Question: Do the changes from the recent tax legislation have any impact on taxes for those with incomes under $450,000 regarding their withdrawals from deferred compensation and 401k plans? D. D.
Answer: One item that is new under this tax law is that everyone with money in 401k or similar plans is allowed to convert part or all of those funds into a Roth account within the employer’s plan. Converting your 401k to a Roth has some advantages as well as a number of disadvantages.
· Money held in a Roth plan grows tax free and withdrawals during retirement are also income tax free.
· Whereas a traditional IRA mandates that you begin Required Minimum Distributions (RMDs) beginning at age 70 ½, Roth IRAs never mandate distributions. Many retires don’t need the money from their retirement accounts so having a Roth IRA allows those people to let their money grow as long as they live without taxation. If you don’t need the money this would be a great asset to pass along to your children or grandchildren. They would be required to begin taking distributions based on their life expectancy but any withdrawals would also be free of income taxes! In order to avoid RMDs on your Roth 401k plan, you would need to roll it over to an individual Roth IRA at retirement.
· If you convert money from your 401k to an employer Roth plan, the conversion will be treated as ordinary income in the year of conversion. For example, you decide to convert $25,000 from your 401k plan to your employer’s Roth plan. You’ll owe income tax on the $25,000 so you must make certain that you have the funds outside of your plan to pay the taxes.
· A conversion might throw you into a higher income tax bracket. You’ll want to do a ‘trial’ tax return to be sure you don’t inadvertently owe more taxes than you expected.
· When converting a traditional IRA to a Roth IRA, the law allows you to ‘look back’ before you file your tax return and decide if it was a smart tax move. If not, you are allowed to ‘recharacterize’ or reverse the transaction. For example, say you converted $50,000 of your traditional IRA in January of this year to a Roth IRA. You estimate that the income taxes associated with the conversion will be $15,000. At the end of the year a bad stock market results in your Roth IRA account now being worth $30,000. You’re still going to owe the $15,000 in income taxes so now the idea doesn’t look so great. Well, you can choose to undo the transaction. You could then choose to do another conversion now using the smaller $30,000! Under the new 401k conversion rules, you are not allowed to recharacterize the transaction. Therefore, you must be certain that under any circumstances, you have the money to pay the taxes.
· Only about half of employer’s retirement plans allow for a Roth conversion. If your plan does not allow Roth contributions, ask your employer to amend the plan.
So who is this strategy best for? First, it should be someone who has the cash to pay the taxes. This also might be a good strategy for someone who is younger in their career and in a lower income tax bracket but who expects to advance in their career and be in a higher tax bracket later.
While not part of the new tax package, under Obamacare, there is an additional 0.9% Medicare tax on income above $200,000 for single filers or $250,000 for joint filers. So if you take a distribution from a deferred compensation plan that bumps you above these thresholds, you’ll be subject to this new tax. And to the extent that you have investment income, crossing these thresholds will also subject your investment income to the 3.8% Obamacare surtax.