ½, the IRS expects you to take Required Minimum Distributions (RMDs) from your tax-deferred accounts. Failure to take your RMDs can result in punishing penalties -- 50% of the amount you were supposed to have distributed but did not.

I have sufficient tax-deferred savings that I’m concerned about ending up in an effectively higher tax bracket due to taxation of my Social Security benefits. I am also concerned that tax rates will increase in the future as right now they are at historic lows. So I am converting 401(k) funds to a Roth IRA, but as I stated earlier I couldn’t do this exactly, or at least not directly. First I had to rollover the 401(k) funds to a rollover traditional IRA and then I converted funds from the rollover IRA to a Roth IRA.

My employer’s 401(k) plan rules allow me to distribute up to $25,000 per year of the company match. Most people probably don’t have this option, but I did. However, you may have funds from prior employers that you’ve either left with them or have already rolled over to an IRA. (If you spent them – shame on you.)

Last year, I created a rollover account at Vanguard which initially was unfunded. Then I contacted my 401(k) plan administrator and asked for a partial distribution with the check made out to Vanguard as the custodian of my rollover account. By having it made out to my IRA custodian I avoided having taxes withheld from the distribution. The check was mailed to me. I then placed it in an envelope with a form I downloaded from Vanguard’s site and filled out with my personal and account information to fund the rollover IRA account I had setup previously.

Later on and before the end of 2006, I converted part of my rollover account to a Roth IRA account which I had previously set up and funded with normal IRA contributions. The part I didn’t convert is still in my rollover IRA. The amount that I converted to Roth added to my tax bill. In order to avoid penalties for underpayment of taxes, I made sure to increase tax withholdings from my salary to exceed the amount I had paid in taxes the prior year, and I went ahead and had enough withheld to cover the taxes on the amount I converted to Roth. I estimated this with a spreadsheet and actually ended up with a small refund due to the telephone tax refund.

In retrospect, I should not have done this with my current employer’s 401(k). I have funds left in a prior employer’s 401(k) plan. I should have started my conversion with those funds. The reason is that if I leave my current employer during or after the year I turn 55, then I can withdraw plan without penalty from my 401(k) sponsored by that employer. I don’t have that option for employer’s I’ve left at a younger age until I reach 59 ½. I also don’t have that option with funds that I’ve rolled over. While taking and spending distributions from my 401(k) is not currently in my plans – well, life happens and it’s good to have options.

I want to reiterate a few points for someone contemplating doing this.
(1) Make sure that you have enough tax-deferred savings or a taxable pension so that when in retirement you use up the standard deduction and personal exemption amount on which you wouldn’t pay taxes anyway.
(2) Make sure the distribution is directly to your rollover account custodian to avoid withholdings.
(3) Plan your income tax withholdings and/or estimated tax payments so that you don’t get hit with a large tax bill and possible penalties the following April.
(4) If you have funds in any traditional IRA which are after-tax, the complexity of your tax returne will increase. Those funds are “non-deductible contributions” to a traditional IRA, see IRS form 8606 that will need to be filed if you do a conversion.
Another consideration is that the funds I’ve converted must remain in my Roth IRA for 5 years or I will pay a penalty.

This year I plan to rollover funds from my prior employer's 401(k) plan and convert them to Roth. I understand that beginning in 2008 that the "two step" won't be required and that 401(k) funds can be directly converted into a Roth IRA. While my employer offers a 401(k) plan with some great funds, I hope they make it even greater by adding a Roth 401(k) option.