Hypothetical: John and Mary, both in their 60s and are delaying Social Security until 70. John is retired and has no earned income, but Mary does have significant earned income. Mary has new access to either 401(k) pre-tax or Roth 401(k) post-tax. The traditional wisdom is that Mary choose pre-tax to defer income at that age.
John is looking in his crystal ball and predicts tax rates now are as low as they will ever be, and doubts that current rates will remain in 2020, much less 2026. He has substantial money in tax deferred accounts, and has decided to convert an amount in 2018 to bring the couple MFJ to about $339k … the max amount of taxable income before getting into 32% marginal.
So now Mary is wondering why John would do a Roth conversion while Mary contributes to a pre-tax 401(k). Wouldn’t the result be the same if Mary went Roth 401(k), and John reduced his Roth conversion by $24,500? Well, no, John says. The difference is that John’s conversion will go into a Roth account that has aged for five years already. Mary’s would be a new one. Thus, Mary would have a 5 year waiting period before she could access earnings (though contributions access would be immediate). Thoughts on this; other considerations?
While it is a difference … We are talking ~ $10,000 ( assuming a 9-10% rate of return over the next 5 years ). By the sounds of your retirement situation ( i.e. this $10,000 is not substantial money for you in the scope of your entire retirement nest egg ), they are essentially equal.
I may not be following. In terms of return on the investment, both options should be equal. The difference that I’m seeing is access to the earnings.
My point was access to those earnings does not seem to be a substantial part of the retirement nest egg, i.e. It doesn’t sound like will they be down to their last $10,000 in savings over the next 5 years ?
ETA:
If this would be the first Roth contribution for Mary’s 401k. For simplicity sake, since you are doing a Roth conversion regardless, I would probably not introduce a Roth portion to Mary’s 401k.
The other issue is RMD, Roth IRAs do not have one, but Roth 401k’s do. But that also can be solved by a conversion when Mary retires.
The 5 year rules for people over 59.5 are pretty trivial to avoid. Both people should open and contribute a nominal amount to a Roth IRA to start the 5 year clock, if they haven’t already. If they planned ahead, this wouldn’t matter at all, and in practice is very unlikely to matter. 401ks that will be converted should be moved into Roth IRAs before withdrawing, even if converting within the plan to a Roth 401k first. This shifts the 5 year clock on the 401k to the one on the IRA, which should have been met as above.
In short, this is kind of a dumb example that should never arise.
That’s a very complete reference and it does have some enlightening information. Both John and Mary do have Roth IRAs that are greater than five years old. I was concerned that Mary’s Roth 401(k), if she goes that route, would have to meet its own 5-year test, but the article gives indication that is not the case.
I don’t know why you’d say that. John and Mary are real and are in fact facing this situation. They do happen to have old Roth IRAs so maybe that excuses them from being called dumb. But if they were high earners during their careers, they may have never had an opportunity to open any Roth IRA. Doesn’t make them dumb.
Well, you did say they were hypothetical or I wouldn’t have said that. As real people, I’m glad they won’t have any issues. As a hypothetical, it’s one of those “unask the question” situations.
Are you saying opening a Roth IRA without funding it is sufficient to start the 5-year clock? You sure can’t fund it if your income exceeds $199,000 (2018, MFJ).
[Update: I’ve searched several sources, including the excellent link xerty posted. It says “five tax years must pass from when the first contribution is made to (any) Roth IRA”. So I’m not understanding what you mean be no income limitation to opening a Roth IRA. There is to contribute anything to one. And until 2010, that limitation applied to conversions as well.
This issue doesn’t matter for the John and Mary scenario though, as both had a window of opportunity a decade ago to open a Roth IRA, and did.]
Get as much as you can out of IRA’s and convert to Roth’s before you reach 70.5 and are forced to withdraw. I have been dribbling out of my substantial IRA’s for a few years. Every November I pre calculate my taxes to maximize the amount I can convert from my IRA to a Roth without going into a higher tax bracket. I still will be forced to make withdraw’s from my IRA when I reach 70.5, limiting my tax strategy flexibility. I wish I would have been contributing and converting into Roth’s earlier.
There is also the IRMAA which is an increase in Medicare premiums and is a functional added tax. The real issue is at the margins, as if you blow $400,000 in conversions it won’t matter, but something to keep in mind. New IRMAA Medicare Premium Surcharges Taking Effect In 2018
Yep. And it gets complicated because IRMAA is not based on current income, but on your income two years prior. And you also have to think about tax on social security itself if 50% of your social security plus income exceeds a very low threshold.
There is the thread “Roth IRA Conversion Laddering” which covers this, with a lot of conflicting dialog. I’ll need to read through that more thoroughly and do more research before saying for sure, but I think my take-away from the thread (and rereading the link above) is this …
When we are talking about funds converted to a Roth, there’s a five-year clock on that amount of money. Thus, when you first opened a Roth account is irrelevant.
Right, but that’s not exactly the question you’re looking to answer. There’s definitely a 5 year clock on the money from the conversion, and each separate conversion. But what you really want to know the answer to (I think), is:
Does the conversion of funds start the 5 year clock on contributions of funds? In other words, if you convert $1 in 2011, then contribute $5,000 in 2016, can you pull out $5,000+earnings tax free in 2017? If that $5,000 in 2016 was a conversion, the answer would be no.
Specifically, you want to know whether that conversion is considered a contribution for purposes of starting the 5 year rule.
We may not be on the same page as far as the question. We’re steered away a little from the original post to this …
xerty said
to which I replied that they may never have had a opportunity due to income limitations. Then …
But at the end of the day, I think we’ve concluded that with respect to conversions, the time clock on any Roth accounts one might already have doesn’t matter. You still have a separate five-year clock on the amount converted.
Going back to the original scenario, it seems that John is wrong and Mary is right. John’s conversion into an old Roth account doesn’t buy them anything. There would still be a five-year clock no matter the age of the Roth IRA account it was converted into.
Mary, on the other hand is not harmed by her Roth 401(k) being a “new” account, as the five-year clock has already run on the Roth IRA that she’s had for a decade. If her employment ends, can she just move that Roth 401(k) money into her Roth IRA, and then have immediate access if needed?