401k to Roth /client is not 591/2 pays taxes and penalty
starting 2008 IRS started to allow direct rollover to Roth from 401(k) but it is a taxable event. who really benefits from this type of transaction. we have a client that wants to rollover his 100,000.00 401(k) money into Roth and he is not 591/2. would he benefit from that? he has to pay taxes and penalty? taxes would be something like 20,000 to 30,000.00 and then penalty on top of that. this client wants to pay the taxes out of his 401(k) or IRA if possible. is that possible or does IRS penalize him?
Permalink Submitted by Alan Spross on Wed, 2009-06-03 23:56
There is no early withdrawal penalty for a Roth conversion, however if tax withholding is elected from the 401k distribution, those funds are NOT converted. Instead they are sent to the IRS as withholding and that portion would therefore incur the 10% penalty as well as ordinary taxes. When determining if any particular transaction is beneficial in the long run, a number of factors would need to be analyzed. But if withholding from the distribution is elected, the conversion is that much more likely to be unwise because the penalty has the same effect as an added 2% to the marginal rate (10% of 20%). In addition, the withheld amount is lost to any tax deferred account.
If the client has after tax amounts in the 401k, they would not be subject to tax or penalty in the conversion. The higher the after tax amount in the 401k, the more advantageous the conversion would be. If the plan allows periodic distributions or conversions, perhaps client would be better served to convert incremental amounts over a period of years and pay the taxes from outside funds.
Permalink Submitted by Joseph Arsenault on Thu, 2009-06-04 16:43
Many people would benefit from the transaction if performed correctly (See Alan’s Post). There is no mathematical advantage to converting to a Roth IRA if you pay the taxes from within the account and tax rates stay the same. However, there will usually end up being a benefit if you pay the tax liability with outside assets.
Being able to pay the income taxes on a conversion to a Roth IRA from outside assets allows a taxpayer to move assets from a taxable environment to a tax-free environment.
Also, you will eliminate the requirement to take required minimum distributions at 70 1/2.