When a Client Enters a Higher Tax Bracket

• AUSTIN KILHAM for the Wall St Journal writes:   
The man was 60 years old and contemplating retirement. So when his employer offered early retirement and a generous severance package, he jumped at the opportunity.

However, he recently had inherited $1 million following the deaths of his parents. That money, combined with his company's offer, would put him into a higher tax bracket post-retirement. Concerned about the tax implications, he sought the help of John Gjertsen, a financial adviser with D.L. Blain & Co., a New Bern, N.C., firm that manages $67 million for 101 clients.

The client had a 401(k) that contained $360,000 in pre-tax contributions and matches and $25,500 in after-tax contributions. He also had $16,000 in after-tax contributions in a Roth 401(k). When Mr. Gjertsen saw that mix, he crafted a plan for separating the after-tax funds inside of his 401(k) from the rest of his savings and combining them with the Roth 401(k) contributions in a new Roth IRA. That way, the funds could grow tax-free.

Transferring the client's after-tax contributions entailed a process that created two new accounts and required the client to front a substantial amount of cash to cover tax withholding. But Mr. Gjertsen explained to his client that the result would be worth it: He would be able take all of his distributions from the Roth IRA tax-free, mitigating the effects of his higher income bracket.

The client was on board, so Mr. Gjertsen had his client take a direct distribution of all of his 401(k) funds and make an indirect rollover of the $360,000 in taxable contributions to a traditional IRA. The move had to be completed within 60 days to avoid paying taxes on those funds, but tax law also requires that the plan administrator withhold at least 20% of the account for federal taxes, which in this case was $72,000.

To complete the rollover, the client needed to place the entire $360,000 into the new IRA. So he had to make up for the $72,000 in withholding tax with outside funds taken from his company severance package, which included nine months' salary totaling $75,000. The client eventually would get the $72,000 back as a tax refund but planned to use the money for living expenses.

"To make this work, you have to have the liquidity to cover the taxes," Mr. Gjertsen says.

With the pre-tax dollars separated, Mr. Gjertsen then rolled the after-tax dollars into a Roth IRA. That rollover also needed to be completed within the 60-day window. The adviser also transferred the client's $16,000 in Roth 401(k) contributions directly to the same account.

Mr. Gjertsen notes that this rollover strategy is available only to clients older than 59 1/2 years. And while it has a lot of moving parts, as long as it is performed carefully it can be a good tax-planning strategy: The adviser estimates that the move will save his client $22,000 in taxes over his lifetime.

Those savings were welcome news for the client concerned about his tax bill. Now, he plans to contribute even more to both of his new IRAs.

"This strategy doesn't make sense in every situation," Mr. Gjertsen says. But in this case, he says, it was the ideal solution.