Do Roth Conversions Make Sense for Me?

[nico08]

Hi. I am trying to find out whether I am eligible to make Roth conversions from my 401k and 457 plans. If I am eligible to make these conversions, I want to find out if it makes sense for me to do it.

44 years old.
small government pension at 60.
I planned on retiring at 45 or 46, but a serious health condition caused me to retire early, possibly temporarily and possibly permanently.

My portfolio has a breakdown like this-
Tax deferred/Tax free- 49.4% (401k, 457, Roth IRAs, Inherited IRA)
Taxable equity- 42.4% (Mostly Vanguard funds, diversified)
Taxable savings- 8.1% (short term bond bond and checking accounts)

Now, if I have no earned income in a year, does that mean I am precluded from doing a Roth conversion?

Under what circumstances are Roth conversions a good idea?

This is an area that I am not really familiar with and that is why I am asking for feedback.

 

[audreyh1]

You don't have to have earned income to do a Roth conversion, and there are no income restrictions either.

People usually do Roth Conversions when there current income tax rate is much lower than they expect in the future. Early retirees are often in their lowest taxable income years right after retiring and before they receive social security and or are old enough to take RMDs. Especially if they don't have a pension, or are living on savings before a pension starts.

For some folks, if they are in the 15% tax bracket, they may convert the amount that keeps them within the 15% tax bracket.

Roth Conversions will increase your AGI (adjusted gross income) and that can reduce the health insurance subsidy you qualify for under the ACA, or increase the Medicare premiums you have to pay once you turn 65 (actually the AGI from 2 years before is used to calculate your premium). So you will want to look at that impact as well.

 

[nico08]

Hi Audrey. Thank you for explaining some of the issues to consider to me.

I think I will be in a low income tax bracket for 2015. I will be living on savings before any pension or SS starts.

I am not sure if I will now be in the 15% tax bracket.

Right now, I am on COBRA, so it's hard for me to predict what effect a Roth conversion will have on any health insurance subsidy, because COBRA does not have the health insurance subsidy attached to it.

Thank you for your insight.

 

[audreyh1]

Hi Audrey. Thank you for explaining some of the issues to consider to me.

I think I will be in a low income tax bracket for 2015. I will be living on savings before any pension or SS starts.

I am not sure if I will now be in the 15% tax bracket.

Right now, I am on COBRA, so it's hard for me to predict what effect a Roth conversion will have on any health insurance subsidy, because COBRA does not have the health insurance subsidy attached to it.

Thank you for your insight.

It's easy to search the 2015 tax brackets with Google, etc. then remember to take off the appropriate standard deduction, exemption etc., to get at the effective upper limit to remain in the 15% bracket.

You won't get an ACA subsidy this year, but your 2015 income may affect your subsidy in the future - but only at first until taxes are filed for the year in question. So it is a temporary problem.

 

[Delawaredave5]

I think there's an "access requirement" on converted money ? You can't access converted money for 5 years ?

Confirm this. Maybe just the Roth account needs to be established for 5 years. May vary by age.

But you would not want to convert money, then need it, then bump into withdrawal restrictions.

 

[karluk]

I think there's an "access requirement" on converted money ? You can't access converted money for 5 years ?

Confirm this. Maybe just the Roth account needs to be established for 5 years. May vary by age.

But you would not want to convert money, then need it, then bump into withdrawal restrictions.

I think the Roth IRA withdrawal rules might actually work to OP's benefit, assuming he is able to wait five years before making withdrawals. That's because withdrawals from 401(k) and 457 plans are generally subject to both taxes and a 10% penalty if withdrawn before age 59 1/2. But conversions to a Roth IRA are not subject to the 10% penalty once the five year waiting period has been met.

So, let's say that OP expects to run out of money in his taxable accounts six years from now. One option for paying his bills in year six is to keep money in his 401(k) for the next five years and then take an early distribution from the 401k, incurring both ordinary income taxes and the 10% penalty. Another option is sometime in TY 2015 to convert money from the 401(k) to a Roth IRA. This incurs ordinary income taxes but no penalty, and what's more sets the five year clock ticking. Then when OP needs the money in six years, five years have passed and no penalty is assessed on the conversion amount.

So, it seems to me that the choice is between paying taxes now and avoiding the penalty in the future vs. paying both taxes and penalty in the future. Everything else being equal, it should be to OP's advantage to make the Roth conversion in order to avoid the 10% penalty.

 

[N02L84ER]

"if I have no earned income in a year"


If you truly have no earned income in a year, absolutely do enough Roth conversions to equal your exemption + standard deduction amounts because the federal tax bill will be $0. If you itemize your deductions, increase the standard deduction amounts in the following numbers to determine the amount to convert. If you have other dependents, increase the exemption amount to determine the amount to convert without paying any tax. If you have ONLY qualified dividends and long term capital gains income, the following numbers still work the same as long as you are still within the 15% tax bracket. If you are getting disability income or non qualified income or interest income or rental income or any other taxable income, those amounts should be deducted from the following numbers to determine the amount of tax conversions possible to still pay $0 in federal tax.


For a single filer that amounts to $4000+$6300=$10,300 to convert and not owe federal taxes.
For a joint filer that amounts to $8000+$12600=$20,600 to convert and not owe federal taxes.


You have 16 years before the pension income comes into play, allowing $160K+ of conversions at $0 tax, if you truly have no other taxable income.

 

[nico08]

Hi NO2L84ER. Thanks for the tip, useful information.

 

[PhrugalPhan]

I think the Roth IRA withdrawal rules might actually work to OP's benefit, assuming he is able to wait five years before making withdrawals. That's because withdrawals from 401(k) and 457 plans are generally subject to both taxes and a 10% penalty if withdrawn before age 59 1/2. But conversions to a Roth IRA are not subject to the 10% penalty once the five year waiting period has been met.

I could be wrong but I am fairly sure you can withdraw from a 457 plan as soon as you are no longer employed without penalty. At least government sponsored 457s. It certainly works that way with my 457 plan, and I have researched that a lot. Although in the end it won't likely matter - I plan to retire shortly after my 60th birthday.

 

[karluk]

I could be wrong but I am fairly sure you can withdraw from a 457 plan as soon as you are no longer employed without penalty. At least government sponsored 457s. It certainly works that way with my 457 plan, and I have researched that a lot. Although in the end it won't likely matter - I plan to retire shortly after my 60th birthday.

Phrugal, I suggest you recheck the rules on your 457. My 457 offers penalty free withdrawals when separating from service at age 55 or older. This is a common option in both 457s and 401(k)s, but OP is only 44 and wouldn't be eligible for penalty free withdrawals under this option.

 

[PhrugalPhan]

Phrugal, I suggest you recheck the rules on your 457. My 457 offers penalty free withdrawals when separating from service at age 55 or older. This is a common option in both 457s and 401(k)s, but OP is only 44 and wouldn't be eligible for penalty free withdrawals under this option.

Well like I said he should check into it. According to my employer I should be able to (not that I will do it before 55) take the money out after retirement at any age. Also, here is a link that refers to this rule: Ask ICMA-RC: 457 Withdrawals | ICMA-RC
As always, in every situation you should do your due diligence before making the leap to ER.

 

[karluk]

Fair enough, Phrugal. Your link contradicts what I was told by my 457 plan representative, but that doesn't mean that I was given correct information. OP may very well get penalty free withdrawals from his 457 account without having to go through Roth conversions first.

 

[nico08]

Thanks Karluk and Phrugal. I am going to check the rules used by my 457 plan. The plan used to be run by the State of New Jersey, but the state privatized the plan and now it operates under Prudential. Before I realized that I could potentially access this 457 money earlier, I rolled some of the money over to Vanguard because they had lower expense ratios on the investments I needed for appropriate diversification and its where most of my investments are located. Oh well, live and learn I guess.

 

[fosterscik]

I agree with Phrugal - no 457 age-related penalty in my plan either. This is what CNN money says:

Is there a penalty for early withdrawals from a 457 plan? No. Unlike with 401(k)s and 403(b)s, the IRS won't slap you with a penalty on withdrawals you make before age 59�. You will, however, owe income tax on all withdrawals, regardless of your age. So busting into a 457 plan early still isn't a good idea. Leaving the money to compound until you're ready to retire will leave you with a much bigger nest egg.

Is there a penalty for early withdrawals from a 457 plan?