The Money Mustache Community
Learning, Sharing, and Teaching => Investor Alley => Topic started by: J Boogie on September 11, 2015, 01:12:16 PM
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I'm 29 and new to this game, but I have always figured that the best times to roll a 401k over into a roth would be:
A - When income will be low so rollover taxed as income will be taxed in a lower tax bracket. (ours will be down almost 50%)
and
B - When stocks are down so amount rolled over will be at its lowest. (My 401k is currently down about 4% overall)
A few more relevant tidbits:
I live in MN. I make about 56k/yr, wife makes about 48k. She'll stop working full time probably in March or April, and will probably find part time work a year from in September. So I imagine our taxable income could be as low as 35-40k for 2016.
I'll have about 15k or so free to rollover. Staying with the company - they allow 2 rollovers a year, from 401k to Roth 401k. I'll continue contributing heavily (though maybe all the way to 18k/yr) to my 401k after doing this. We haven't started any Roth IRAs yet.
I figure it's a decent hedge against my wife and I either having big income during a few of our retirement years or taxes being much higher during our retirement years. Also since I can't roll it over to a Roth IRA until I leave my company this is a good time to pay the price on the rollover which will, in the future, not be taxed.
Any thoughts? Wise, foolish, or won't make much of a difference?
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You're right that lower-income years are better for Roth conversion than higher-income years, and Roth accounts do act as a hedge against higher tax rates in the future.
Some things to consider:
- At your income level the saver's credit comes into play. If you contribute enough to retirement accounts to get your AGI below $36.5k (and don't push yourself above that level with Roth conversions), you'll get a saver's credit that will almost certainly be high enough to offset your entire income tax before the refundable child tax credit. Between $36.5k-$39.5k, the credit will go down to $800, and will be $400 if your AGI is between $39.5k and $61k. If you make enough Roth contributions or conversions to push your AGI above $61k, you get no saver's credit.
- Also consider the Earned Income Credit. With one child and earned income around $35k, you can get about $1,400. This amount decreases until phasing out entirely around $44k
Both of these credits can affect the actual tax rate you pay on Roth conversions above and beyond your standard marginal rate. Note that you won't be able to qualify for either of them in retirement, so it's not like you're deciding whether to claim these credits now or later; it's now or never.
Note that if you do decide to go for Roth anyway, you might consider making Roth contributions instead of conversions. If you contribute $18k pre-tax and convert $10k, you pay the same tax this year as if you contribute $10k to Roth and $8k to pre-tax. With conversions there's a five-year waiting period before you can withdraw without penalty, but with direct contributions there isn't.
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Thank you for the advice Seattle Cyclone! I hadn't really thought about those options. Seems like the Roth Conversion should take a backseat to the other ways you mentioned to optimize savings.
I forgot to mention we're also looking to buy a duplex in early 2016. Between the interest we can deduct for that and interest on student loans, and the pre-tax money we'll be spending on having a baby, and the 401k, we're going to aim for that 36.5 figure. Thanks again!
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And when you retire your taxable income could be much lower than $40k. So that would be another great time to convert. But good on you for thinking about ways to optimize things now.
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That's my plan if I (hopefully) go to grad school. The combination of tax free growth/earnings before the conversion and a lower tax rate when converting is very attractive. The only downside is the 5-year delay before you can access funds, but as long as you have a separate emergency fund that shouldn't be an issue.
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Rather than roll over a big amount, why not just start contributing annually to Roth accounts?
At your income level, ~100k currently, you're solidly in the 25% marginal federal bracket (plus a bit in MN state tax and SS/medicare). Looks like in 2016 you are very likely to be in the 15% bracket. If you think you will stay in the 15% federal bracket thereafter, it may be easier/less headache to simply start contributing more toward a Roth going forward than to convert traditional to Roth?
Other complications: your employer (current) may not allow conversions, or there may be other issues. Check with HR and read through your disclosures. Be warned, I mentioned just changing your allocation to Roth going forward because this could take a lot of effort to get clear on your employer 401k plan rules.
At the end of it all, you're in an income range which over a long period of time is unlikely to be the target of significant tax increases. Of course, anything could happen, but just something to consider. Since no one knows what the future holds, the best way to deal is to have a bit of both. If I were you, I'd maximize my Roth accounts first (11k combined starting in 2016), and then put as much as possible in your 401k.
Things could change depending on your estimates of likely future income. If you think you'll stay in a similar range (inflation adjusted), then it won't make too much of a difference. If you see your income doubling or greater, then more Roth now might be helpful.