How to pay for a Roth 401 (k) conversion

For some, the newly authorized ability to convert money from a 401 (k) account to a Roth 401 (k) account as part of an actively employed plan opens up new possibilities for tax planning. Our first question relates to some reasons for not rushing into the execution of such a conversion, in particular the question of the payment of the taxes due. I also provide a quick response to a question about the NUA and an ESOP and Social Security benefits for a widow.

Q.In a previous column on the conversions in the 401 (k) funds plan to Roth 401 (k), you wrote “… you must have money outside of your plan to pay taxes on the conversion or the attractiveness of a plan Conversion drops off dramatically. You may be able to access plan funds to pay taxes through a loan, but this has its own negative impact s … “Could you discuss this further? – TG

A. I would be happy to do so. The decision to execute a conversion in the 401 (k) money plan to a Roth 401 (k) is similar to converting a traditional IRA to a Roth IRA. If you expect your tax rate to be higher in the future when you access your funds, you should consider a conversion. The idea is to pay taxes now so that no tax is due later when the higher rate applies. If a conversion makes sense to a family, generally the more it can be converted at today’s favorable tax rate, the better. The lower your marginal rate today, the better the chances that a conversion will pay off.

If you convert $ 10,000 while in a 25% marginal tax bracket, paying with outside money means that every $ 10,000 and the growth of it would be available tax free. in the future. If you pay from the retirement account, only $ 7,500 would be affected. Then there is the tax treatment.

Converted amounts and amounts withheld for taxes are all treated as taxable income. Taxable income from IRAs and 401 (k) is taxable income subject to a 10% early withdrawal penalty, with some exceptions. Amounts converted to Roth treatment are exempt, but amounts that pay tax are not. Therefore, for taxpayers under 59 1/2, the rate used to determine whether a conversion might be a good idea increases by 10% if the taxpayer plans to pay taxes with 401 (k) funds.

In the example above with $ 2,500 withheld, only $ 7,500 was actually converted. If you grossed up the amount to $ 13,333.33 so that after you withhold 25% all of the $ 10,000 has been converted, you still aren’t converting all of the gross income. This additional $ 3,333.33 is subject to a penalty.

Ten percent may not seem like a lot until you translate that into income levels. For example, for a married couple filing jointly, the marginal rate is 25% for taxable income between $ 72,501 and $ 146,400. For a conversion to be advantageous after adding a 10% penalty, the taxable income of this couple would have to exceed $ 450,000 under the current tax system to reach a marginal bracket above 35%. It’s not that simple due to things like phasing out exemptions and deductions and new taxes on net investment income, but you get the idea.

Borrowing on a 401 (k) is quite easy (no credit check for example) and would not subject the money to the 10% penalty, but borrowing has some drawbacks. Although you pay yourself interest, it is paid with after-tax money. As long as the loan is outstanding, interest is all it will earn. He will not be able to stay invested. Some plans do not allow employees to receive matching funds until their loan is repaid. It’s spending free money. If you terminate your employment, the loan must be repaid, usually within 60-90 days, otherwise the outstanding loan balance is considered a distribution and therefore is taxable and subject to the pre-59 1/2 penalty.

Two final thoughts. Keep in mind that unlike a traditional IRA conversion to a Roth IRA conversion, in-plan conversions cannot be “recharacterized”, the IRS term for “reversed”, so you better be confident in your choice. . Also, while the law allows these conversions, it does not require your plan to offer the conversion functionality within the plan. If your plan hasn’t been changed to allow conversions within the plan, you can’t.

Q.I was made redundant by a Canadian company, worked there for about eight months and participated in ESOP, do I qualify for this NUA you are talking about? – DX

A. You will need to check with your benefits department to see if ESOP is a US-based pension plan and therefore subject to US tax rules. If they are based in the United States, they should know how to properly administer a distribution for the treatment of unrealized capital gain. If you have a plan document, a clue can be found in the title. In the United States, ESOP is the abbreviation for “Employee Stock Ownership Plan” but in other countries it is often “Employee Share Ownership Plan” but the title is not definitive.

Q.My husband passed away five years ago. He was 60 at the time and due to his cancer had to retire early … my age at the time was 50. I am now receiving his retirement. Will I also get his Social Security when I turn 60 or will I lose my retirement … no I don’t work. -P.

A. If he would have received Social Security retirement benefits, you should be entitled to Social Security survivor benefits. Since he died before the start of his benefits, your full widowhood benefit is based on the benefit he would have received at the age of full retirement. You can withdraw this amount from your full retirement age (FRA). If you start before your FRA, your widow’s benefits are permanently reduced. If you start at age 60, your payment would be 71.5% of the full benefit. For each month that you wait past the age of 60, the more you will receive the full benefit.

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