Roth Conversions and How Dividend Income are Taxed in Roth IRA

[G-Man]

Roth Conversions and How Dividend Income is Treated in Roth IRA

Let me point out that the intent of this thread is not to trigger a debate about total return vs dividend return in retirement.

I have a situation where I have a Traditional 401k with company stock that pays a quarterly dividend. The plan is to start taking dividend distributions during retirement starting at age 60. I realize I would be paying ordinary income tax on the dividend distribution from the Traditional 401k.

So, the question is how I can pay zero taxes on the dividend distributions starting at age 60?

Can I rollover the company stock position in my Traditional 401k to a T-IRA and then do a Roth conversion to a Roth IRA at age 60?

At this point will I have immediate access to the dividend income tax free or does the Roth IRA 5-year seasoning rule apply to dividend income inside a Roth IRA?

Is dividend income inside a Roth IRA treated as qualified distributions and that is why the 5-year seasoning rule apply?

FYI. I will be 58 years old in 2024 and my first ROTH IRA account was created in 2022.

Please advise. Thanks

 

[VanWinkle]

Seems you'll be paying ordinary income taxes on the 401K/TIRA money if you convert the entire amount to a Roth IRA. This is not usually advantageous due to increasing your last dollar tax brkt. You will need to satisfy the 5 year rule of having the Roth open for 5 years in order to withdraw dividends tax free. I would lean more to slow conversions between 60 and SS time to keep the tax hit to a minimum. Then after 5 years(2027) you could start getting dividends from the Roth tax free.

 

[G-Man]

Seems you'll be paying ordinary income taxes on the 401K/TIRA money if you convert the entire amount to a Roth IRA. This is not usually advantageous due to increasing your last dollar tax brkt. You will need to satisfy the 5 year rule of having the Roth open for 5 years in order to withdraw dividends tax free. I would lean more to slow conversions between 60 and SS time to keep the tax hit to a minimum. Then after 5 years(2027) you could start getting dividends from the Roth tax free.

I was under the impression that each Roth conversion had its own 5-year period before you have withdrawn funds.

 

[pb4uski]

All Roth withdrawals that meet the requirements to be tax free are tax free irrespective of the source of the growth. You're definitely overthinking it.

Also, if you total taxable income is in the 12% tax bracket, really the 0% LTCG tax bracket, then all qualified dividends are tax free so there would be no need for the Roth

 

[pb4uski]

I was under the impression that each Roth conversion had its own 5-year period before you have withdrawn funds.

Not after you are 59-1/2, at that point all Roth withdrawals are tax free.

 

[G-Man]

All Roth withdrawals that meet the requirements to be tax free are tax free irrespective of the source of the growth. You're definitely overthinking it.

Also, if you total taxable income is in the 12% tax bracket, really the 0% LTCG tax bracket, then all qualified dividends are tax free so there would be no need for the Roth

This may be a dumb question. Is dividend distribution on company stock inside my Traditional 401k considered qualified dividend or non qualified dividend? Or do I need to rollover my company stock position inside my Traditional 401k to T-IRA to make the dividend distribution treated as qualified dividend?

 

[G-Man]

All Roth withdrawals that meet the requirements to be tax free are tax free irrespective of the source of the growth. You're definitely overthinking it.

Also, if you total taxable income is in the 12% tax bracket, really the 0% LTCG tax bracket, then all qualified dividends are tax free so there would be no need for the Roth

Unfortunately 2 pensions and wife's SS early in retirement will cause us to be in the 22% marginal tax bracket even after our standard deduction.

 

[VanWinkle]

This may be a dumb question. Is dividend distribution on company stock inside my Traditional 401k considered qualified dividend or non qualified dividend? Or do I need to rollover my company stock position inside my Traditional 401k to T-IRA to make the dividend distribution treated as qualified dividend?

You may want to look into rolling the company stock out to a taxable account and pay tax on the cost basis only.

"When you transfer most types of assets from a 401(k) plan to a taxable account, you pay income tax on their market value. But with company stock, you pay income tax only on the stock's cost basis—not on the amount it gained since you bought it."


https://www.investopedia.com/investing/rolling-over-company-stock/

Worth looking into.

 

[pb4uski]

Most dividends on domestic stocks are qualified dividends, but in the situation that you describe the type of account that the stock is held in trumps it being qualified.

If the stock is in a tax-deferred account then the dividend is tax deferred but withdrawals of money from the tax deferred account is ordinary income (unless some is principle/basis). OTOH, withdrawals from a Roth are tax free irrespective of whether the growth was from qualified dividends, interest, capital gains or unrealized appreciation.

Or another way, the qualified dividends distinction only applies to taxable account income, but not to tax-deferred or tax-free accounts.

 

[qwerty3656]

I think the roth conversions should be treated separately from the dividend issue. I would build up Roth money based on your tax situation and expected future tax situation. You can always sell the stock in your 401k/TIRA and then buy the stock (or any other investment) in your Roth (neither the buys or sells have any tax impact).

 

[G-Man]

Most dividends on domestic stocks are qualified dividends, but in the situation that you describe the type of account that the stock is held in trumps it being qualified.

If the stock is in a tax-deferred account then the dividend is tax deferred but withdrawals of money from the tax deferred account is ordinary income (unless some is principle/basis). OTOH, withdrawals from a Roth are tax free irrespective of whether the growth was from qualified dividends, interest, capital gains or unrealized appreciation.

Or another way, the qualified dividends distinction only applies to taxable account income, but not to tax-deferred or tax-free accounts.

Ok.. That clears it's up.

Also I realize that I would need to pay the taxes on the Roth conversion which would be in the upper 5 figures.

I wondering if I should rollover 1/2 of the company stock holding to a T-IRA and then convert to Roth IRA at age 60. That would soften the conversion taxes being paid.

If I do that, 1/2 of the dividend income would be taxed at ordinary income tax (non qualified dividend) and the other 1/2 would be tax free.

 

[G-Man]

I think the roth conversions should be treated separately from the dividend issue. I would build up Roth money based on your tax situation and expected future tax situation. You can always sell the stock in your 401k/TIRA and then buy the stock (or any other investment) in your Roth (neither the buys or sells have any tax impact).

When I officially retire (age 59), I am counting on the dividend income as a income source in retirement at least for a number of years. When I reach 70, SS will kick in and I don't need to realize on the dividend income any more.

 

[pb4uski]

Most importantly, you should seriously be thinking about your concentration risk having so much of your retirement money in a single stock. Dangerous to your financial health. Think Enron. Or GM.

Secondly, holding domestic equities in a tax deferred account converts preferenced income to ordinary income so it is better to hold domestic equities in tax-free or taxable accounts.

 

[G-Man]

Most importantly, you should seriously be thinking about your concentration risk having so much of your retirement money in a single stock. Dangerous to your financial health. Think Enron. Or GM.

Secondly, holding domestic equities in a tax deferred account converts preferences income to ordinary income so it is better to hold domestic equities in tax-free or taxable accounts.

Thanks for the advise as always pb4uski. I have been thinking about an exit plan for the concentration risk.

 

[G-Man]

I feel I'm in a great position as it relates to retirement. However, I think there are some opportunities to optimize my financial plan. That is what I will be focusing on until April 2025.

 

[TheWizard]

I feel I'm in a great position as it relates to retirement. However, I think there are some opportunities to optimize my financial plan. That is what I will be focusing on until April 2025.

One part of optimizing involves not paying either too much or too little income tax each year.
Use Roth conversions to keep your tax burden gradually growing from year to year, no big jumps...