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3 FAQs About 401k Retirement Plans

Laura answers reader questions about 401ks and 403bs, including what happens to your account if you get divorced, how to handle a retirement provider that doesn't seem reputable, and how to pay taxes when you convert a traditional plan into a Roth IRA. 

By
Laura Adams, MBA
7-minute read
Episode #424

Retirement Question #3: 

Jon says, “I recently completed my doctoral fellowship and will be starting my career as a physician next year. In a few months my income will go from $55,000 to $250,000.

I have a traditional 403b worth $1,500 and about $20,000 in a pension plan. I’m considering rolling them over into a Roth IRA; however, we have no money to pay extra taxes this year. Would the tax be automatically deducted or would we owe more tax in April?”

Answer: As Jon mentions, converting traditional retirement funds into a Roth IRA triggers taxes. That’s because traditional accounts are funded with pre-tax dollars and Roth accounts can only have after-tax dollars.

The benefit to having a Roth is that after you pay tax upfront, you never pay tax on contributions or earnings in the account again. Unlike a traditional retirement account, when you take withdrawals from a Roth to spend in retirement, they’re completely tax-free. That can give you huge tax savings!

There are some other nice benefits to a Roth IRA, such as being able to make contributions at any age, and never having to take minimum distributions in retirement.

The downside to a Roth IRA is that when your income exceeds certain limits, you’re not allowed to contribute to it. In other words, if you’re a high earner, you can own a Roth IRA and let it grow on a tax-free basis indefinitely, but you can’t add additional funds to the account. 

For 2015, the income cutoff for a Roth IRA if you’re married and file taxes jointly is $193,000. If you’re single the income limit is $131,000. Since Jon will earn $250,000 next year, he can have a Roth IRA, but he won’t be eligible to contribute to it.

Regardless of your income, you can convert a traditional retirement account into a Roth IRA by paying income tax on the account balance. Since that can be a big tax bill, I generally don’t recommend it.

However, since Jon’s income is about to go up substantially, this is an ideal time for him to do a Roth conversion. He’s earning $55,000 now, which puts him in a much lower tax bracket than he’ll be in next year. So converting sooner rather than later will save him a heap of taxes.

Making an early withdrawal is just too expensive, and it also puts a huge dent in your potential future gains in the account.

But I don’t recommend tapping a retirement account to cover the taxes on a Roth conversion. Early withdrawals are subject to both income tax and an additional 10% penalty if you’re younger than age 59½.

Making an early withdrawal is just too expensive, and it also puts a huge dent in your potential future gains in the account.

Tax on Jon’s 2015 Roth conversion would be due on April 15, 2016. To find out how much he’d owe, he should ask his retirement account custodian or a tax accountant.

Since Jon will have much more income soon, I’d recommend that he do a 2015 Roth conversion and begin saving for the taxes. If for some reason he can’t come up with enough cash by mid-April, he could always reverse the conversion, which is called a recharacterization.

A recharacterization could be completed anytime before October 15, 2016. It could apply to all or just a portion of what he converted into a Roth. Doing a partial conversion means that he’d have a smaller tax liability.

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About the Author

Laura Adams, MBA

Laura Adams received an MBA from the University of Florida. She's an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura's previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.