TSP (401K) conversion to Roth IRA

[jimbohoward69]

Hey everyone...I've been doing quite a bit of research on this lately and wanted to get the board's opinion:

I retired from the Air Force back in May of 2011. Since that time, I've been a full time student...only collecting my taxable retirement check while enjoying the tax free benefits of the G.I. Bill. Between my pension and V.A. Housing Allowance through the G.I. Bill, I don't have to work. Here are the numbers I'm crunching to decide whether to convert or not:

Total contributions to TSP: $69,555
Current amount of TSP: $92,500
Tax Exempt amount: $6,375
Amount to convert: $86,125
Current Age: 42
Age at retirement: 57 (when I would LIKE to stop working)
Current Marginal Tax Rate (2011 Tax Return): 15%
Current Effective Tax Rate (2011 Tax Return): 6%

(My Marginal Tax Rate has been 15% for as long as I can remember...)

Since my tax rates are so low right now, and I will continue to be a full-time student until October of 2012, does it make sense to convert now? I would pay the tax out of a savings account so I don't have to touch the TSP amounts. I've been thinking about this because I figure my "next job" could very well bump me up into a higher tax bracket when adding in my pension. For the record, I live in Florida and pay no state income taxes.

Your thoughts? Is there any other information I need to include for a more informed opinion?

Also, can you do a conversion ANY time during the year? Or do you have to do it before the April 15th deadline?

Thanks in advance!

James

 

[Animorph]

You must convert within the calender year for which you want to pay the income taxes. So convert this year and you owe 2012 taxes, reconciled by Apr 15, 2013. Too late to convert for 2011.

Sounds like a good idea to use the 15% bracket while you can. I can't speak to converting TSP 401k to Roth specifically, but I'm sure others here can.

 

[Nords]

Hey everyone...I've been doing quite a bit of research on this lately and wanted to get the board's opinion:

I retired from the Air Force back in May of 2011. Since that time, I've been a full time student...only collecting my taxable retirement check while enjoying the tax free benefits of the G.I. Bill. Between my pension and V.A. Housing Allowance through the G.I. Bill, I don't have to work. Here are the numbers I'm crunching to decide whether to convert or not:

Total contributions to TSP: $69,555
Current amount of TSP: $92,500
Tax Exempt amount: $6,375
Amount to convert: $86,125
Current Age: 42
Age at retirement: 57 (when I would LIKE to stop working)
Current Marginal Tax Rate (2011 Tax Return): 15%
Current Effective Tax Rate (2011 Tax Return): 6%

(My Marginal Tax Rate has been 15% for as long as I can remember...)

Since my tax rates are so low right now, and I will continue to be a full-time student until October of 2012, does it make sense to convert now? I would pay the tax out of a savings account so I don't have to touch the TSP amounts. I've been thinking about this because I figure my "next job" could very well bump me up into a higher tax bracket when adding in my pension. For the record, I live in Florida and pay no state income taxes.

Your thoughts? Is there any other information I need to include for a more informed opinion?

Also, can you do a conversion ANY time during the year? Or do you have to do it before the April 15th deadline?

Thanks in advance!

James

Hey, Jimbo, welcome back! How about a retirement status report? How's the GI Bill bureaucracy treating you?

As mentioned, you have to do the conversion before 31 December. You probably want to get started on it in early November, especially if you're rolling out of the TSP and into another fund company instead of just converting a conventional IRA account to a Roth account with the same company.

Many people do it in July-September, especially if the stock market tanks 10-20%. The lower the values of your shares, the fewer gains to pay taxes on.

I haven't done the analysis, but at some point it's better to stay with the TSP's 0.025% expense ratios (and not convert until later) than to convert now and end up in mutual funds or ETFs that have 0.40% expense ratios. I don't know what the magic number would be on fund expenses or how many years it would take to make it more expensive. If you're going with a Vanguard or Fidelity fund with expenses down in the 0.20% range then you're probably better off converting. If you were going to an Ameriprise fund or using a full-cost financial advisor and paying 2% then you're probably better off with the TSP.

But you could also leave your funds with the TSP for another 15 years and revisit this situation in your late 50s or early 60s. If you retire at age 57 you still have time before you're starting Social Security, let alone RMDs.

 

[TeeRar]

I'd do it sooner rather than later

I'd move as much as I could every year without moving into a higher tax bracket. My opinion is that the long term trend for taxes is UP and anyone should take advantage of a current low tax bracket to make some moves from tax deferred to tax exempt.
Others have made good points about moving from a very low expense fund (TSP) to something that would possibly charge you more.

 

[ziggy29]

I'd move as much as I could every year without moving into a higher tax bracket. My opinion is that the long term trend for taxes is UP and anyone should take advantage of a current low tax bracket to make some moves from tax deferred to tax exempt.

To a degree, I tend to agree. However, if one is in a high bracket now and would (under current laws) expect to be in a lower bracket in retirement, this can be counterproductive even after considering that overall taxes will rise in the decades ahead.

For example, we are in the 25% marginal bracket now; any Roth conversions we performed would be taxed at 25%. Based on current retirement plans and projected retirement income, we would be in what is now the 15% bracket at retirement. Even if that 15% bracket rises, I'm not convinced it will rise to 25% or more. As a result, a Roth conversion wouldn't be a slam-dunk move for me, and might even be counterproductive. (There are other concerns as well, such as RMDs and whether or not any of the untaxed withdrawal from Roths will be considered in possible future means-tested benefits. These are based on conjecture, though, not what *is* in the here and now. They're worth considering and perhaps hedging for, but not for going "all in" with assumptions about what we think may happen.)

But yeah, I think for most folks currently in the 15% bracket or below it's probably not a bad move to convert until they are about to be kicked up into a higher bracket.

 

[ejw93]

Jimbo -

Congrats on completing your career.

To note, you'll have to do a 'Texas Two-Step' to convert your TSP funds to Roth. There are no plans at present to allow within-TSP conversions. It is likely that you must:


1) Open an IRA account with your favorite outfit (USAA/Schwab/Fidelity/Vanguard).

2) Rollover some or all of your TSP (at a minimum, the desired conversion amount) in to this new Rollover IRA (MAKE SURE you ask for a 'Trustee-to-Trustee Transfer' of funds, NOT a check written out to yourself).

3) Convert the Rollover IRA to a Roth IRA.

4) Consult your tax professional. It is likely that you will have a $6375 'basis' on the converted amount that will not be taxed as income.

5) Note there is a 5-year wait on withdrawals from 'converted' Roth IRAs.

Based on your stated goal of retiring at age 57, my preferred strategy would be to convert only the tax-free amount ($6375) now and leave the rest in the TSP. This would (1) make tax record-keeping simple on the converted amount and (2) leave the remainder of the money in a 401k equivalent.

If you want to retire at age 57, you can make penalty-free (NOT income tax free) 401k withdrawals (from your 'final' employer's plan) before you reach age 59 1/2. I'm oversimplifying a bit, but you don't have this pre-age 59 1/2 flexibility if your tax-deferred money is kept in indivudual retirement plans.

Using your 'convert it all' strategy would free-up only the 2012 Roth conversion basis (what you got taxed on) for withdrawals after the 5-year wait period. The earnings in the converted Roth acct can only be withdrawn penalty-free after age 59 1/2.

 

[jimbohoward69]

Thank you to everyone who has posted thus far! I greatly appreciate it

@Nords - Military retirement is going well. However, I am "chompin' at the bit" to get back in the workforce. Since none of my other friends are "retired", I can only play golf BY MYSELF every so often Also, the V.A. has VASTLY improved how the G.I. Bill is being handled...since I started in August of last year, I haven't had to wait for a payment yet.

@ Animorph, TeeRar, ziggy29, ejw93, and Nords - I've done a good deal of research since my first post and crunched some numbers. In the beginning, I made a newbie mistake of thinking that the entire conversion amount would be taxed at 15% instead of realizing that it's treated as ordinary income and will "bump you up" each bracket accordingly (in my case, all the way up to 28% when accounting for both the conversion amount and my retirement pension).

If/when I convert, it will definitely be to Vanguard...I set-up a Rollover IRA months ago for just such an occasion.

At this point, I'm leaning either towards TeeRar's advice of just converting just enough this year to keep me in the 15% bracket (or 25% in subsequent years when I start working again...if it makes fiscal sense).

However, ejw makes a good point about having the taxable portion remain in the TSP in case I want to start 72(t) distributions in the future (I assume that's what you were referring to?).

Mmmmmm.......decisions, decisions.

 

[ejw93]

However, ejw makes a good point about having the taxable portion remain in the TSP in case I want to start 72(t) distributions in the future (I assume that's what you were referring to?).

Mmmmmm.......decisions, decisions.

No, not at all referring to 72(t)... you can do a 72(t) with an Individual Retirement Account.

Look up the IRS rules on 401k withdrawals... you can quit your job in the calendar year of your 55th birthday and begin making penalty-free withdrawals from the employer's plan. You can't do this with an IRA unless you pay the 10 percent tax penalty or do the 72(t) stretch payment based on your life expectancy.

I'm in agreement that maxing out your coversion to stay just at or below the 15 percent bracket is probably the best course.

 

[jimbohoward69]

No, not at all referring to 72(t)... you can do a 72(t) with an Individual Retirement Account.

Look up the IRS rules on 401k withdrawals... you can quit your job in the calendar year of your 55th birthday and begin making penalty-free withdrawals from the employer's plan. You can't do this with an IRA unless you pay the 10 percent tax penalty or do the 72(t) stretch payment based on your life expectancy.

I'm in agreement that maxing out your coversion to stay just at or below the 15 percent bracket is probably the best course.

Thank you for the info! I had no idea about that particular rule...