Changes in IRS (Internal Revenue Service) rules invariably spur some head scratching for taxpayers—even when a new rule is supposed to make something easier. The 2008 rule change regarding conversions of a 401(k) or other employer retirement plan to a Roth IRA is no exception.
"There has been some conversion confusion," notes Dennis Zuehlke, compliance manager for CUNA Mutual Group, a financial services provider for credit unions and their members worldwide, in Madison, Wis.
Up until Jan. 1, 2008, you had to follow a two-step process to roll over a qualified employer plan—such as a 401(k), 403(b), or 457—to a Roth IRA (individual retirement account). You first had to roll over the plan funds to a traditional IRA, and then convert the traditional IRA to a Roth IRA. The new rule lets you skip the first step and roll over directly to a Roth IRA.
This is a more streamlined process, but it's not without complexities and potential for mistakes—mistakes that can be costly to you, given the huge amount of money typically involved.
Here are a few pointers to help you get the best possible result with your conversion.
First, Zuehlke points out, consumers need to be aware of eligibility requirements to convert from a qualified plan to a Roth IRA. "You need to meet the same tests for income and tax-filing status as you do in moving money from a traditional IRA to a Roth IRA," he says. He adds that you can only convert an eligible rollover distribution to a Roth IRA, and the plan administrator will tell you if you meet this test.
In 2008 and 2009, you must have an annual modified adjusted gross income of no more than $100,000. And you must be either single or married filing a joint return. If you're a married person filing a separate return you can't convert funds.
Your conversion amount does not count in determining if you're below the income limit. You might have a rollover amount of $200,000, for instance, but if your modified adjusted gross income is $100,000 or less, you can convert funds.
The restrictions related to income and tax-filing status will go away, however, Jan. 1, 2010. Then conversions to Roth IRAs will be permissible no matter what your modified adjusted gross income may be or how you file your tax return.
If you're over the income limit now, you could wait to convert to a Roth IRA in 2010, parking your rollover money in a traditional IRA in the meantime. Your employer also might allow you to leave the funds in the 401(k) or other plan for the interim.
When the time comes to transfer funds from your qualified plan to an IRA, you can opt for a direct rollover, also known as a trustee-to-trustee transfer. That means the money moves directly from the qualified plan to the IRA account—which could be a traditional IRA, a Roth IRA, or you might put some funds into each type. Funds you have in a Roth 401(k), however, must roll over to a Roth IRA.
You also can opt to receive the funds yourself, and then you have 60 days to put the money into an IRA. If your employer writes out the check to you, that's considered to be a distribution, in which case the IRS requires your employer to withhold 20% up front to cover taxes.
Most often, the transfer occurs by direct rollover. Notify your credit union (or wherever you have your IRA account) in advance that the check will be coming from your employer's plan. Find out what information your credit union will need so that when the check arrives, the money will end up in the correct account.
"That way you'll make sure they don't just plunk it in a traditional IRA instead of a Roth IRA," Zuehlke points out. "More often what happens is that the distributing plan doesn't correctly identify [the intended destination]. The financial institution gets the check and may end up putting it into a non-IRA account, which can be a problem."
You'd then have 60 days to move that money into an IRA. "But a lot of times," Zuehlke cautions, "members don't realize that the funds went into the wrong account until after the deadline for converting."
You must pay income taxes when you convert funds from a 401(k) or other qualified plan to a Roth IRA. That's because contributions you made to your 401(k) were tax-deferred. You put that money away and paid no taxes on it.
But with a Roth IRA, you pay taxes at the front end. Then someday you'll withdraw contributions and earnings tax-free—as long as you're older than age 59½ and have had the account for at least five years. (You also can take up to $10,000 tax-free from a Roth IRA, at any age, to buy your first house—if you've had the account at least five years.)
Converting to a Roth IRA can trigger a dramatic change in your tax situation. If your plan distribution is $200,000, and your annual income is $80,000, your taxable income jumps to $280,000. "You're going to pay out a substantial amount of money in taxes," Zuehlke says. "So check with a tax adviser to be sure this is the right decision for you."
The IRS provides a way to ease the impact of the tax bill—if you wait until 2010 to do the rollover to a Roth IRA. You'll be allowed to spread the tax bill over two or three years, according to Zuehlke, rather than having to pay it all in one tax year.
Think, too, about how you'll pay the tax due. If you can't pay it out of other financial resources, you'll need to take money from the rollover itself. But you'll pay a 10% penalty if you're younger than age 59½ and have had the Roth IRA less than five years. So you'll suffer another financial hit.
Another option: You could roll over your qualified plan funds to a traditional IRA instead of a Roth IRA. You'd pay no income taxes now, but taxes will be due when you withdraw the money. Will you be in a lower income tax bracket at that time?
Another factor to weigh is that with a traditional IRA, you must start taking minimum required distributions at age 70½. With a Roth IRA, you have no minimum required distributions—ever. The money can sit there as long as you wish, even until after your death.
"You can shelter money from taxes for a longer period of time," Zuehlke notes. "Your beneficiaries also will benefit because the money in a Roth IRA moves tax-free to them, just as it would have been tax-free to you."
Again, sorting out your best move demands professional tax advice, Zuehlke emphasizes. "It's more than just checking a box on a form," he says. "If you have $100,000 to roll over, the difference between checking 'traditional IRA' and 'Roth IRA' could be a $30,000 or $40,000 tax bill."
Still, for many people, it's worth paying that tax bill now, so as to reap the tax-free benefits later. It's up to you to get guidance tailored to your circumstances.
"People are rolling over what may well be the single largest chunk of cash they'll ever get in their lives," Zuehlke says. "But too often they don't ask any questions, and they end up making unwise decisions."
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