401k to Roth IRA conversion and taking early distributions

Submitted by Tyler Ramsey on Thu, 2014-04-03 20:25

Had a client present a scenario, and just want to make sure I answer it with the correct info:

here is a scenario: so I am 36 years old, making 50300 a yr, investing 15% to my 401k. for the 2013 yr my rate of return was 34% (2014 beginning balance of $37800). lets say I keep investing and my return does the average 12% (market average). when I hit 50 yrs old I decide to quit my job and roll my $ to a roth IRA. obvious that I would pay taxes at the time of the rollover, so if I decide to take distributions of $60,000 a yr,

1. would I have to pay penalty only on the $60,000?
2. wouldn’t the balance that I did NOT withdraw keep being invested?
3. wouldn’t I be in the 15% tax bracket?

Thanks



Submitted by Alan - IRA critic on Thu, 2014-04-03 22:03

  1.     Yes, for the first 5 years only
  2.     Yes
  3.     Not with this income only because it is not taxable. If you considered the penalty to be equivalent to a tax bracket, then you would be in the 10% bracket.
  4. Note that if you planned to retire at 50 with this income only, you would probably run out of money early in retirement because you would be taking out around 10% a year. The usual rule of thumb is not to exceed 4%, and it would also be risky to keep everything in stocks.
  5. You would never convert the entire balance in one year because the taxes due would be in the top bracket. In fact, it you retired with no other income you would probably not convert any of it because if you did not convert, and only took out the recommended 4% per year, you would not exceed the 15% bracket. Tax rate depends on marital status and if spouse has income.

 

Submitted by [email protected] on Tue, 2014-04-08 18:59

why is 1. “Yes, for the first 5 years only?”wouldn’t the client still be under A 59 1/2 and be subject to the qualified distribution rules? I suppose you are assuming he would be pulling contributions only until he’s over 59 1/2 when earnings would come out?Thanks,

Submitted by Alan - IRA critic on Tue, 2014-04-08 19:17

The first dollars into this Roth IRA will be from conversions. Conversions must be held 5 years or until 59.5 to avoid a 10% penalty. Once the conversion amounts are distributed, since there are no regular contributions in the Roth, any earnings would be next out, and they are subject to both tax and penalty until age 59.5 is reached AND a 5 year holding period. This is a different 5 year holding period, but in this case they run concurrently because the Roth was started with a conversion.

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