Q. In a prior column about in-plan conversions of 401(k) moneys to Roth 401(k) you wrote "... you have to have money outside your plan to pay the taxes on the conversion or the attractiveness of an in-plan conversion drops considerably. You may be able to access funds in the plan to pay the taxes via a loan but that has its own negative repercussion s..." Could you discuss this more? — T.G.
A. I'd be happy to do so. The decision to execute an in-plan conversion of 401(k) money to Roth 401(k) is similar to converting a traditional IRA to a Roth IRA. If you expect your tax rate to be higher in the future when you access your funds, you should consider a conversion. The idea is to pay taxes now so no taxes will be due later when the higher rate would apply. If a conversion makes sense for a family, generally the more that can be converted at today's favorable tax rate, the better. The lower your marginal rate is today, the better the odds a conversion will pay off.
If you convert $10,000 while in a 25% marginal tax bracket, paying with outside money means all $10,000 and growth on it would be available tax free in the future. If you pay from the retirement account, only $7,500 would be so affected. Then there is the tax treatment.
Converted amounts and moneys withheld for taxes are all treated as taxable income. Taxable income from IRA's and 401(k)s are taxable income subject to a 10% early withdrawal penalty unless an exception applies. Amounts converted to Roth treatment qualify for an exception but amounts that pay taxes aren't. Therefore, for taxpayers younger than 59 1/2, the rate used to determine if a conversion might be a good idea jumps 10%, if the taxpayer is planning to pay taxes with 401(k) funds.
In the above example with $2,500 withheld, only $7,500 was actually converted. If you grossed up the amount to $13,333,33 so that after withholding 25%, the full $10,000 was converted, you still aren't converting all of the gross income. That extra $3,333.33 is subject to penalty.
Ten percent may not seem like a lot until you translate that into income levels. For instance, for a married couple filing jointly, the marginal rate is 25% for taxable income between $72,501 and $146,400. In order for a conversion to be beneficial after adding another 10% for the penalty, that couple's taxable income would need to exceed $450,000 under the current tax regime to reach a marginal bracket over 35%. It isn't quite so simple due to items like phase outs of exemptions and deductions and the new taxes on net investment income but you get the idea.
Borrowing from a 401(k) is fairly easy (no credit check for instance) and would not subject the money to the 10% penalty but borrowing has some downsides. While you will pay interest to yourself, it is paid with after-tax money. While the loan is outstanding, the interest is all it will earn. It won't be able to stay invested. Some plans do not allow employees to receive matching funds until their loan is paid off. That is passing up free money. If you terminate your employment, the loan must be repaid, usually within 60-90 days, else the outstanding loan balance is deemed a distribution and is therefore taxable and subject to the pre-59 1/2 penalty.
Two final thoughts. Keep in mind that unlike a traditional IRA to a Roth IRA conversion, in-plan conversions cannot be "recharacterized,” the IRS term for "reversed" so you better be confident in your choice. Also while the law allows for these conversions, it doesn't compel your plan to offer the in-plan conversion feature. If your plan hasn't been amended to allow the in-plan conversions, you can't do one.
Q. I was laid-off by a Canadian company, I worked there for about eight months and participated in the ESOP, do I qualify for this NUA you talk about? — D.X.
A. You will need to check with your benefits department to see if the ESOP is a U.S. based retirement plan and therefore subject to U.S. tax rules. If U.S. based, they should be familiar with how to administer a distribution properly for Net Unrealized Appreciation treatment. If you have a plan document, one hint might be found in the title. In the U.S., ESOP is short for "Employee Stock Ownership Plan" but in other countries it is often "Employee Share Ownership Plan" but the title isn't definitive.
Q. My husband passed away five years ago. He was 60 at the time and because of his cancer had to take early retirement ... my age at the time was 50. I am now receiving his retirement. Will I also receive his Social Security when I turn 60 or do I lose his retirement ... no I do not work. — P.
A. If he would have received Social Security retirement benefits, you should be entitled to Social Security survivor's benefits. Because he passed away before starting his benefits, your full widow's benefit is based upon the benefit he would have received at his full retirement age. You can draw that amount at your full retirement age(FRA). If you start anytime before your FRA your widow's benefits are permanently reduced. If you start at age 60, your payment would be 71.5% of the full benefit. Every month you wait past age 60, the more of the full benefit you will receive.
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