Questions about converting Traditional 401k into Roth 401k

[Hoopz]

If I invest this year in a traditional 401k, as I understand it, I can then convert it to a roth 401k at a later date.

 

My questions are:

• When I convert to Roth, will I be paying tax based on the tax bracket I'm in when I do the conversion? So if I'm unemployed when I convert, do I pay less tax on the Roth than if I were to open a Roth while employed?


• Are there typically any fees associated with converting?


• Is there a time limit? or can I convert at any time?

 

I'm looking into this is because I'm thinking about becoming a stay at home parent. I want to get the tax benefits from contributing to a traditional 401k while I'm employed, and I also want to be taxed less when I eventually convert to a roth 401k.

 

Ultimately, I want a roth 401k. The decision for me is whether I go traditional and convert to roth, or go roth right from day one.

[PhysicianOnFIRE]

Your ability to convert may depend on the company.  You should be able to check with the plan administrator.

You should definitely be able to roll it over to a traditional IRA if you were to leave the job.  In that case, you could convert some each year to Roth IRA, and pay tax on the converted amount at your marginal tax rate, which would most likely be lower than it is now.

I wouldn't expect there to be fees, just taxes, although I suppose that depends on the company as well.

No time limit.  You can convert as little or as much as you want each year.  A good strategy would be to convert at the end of the year up to the top of your current tax bracket without going over.

 

[PenguinMD]

Hmmm, haven't heard of a plan allowing that but maybe.

In your scenario it could play out like:
- Contirbute to the trad 401k while working to get the tax deferral benefit
- Become a stay at home parent
- Now when your household income is low do the conversion
- Roll-over to a traditional IRA
- Convert the traditional to a Roth IRA

Pay the tax (presumaly lower than you would since it's less income).

That could work, just make sure you have money to pay the tax, especially now that your household income dropped.

[litovskyassetmanagement]

Hoopz wrote:

If I invest this year in a traditional 401k, as I understand it, I can then convert it to a roth 401k at a later date.

 

My questions are:

• When I convert to Roth, will I be paying tax based on the tax bracket I’m in when I do the conversion? So if I’m unemployed when I convert, do I pay less tax on the Roth than if I were to open a Roth while employed?


• Are there typically any fees associated with converting?


• Is there a time limit? or can I convert at any time?

 

I’m looking into this is because I’m thinking about becoming a stay at home parent. I want to get the tax benefits from contributing to a traditional 401k while I’m employed, and I also want to be taxed less when I eventually convert to a roth 401k.

 

Ultimately, I want a roth 401k. The decision for me is whether I go traditional and convert to roth, or go roth right from day one.

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I doubt you can do this with any current custodians.  The only way you can do this is with a custom document:

https://www.whitecoatinvestor.com/improving-the-vanguard-individual-401k-with-a-customized-plan

If you have a plan document, you can have your solo 401k at any custodian.

You might be able to make a distribution into a Traditional IRA, convert to Roth IRA, and maybe move the money back into the solo 401k (if the custodian allows incoming rollovers), but that's quite a complex and lengthy process to complete every year.

To answer your questions:

• When I convert to Roth, will I be paying tax based on the tax bracket I’m in when I do the conversion? So if I’m unemployed when I convert, do I pay less tax on the Roth than if I were to open a Roth while employed?

Yes, most likely.

• Are there typically any fees associated with converting?

No.  However, your TPA would have to document all of the transactions since the custodian won't have any part in this.  You will need to pay your TPA for this service.  You will also have to file form 5500 once the assets are over $250k, so I would hire a TPA anyway if you want to do complex transactions such as in-plan Roth conversions, as you have to follow the rules (and make sure that your form 5500 is filled out correctly).

• Is there a time limit? or can I convert at any time?

You can convert at any time.  Here's what you can convert:

https://www.irs.gov/Retirement-Plans/Designated-Roth-Accounts-In-Plan-Rollovers-to-Designated-Roth-Accounts

 

[jfoxcpacfp]

Since you are considering being a SAHP, I believe what you are considering is contributing to your employer's 401k now, then quitting work and rolling out to a Roth IRA. This is easily done and you should time it according to when you are in a lower tax bracket. I see no need to contribute to a Roth 401k now when you are in a higher tax bracket. Of course, if you continue to work as self-employed after leaving your current job, you can then set up a SOLO 401k and later roll into a Roth as your tax projections permit.

Fees depend upon your custodian.

Apologies if I didn't read between the lines correctly.

[Hoopz]

thank you for all the replies. I have no experience in this area so this has been very educational. What it seems I should do is go with Traditional 401k now so I can take advantage of the tax breaks. Once I leave my job, I can roll the traditional 401k over to a Roth IRA and pay lower taxes since I will be unemployed. If I understood the advice correctly, this seems like a smart option for me.

 

[PhysicianOnFIRE]

Hoopz wrote:

thank you for all the replies. I have no experience in this area so this has been very educational. What it seems I should do is go with Traditional 401k now so I can take advantage of the tax breaks. Once I leave my job, I can roll the traditional 401k over to a Roth 401k and pay lower taxes since I will be unemployed. If I understood the advice correctly, this seems like a smart option for me.

 

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It's more likely you will roll the traditional 401(k) into a traditional IRA when you separate from your employer.  Then, each year in retirement, you will convert a portion of the traditional IRA into a Roth IRA.  How much depends on a number of factors, mainly your marginal tax bracket, but you may also be looking at phase outs of different tax credits, deductions, ACA health insurance, etc...  You will be able to control your taxable income with the amount converted each year.

If you convert it all to Roth in one tax year, you will likely lose most or all of the benefit of tax arbitrage.

[Hoopz]

So perhaps the question I should be asking is, should I go with Traditional 401k or Roth 401k? All the reading I've done says that I should be going Traditional because I'm in a high tax bracket. With that said, Roth is appealing to me because you pay tax now, on a smaller sum, and then don't need to worry about it ever again.

[jfoxcpacfp]

My recommendation is the TIRA if you are planning on leaving the workforce in the next couple of years and your income will decrease significantly. You might consider setting aside the tax savings you get by contributing to the TIRA until you quit working and use it to pay some of the tax on the conversion when you move to a Roth. Remember, you don't have to move 100% of the account at once - do your tax planning.

[Hoopz]

What's a TIRA?

 

EDIT: traditional IRA. Took me a second.

[jfoxcpacfp]

I apologize for the shortcut!

[PhysicianOnFIRE]

I would still go traditional now.  If your marginal tax bracket is 40 to 50% (federal + state + medicare +), it costs $18,000 to contribute to the Roth.  It costs $8,000 to $10,000 to contribute to traditional.  You're likely to pay tax in a lower bracket when you withdraw from the traditional.

See this highly entertaining thread on the SDN forum that addresses this exact question.

[litovskyassetmanagement]

PhysicianOnFIRE wrote:

I would still go traditional now.  If your marginal tax bracket is 40 to 50% (federal + state + medicare +), it costs $18,000 to contribute to the Roth.  It costs $8,000 to $10,000 to contribute to traditional.  You’re likely to pay tax in a lower bracket when you withdraw from the traditional.

See this highly entertaining thread on the SDN forum that addresses this exact question.

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This is about diversifying your future tax liability and at the same time 'weighing' your contributions to a more advantageous type of account as your situation changes.  I'd recommend Roth/backdoor Roth regardless of your income level.  I'd also recommend maxing out tax-deferred for those in high tax brackets.  You should still be contributing some after-tax money into a tax-efficient portfolio.  Of course, if your income dips and/or you stop working, converting to Roth is a great idea, and so is making more Roth contributions vs. tax-deferred ones if you are in a lower tax bracket.  Those in lowest brackets might want to use Roth contributions exclusively.  That said, those in high tax brackets are also not far behind - they have the ability to make Roth conversions when they retire.  The end game is to build a tax-diversified portfolio so that at retirement you are able to minimize your taxes and RMD by converting as much as you can of the tax-deferred assets into Roth.  This can be done inside a 401k plan (if you have a solo 401k or a practice 401k), and if not, then converting parts of your traditional/rollover IRA to Roth.  This game is all about amounts and timing, so before doing anything having to do with taxes, I'd suggest creating a tax planning spreadsheet (and/or consulting your CPA or adviser) to make sure that the numbers work in your favor. When it comes to actual distributions from retirement accounts (and figuring out the amounts and timing of Roth conversions), that's another ballgame altogether.

[jfoxcpacfp]

>>I’d recommend Roth/backdoor Roth regardless of your income level.<< Wow, Kon Litovsky, given that the original question pertained to becoming a stay-at-home parent, why would you recommend forgoing the deduction when Hoopz is at (presumably) peak earnings rather than conversion when income dips? With all due respect, not sure I would need a spreadsheet to figure that one out.

[litovskyassetmanagement]

jfoxcpacfp wrote:

>>I’d recommend Roth/backdoor Roth regardless of your income level.<< Wow, Kon Litovsky, given that the original question pertained to becoming a stay-at-home parent, why would you recommend forgoing the deduction when Hoopz is at (presumably) peak earnings rather than conversion when income dips? With all due respect, not sure I would need a spreadsheet to figure that one out.

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Well, for one thing, Traditional IRA is non-deductible at higher income levels, so there isn't much we can do about that.