Roth conversion can create a tax trap

Stewart Welch for AL.com writes: Tax time often brings a lot of solid questions from folks pondering their investment strategy, considering retirement, or expressing concerns about their overall financial future. Here are a few scenarios I've run across in recent months and answers that can be informative for a wide range of investors. 

Reader question: 

I plan to retire in the next 5-8 years at 58 years old and expect to have approximately $800,000 in my 401K plan.  I originally planned to move my 401K plan into a traditional IRA so I could have more control and more investment options.  However, I do not expect to need it at all.  Between my husband’s retirement annuity and my retirement annuity (and social security), our income will be $225,000 with annual adjustments.  Therefore, upon retirement, I am thinking about transferring my 401K from a traditional IRA to a Roth IRA.  This would require me to pay immediate taxes on $800,000.  But $800,000 invested for 30 years at 5% would be $3.5 million that my heirs would eventually have to pay tax on (when they reach retirement age).  So, should I transfer my 401K to a Roth IRA upon retirement if I don’t need the money during retirement?  D.J.

Answer: 

First, congratulations on doing a great job of preparing for your retirement!  The first rule of converting a traditional IRA to a Roth IRA is that you must be able to pay the income taxes from funds outside of your retirement accounts.  If this is not the case, generally, you are better off holding onto the IRA.  This is because when your heirs (presumably children) inherit your traditional IRA, they are allowed to ‘stretch’ the income tax liability over their life expectancy which may extend the tax payments over additional decades.  If you do have personal money from which to pay the taxes on a Roth conversion, you’ll likely be better off, tax wise, spreading the conversion over a number of years.  You want to avoid being drawn into the new higher income tax bracket (39.6%) that applies to couples with adjusted gross incomes exceeding $450,000.  I encourage you to work closely with your CPA to devise the most tax efficient strategy.

Reader question:  

I am fifty-two years old; have just changed jobs; and I have $20,000 in my old employer’s 401k.  My new employer provides a 100% match for up to 4% of annual contributions.   Should I roll my old 401k into my new employer’s plan or roll over into an IRA?  I was also told that if I need some of that money for a mortgage to buy a home, I can do so without penalties.  Is that correct?  A.G.

Answer:  

The main advantage of rolling your old 401k into your new employer’s plan (if they allow this) is that it consolidates your retirement money into one place.  If, instead, you roll over into an IRA, you’ll significantly increase your investment options.  Generally, my preference is more investment options.  You can withdraw up to $10,000 from an IRA penalty free for a home purchase if you are a first-time home buyer. This withdrawal will be treated as income for income tax purposes.  To qualify as a first-time homebuyer, neither you nor your spouse can have owned an interest in a home for the past two years. With your 401k, some employers allow you to take a loan of up to 50% of your vested balance or $50,000 whichever is less. My recommendation is to find another way to finance the purchase of your home.