401k rollover to roth IRA, two step or not?

Submitted by [email protected] on Fri, 2012-02-24 22:29

Due to change in employment we have the option to rollover an existing 401k to a self directed IRA or to the new employer 401k plan. We fall in the higher income category that normally prevents us from funding a Roth IRA directly (though we can do conversions now). So if we wanted to rollover the 401K to a Roth IRA does it need to be a two step process (i.e. into a Traditional IRA and the do a conversion) or can be just have it rolled over directly at once. (I assume either way we will receive a 1099for tax purposes).

Thanks for your insight
George



Submitted by Alan Spross on Fri, 2012-02-24 22:50

You can do the rollover either way, but you may not want to get hit with the tax bill for a large conversion, which may increase your tax rate. Your employer probably allows you to split the distribution between a direct rollover for a portion to a TIRA and the rest to a Roth IRA, with only the Roth rollover portion added to your taxable income.

If they do not allow you to split the rollovers, then you could roll the entire amount to a TIRA in a direct rollover and from there convert the amount you wish to be included in taxable income.

One factor that should be considered is whether you have after tax amounts in the plan that could be converted tax free. In that case, you may want to investigate ways to “isolate the basis”. That would allow you to convert the after tax amount tax free with or without some of the taxable balance. Post back if you have an after tax balance significant enough to consider this.

NOTE: Remember that if you converted in 2010, you may already have an amount of additional taxable income from that year to report in 2011 and 2012.



Submitted by george yuen on Sat, 2012-02-25 07:48

After putting some more thought to this my preference is to rollover the 401k (about 200K) to a traditional IRA only (I want to pay the least taxes possibly at this time). One issue is that I already contributed in early January this year 5K to a non-deductible IRA and did a backdoor Roth IRA conversion. This was done at a time when I had no other IRA balance and would not have paid any taxes on it. If I now fund this new rollover tIRA would that 5K conversion now be subject to being taxed as if it was proportionately withdrawn from the new mix?
If that is the case then could I recharacterize the conversion to avoid paying taxes? and is there an option to undo the non-deductible IRA once recharacterized so I won’t have to file form 8086 going forward.
Thanks for your helpful opinions



Submitted by Alan Spross on Sat, 2012-02-25 18:48

You are correct. If you do the rollover to a TIRA this year, your recent conversion will be 97.6% taxable based on 12/31/2012 adjusted values. If that is not acceptable you could:

1) Delay the rollover until next year if that does not exceed the plan deadline to execute the rollover option
2) Recharacterize the conversion back to a TIRA, but that leaves you with 8606 basis as long as you have a TIRA, and the resulting pro rate rules
3) Recharacterize the conversion and then request a return of your original contribution plus/minus earnings

The main decision is comparing the benefit of doing on going back door Roth contributions vrs the benefits of having the 200k in your TIRA instead of the 401k plan. Since the 200k is so much more than backdoor Roth contributions it may come down to the investment options and expenses in the plan vrs what they would be in an IRA. Plans will be required to fully disclose their expenses to employees by mid summer. It would be helpful if you had that information before the rollover deadline.



Submitted by [email protected] on Mon, 2012-02-27 07:46

Hi Alan

I am considering option 3 as you stated; having that substantial amount of money in a TIRA makes more sense in terms of fees/investment options over the 401k plan. I will forego doing future backdoor Roth IRA conversions (hopefully in the future they will lift the income limit for direct Roth IRA contributions–any insights on this possibility?).
My question is after I recharacterize the Roth back to a non-deductible IRA and then request return of original contribution plus/minus earnings, are there any penalties, taxes, filing of forms involved? Is this the same as a early withdrawal/distribution from an IRA or is there a term to describe the process to undo the IRA that the custodian (Charles Schwab) should do?



Submitted by Alan Spross on Mon, 2012-02-27 16:47

You would ask Schwab [b]to return your specific contribution [/b](whether for 2011 or 2012). Schwab will calculate the earnings that must be returned in addition. Those earnings are taxable IN the year you made the contribution (2012) on line 15b of Form 1040, and subject to 10% penalty. You should also include an explanatory statement on what you did. That would include the amount of the contribution, the conversion and recharacterization of the conversion and the final withdrawal of the contribution with the amount you received. You would be consolidating two statements into one this way.

You would not need an 8606 because you withdrew the contribution and recharacterized the conversion.

The direct rollover of the pre tax 401k would be reported on line 16a and 16b of Form 1040 with -0- on 16b and “rollover” entered on the line next to 16b.

There are no active proposals in Congress to increase the income limit for regular Roth contributions, so the odds of this happening in the next 5 years is probably less than 10%.



Submitted by [email protected] on Tue, 2012-02-28 06:55

Please clarify if the 10% penalty for withdrawing/undoing the non-deductible IRA is only on the earnings (if any) or would it apply to the whole withdrawn amount of about 5K (like an early distribution penalty)?

Thanks



Submitted by Alan Spross on Tue, 2012-02-28 17:00

Only on the earnings, if there are earnings.



Add new comment

Log in or register to post comments