roth conversion of part of an account

Submitted by Richard Stumpf on Thu, 2018-04-19 23:31

Hi,

Client has a cash balance plan worth 800,000. Age 56. Client just changed jobs, money is still in the old plan. The old plan has an all or nothing rule, ie either leave it all in or take it all out, can’t take out partial distributions.

Client would like to roll 400,000 to an IRA, convert 200,000 to a Roth (assumes they will be in an equal or higher bracket in the future), and keep the remaining money in after tax cash. But to avoid the 10% penalty using the after age 55 rule, combined with the all or nothing plan, I’m not sure how to make all this happen.

Here’s my thought:

Take a total cash out distribution of the 800K. Plan will withhold 20%, or 160K.

Client rolls 200K to a Roth
Client rolls 400k to an IRA

Leaves 40K in cash.

Next April gets an 80K refund from what was originally withheld.

We avoid the 10% penalty, fund the IRA, convert to the Roth, and leave after tax cash.

Any holes in my logic?



Submitted by Alan - IRA critic on Fri, 2018-04-20 00:12

  • Since client is still working, his taxable income is going to really spike if he adds 400k in taxable distributions to it. Since he can no longer recharacterize the conversion, he may want to rethink converting that much. In addition, it sounds like he does not have the funds available to pay the conversion taxes without withholding from the conversion distribution, which means that less money goes into the two IRA types.
  • All distributions will be exempt from the 10% penalty due to the age 55 separation exception.
  • The 20% mandatory withholding is only required for amounts that he does NOT roll over.

Submitted by Richard Stumpf on Fri, 2018-04-20 16:10

Because of the all or nothing rule on the retirement plan, we are going to have to do a taxable distribution of the whole amount.  So they will withhold the 20% on the full amount, with client getting a refund on the amount that is finally rolled over.  That’s the only way I can figure out how to use the 10% penalty exemption rule on the part they want to keep in after tax cash.  Client understands the tax hit, has talked to her accountant about it, and still wants to do it.    Do you know of any Roth conversion calculators that compute the values if you have to use IRA funds to pay the taxes?  The ones I normally use all assume outside dollars to pay the taxes.

Submitted by David Mertz on Fri, 2018-04-20 20:22

  • It seems unlikely that the client will get back $80k of this as a tax refund.  Since the client is working, unless the client has some way to claim significant losses to offset the income, the increase in federal tax liability resulting from the $400k of ordinary income resulting from all of this very likely will be more than 20%, perhaps more than 30%. I would be surprised if the client would get back more than $40k of the $160k of withholding, and much of that could go to state income taxes if the client is subject to state income tax.
  • Of course I don’t know the full circumstances, but it seems like it would make more sense to roll considerably more to the traditional IRA and convert less (perhaps none) to Roth initially, then convert smaller amounts to Roth over several years at lower marginal tax rates (unless the client is already in the 35% to 37% tax bracket without this income, but in that case it seems likely that the client would be able to pay the income taxes with outside dollars).  The only reason I can think of where it might otherwise make sense to convert to Roth rapidly is if the client is terminally ill.
  • Unless the marginal tax rate on the conversion is expected to be less than the marginal tax rate in retirement, paying the taxes with retirement money generally results in the Roth IRA having no more value than the traditional IRA with its embedded tax liability, and perhaps will have less value.

Submitted by Alan - IRA critic on Fri, 2018-04-20 20:45

I think the client may be misinterpreting the “all or nothing” requirement. The plan may require a lump sum distribution but that does not necessarily equate to a taxable distribution to client. In fact Sec 401(a)(31) requires the plan to offer a direct rollover of an eligible rollover distribution. That would still be considered a lump sum distribution of the entire balance, but is done via direct rollovers or in combination with non rollover distributions. The amounts directly rolled over will be exempt from the 20% withholding. This should bring more flexibility to client’s options, since client should only need to have distributions paid directly to client if client wants such a distribution. Obviously, the client may want to have some of the 800k paid to him if he needs to access some funds without the penalty or perhaps to pay taxes on the Roth conversion amount he decides on.

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