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401k Rollovers: To Roth or Not to Roth – 7 Fiduciary Questions

401k Rollovers: To Roth or Not to Roth – 7 Fiduciary Questions
August 08
00:03 2017

There’s a growing belief that it makes sense for retirement savers to roll over their retirement plan assets into a personal IRA once they leave their firm. Setting aside the pros and cons of this, rollover candidates need to focus on the choice of whether to make a Roth conversion when rolling over. Some plans offer the option to convert pre-tax 401k savings into after-tax Roth IRAs. Research shows this is an underutilized strategy. According to the Investment Company Institute, (“Ten Important Facts About Roth IRAs,” July 2017), only 1.9% of all Roth IRAs are rollovers. Why aren’t more opting to rollover into Roths?

Fundamentally, the decision between rolling over into a tradition pre-tax IRA and a post-tax Roth IRA comes down to taxes. “In the calendar year of a rollover from an account in a corporate retirement plan into a Roth IRA, or the year of a conversion from a traditional IRA into a Roth IRA, 100% of the fair market value of the rollover or conversion is included in the individual’s (or couple’s) Gross Income,” says Barry Kozak, a consultant at the Chicago office of October Three Consulting LLC. When given such an option, former employees need to consider seven critical questions.

1) Can you afford to pay the tax that results from a conversion?
This represents the first (and usually only) question most people consider. If they don’t have the money to pay the tax, they either need to take it out of the IRA Rollover or forgo the Roth conversion all together. “The first thing they should consider is what is their current ordinary income tax bracket, and if they do the conversion to a Roth, approximately how much money will be due in taxes from that conversion,” says Calvin Goetz, Author of Climbing the Retirement Mountain and Partner and Co-Founder of Strategy Financial Group in Phoenix, Arizona. “This is important because you must be prepared to pay the amount you will be liable for.”

“Ultimately it comes down to the initial tax burden,” says Evan Tarver, a small business and investments writer for Fit Small Business. “If you have $100k in a pre-tax retirement account and you want to roll it over into a Roth, you have to be comfortable with paying between $25k – $33k in taxes. This is because you’ll be taxed on your contributions at your ordinary tax rate.”

But it goes beyond simply whether you have the money to pay the tax. The source of funds represents a critical factor. Goetz says, “The next most important thing to consider is whether or not they have non-IRA funds, enough to pay the tax without drastically impacting their emergency savings accounts.” It’s OK to take from emergency funds (these funds are, after all, there for “emergencies”) as long as the emergency fund can be replenished in a reasonable time.

2) Will a conversion bump you up to a higher tax bracket?
any consider the tax impact based on their current marginal tax rate. In truth, the conversion amount must be added to income and that may change the tax rate. “Be careful not to convert an amount that would bump you into the next tax bracket,” says Dustin Javier, an independent financial planner with Dean Johnson Advisory in Bartlett, Illinois. “Any converted amount into a Roth IRA is subject to ordinary income tax. Consult with your tax advisor.”

Since a conversion to a Roth can sometimes involve a significant sum, those seeking to discover the tax impact of such of a conversion must look not just at the marginal tax rate, but at other possible changes this might cause on the federal tax form. “A higher income tax liability due to the IRS can occur for three cumulative reasons,” says Kozak. “First, the imputation of the rollover or conversion into ordinary income, in and of itself; second, the high likelihood that this additional income will cause the individual’s (couple’s) marginal income tax rate to creep up to a higher band; and, third, the possibility that the elevated AGI for the particular calendar year reduces the chances of a higher offset to tax liability through the aggregation of itemized deductions than the offset that the individual (couple) will enjoy through the use of the standard deduction.”

3) Beyond the impact on federal taxes, what’s the impact on your state tax?
Don’t forget to also examine what will happen on your state tax return. Kozak says, “If the individual lives in a state with its own income tax scheme, and if the first line on that state’s tax return is the AGI shown on the federal return (as is the case with many of the state income tax regimes), then in addition to a higher-than-expected federal income tax liability for the tax year of rollover of conversion, the individual should also expect a larger-than-usual state income tax liability.”

4) Will this impact eligibility for Medicare or other government programs?
Eligibility for certain state and federal government programs might be impacted by even a temporary spike in your annual income. “If the individual has attained at least age 63 in the year of rollover or conversion,” says Kozak, “then two tax years in the future, his or her monthly Medicare Part B premiums and Medicare Part D premiums (assuming he or she applies for Medicare at age 65) will likely be greater-than-expected (there is currently a published chart on showing 2017 Part B and Part D premium surcharges based on income shown on the beneficiary’s 2015 federal income tax return).”

5) When do you need the money?
Here’s an often overlooked question, since so many people tend to concentrate on the very short-term rather than even the not-so-short-term (let alone the long-term). For example, the timing of the need for the money can determine whether it’s wise to convert to a Roth or not. “You need to be aware of your time until retirement,” says Tarver. “Having a Roth account that doesn’t tax your gains is great, but if you’re retiring in 5 years the benefit isn’t as great compared to if you were retiring in 30 years. This is because the longer the time to retirement, the more gains you stand to make.”

In addition, there are absolute restrictions on your ability to withdraw money from a Roth IRA. “When they need the money is important,” says Richard E. Reyes, a CFP based in Maitland, Florida. “There is a little timing issue between rolling over a Roth 401k to Roth IRA. It must occur at least five years after Roth IRA owners established and funded their first Roth IRA. That is, if the client has an existing Roth IRA, once the Roth 401k distribution is in the account, it has the same holding period as the Roth IRA funds.”

After the choice of timing is determined, the IRA holder must then figure when distributions need to be taken (i.e., the required minimum distribution or “RMD”) and what’s actually needed to pay retirement expenses. Kevin Avent, Managing Director – Wealth Management at Unified Trust Company in Lexington, Kentucky, says, “Participants should consider whether they definitively need to take distributions from their IRA to fund their living expenses in retirement. If they do, then most likely a traditional makes more sense from a tax perspective over their lifetime. If they do not, then converting to a Roth is probably the better option for tax savings.”

RMDs add an interesting twist to this analysis. When, where, and how they might impact future taxes can tilt the scales in favor of a Roth over a traditional IRA (or vice-versa). “In some cases, individuals may be able to delay taking required distributions if they currently work past the initial required distribution age (70½),” says Steve Martin, Founder and Wealth Planning Advisor for Oasis Wealth Planning Advisors in Nashville, Tennessee. “This delay applies to one’s current employer, however, so the 401k would have to be rolled over into the new employer’s 401k plan, if allowed. Delaying required distributions can be significant if one continues to work since the employee’s wages push the employee’s tax wages up. Adding the ordinary income from a Traditional IRA’s required distributions can exacerbate the tax problem.”

You can easily imagine how quickly things can get complicated when considering all the different scenarios involving RMDs. “Many financial advisors have a mantra that Required Minimum Distributions from a traditional IRA (or employer plan) are evil, and should be avoided at all costs,” says Kozak. “If that belief is correct, then it arguably is limited to wealthy individuals (couples) who have multiple sources of income and wealth in retirement, and given the choice, they would prefer to consume through the spend-down of those other assets, leaving the precious tax-deferred traditional IRA account or Roth IRA account ever growing, and using it as part of the legacy planning. However, for those individuals and families who need to take distributions out of their traditional IRA accounts because they don’t have a choice of multiple sources of income and wealth in retirement, then the RMD factors generally allow the account to be depleted slowly, over 20 to 25 years, and while an individual can take more than the minimum in any year, the minimum amount plus the benefits from Social Security might actually be a great way to set up a budget for retirement expenses.”

Only once all the possible situations are outlined and analyzed does it begin to become apparent which type of IRA might be more advantageous. “After you’ve determined whether you need to take distributions from your employer-sponsored plan (or traditional IRA) to live on in retirement, the next most important thing is determining how much money you plan to spend on an annual basis,” says Avent. “Since the money is taxed as ordinary income, if you plan to live on less in retirement than during your working years (and for most people it’s significantly less) then keeping money in a pre-tax status will reap the biggest tax benefit. However, if you plan to live on more in retirement than during your working years, then converting to a Roth will give a greater tax benefit. Please note that it is impossible to know what future tax rates will be. If they go up across the board then converting to a Roth becomes more and more attractive regardless.”

6) Do you want a diversification of taxable/non-taxable accounts?
Avent’s comments bring us to the penultimate question, one that is rarely discussed but has become increasingly of interest to more sophisticated planners. This is the idea of tax diversification of retirement accounts. “Another important factor to consider is one’s comprehensive retirement plan including your asset location,” says Javier. “What is the breakdown of tax deferred, tax free, or taxable accounts to draw from in their retirement years?” This has traditionally been thought of as being between tax-deferred IRAs and taxable savings accounts. The Roth IRA has introduced a new form of account into the mix, one that is replacing taxable savings accounts.

7) What professional do you wish to work with?
If you made it this far into the article, this question makes perfect sense to you. The decision to choose between rolling over into a traditional IRA or a Roth IRA is not a quick “back-of-the-envelope” calculation. There are many variables and many decisions, most involving which assumptions are acceptable and which are not. Given this, it’s a lot to ask the typical employee to go solo when it comes to this analysis. Gary M. Shor, VP Financial Life Planning at AEPG Wealth Strategies in Warren, New Jersey, says, “Are they working with a qualified financial professional to crunch the numbers? You do not want to be surprised at tax time.”

While some people have no problem doing their own taxes, even when those taxes are complicated, most folks stand a better chance if they get expert help. “The Roth/Traditional question I think is one that you really have to work with a qualified financial adviser to understand,” says Reyes. “Many investors know what a Roth IRA is but don’t have any idea how to manage it. I see folks with $1,000,000 in their IRA/401k and $10,000 in a Roth weekly. I’m sorry there is no benefit to this. This will do nothing for your future retirement as far as taxes are concerned. Working with a good financial advisor will provide ways where you can convert/change those taxable dollars into future tax-free dollars.”

Recent research shows more than two-thirds of Roth IRA holders use a financial professional (“Ten Important Facts About Roth IRAs,” Investment Company Institute, July 2017). This is the ultimate fiduciary question: Do you think rollover candidates want advice from professionals looking out for the rollover candidates’ best interests? “Relationships are the most important thing people should consider when trying to decide whether to make the rollover from their corporate retirement into a ROTH or traditional IRA,” says Keith Clark, co-founder of DWC – The 401(k) Experts, based in St. Paul, Minnesota. “Most individuals want to chat about their retirement planning and investment decisions with a professional who cares about them – and knows them.”

Preferred Members of have access to premium content on this topic through the following articles:

  • 5 Reasons to Convert to a Roth |
    Retirement savers under the age of 45 are 2 to 4 times more likely to save in an after-tax Roth vehicle rather than a traditional tax-deferred savings vehicle. The growing popularity of using Roths makes converting to them an option worth considering. Here are five reasons to convert to a Roth, four of which you rarely read about.
  • 7 “It Depends” Reasons to Avoid Converting to a Roth |
    You’ve heard it all – the Roth means never having to pay taxes again. But there’s more to converting than meets the eye. It all depends on several factors you might not be things about (but should). Just in case you might have missed one, we’ve provided you a list to quickly scan.
  • A Last Minute 5 Point Checklist Once You’ve Decided Whether to Convert to a Roth |
    After you’ve done your preliminary analysis and are ready to pull the switch to convert, there’s one more thing you need to do. Actually, there are five more things to do, and we present them in this concise checklist.

Christopher Carosa is a keynote speaker, journalist, and the author of  401(k) Fiduciary SolutionsHey! What’s My Number? How to Improve the Odds You Will Retire in Comfort and several other books on innovative retirement solutions, practical business tips, and the history of the wonderful Western New York region. Follow him on Twitter, Facebook, and LinkedIn.

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA


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