I have an old 401k from my previous job. For the first 7 years I worked there I was making traditional 401k contributions but in my last year there, they also made a Roth 401k plan available to contribute to, which is what I did for my last year at the company.
I have no desire to rollover the 401k into a Roth IRA as my 401k is with Vanguard and the plan itself has a variety of low cost funds I like. That said, I want to eventually convert the 7 years of contributions to Roth contributions, but I'm not sure if the taxes I'll have to pay on it is based on the present value of those 7 years of contributions or the original contribution amount? All 8 years I contributed the maximum allowed by the IRS during those years but obviously the value of contributions from years ago is much higher now (from appreciation) than the original contribution amount. Also, as there was a company match, do I pay taxes on the conversion of the amounts deposited by my former employer?
I know the conversion will be taxed at my normal tax rate and puts me in danger of moving me to a higher tax bracket, so this conversion would be something I do piecemeal.
You have indicated that you want to convert your traditional 401(k) contributions to Roth 401(k) and want to know how the value is determined. First of all, you need to review your Summary Plan Description or contact the HR Department of your former employer to find out if your plan allows for this type of conversion, i.e. permitting the conversion of all sources of contributions and allowing a “piecemeal” conversion. Any converted monies are taxable in the year of conversion based on the account value at the time of conversion and the impact on each individual is a question that should be directed to your personal CPA or tax advisor.
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Great questions and great thoughts on your part.
OK, I'll hit things as simply as I can. I'm afraid you won't like the answers on them, but they are what they are.
First - all Roth conversions are treated, tax-wise, as if they are withdrawals, so your tax will be based upon the amount converted that consists of taxable distributions.
The amount of taxable distribution is determined by the "exclusion ratio" of your distribution. The ratio determines which dollars are taxable and which are not. Essentially - if you've already paid tax on a dollar within the plan, you don't have to pay tax on that dollar again. But - unfortunately, you cannot pick and choose which dollars to distribute out or convert - they are all blended within the account. This is referred to as the "Cream in the Coffee" Rule. Just like a drop of cream in a cup of coffee - once a dollar is in the plan, generally it is blended up with the other dollars for tax purposes unless a specific exemption rule applies.
So, I'll go through an example to explain it. Suppose you have $100,000 in your 401k. $30K is from your own contributions (before tax), $10K is from your employer's contributions (before tax), 20K is from contributions that you've paid tax on already (this sometimes happens, especially with stock options or company stock), and $40K is untaxed growth within the account. In this case, $80,000 in the account has not been taxed, and $20,000 has been taxed. Your ratio is 80/20 - for every dollar pulled out, then 80 cents is treated as taxable income, and 20 cents is not included in your income.
If you pull out, distribute, or convert $10,000 of the $100,000 balance - then you will have to declare $8000 as income, and you can ignore the remaining $2000. You can roll the full amount over to an IRA without taxes - but you are still faced with the same problem. Also - the IRS has ruled that ALL IRA's - no matter where they are - are treated as one big IRA for tax reporting purposes - the "cream" has spilled through out all of your coffee cups!
In some cases, such as a full distribution or rollover event -- you CAN choose which dollars go where - and it might make sense to "carve out" the untaxed dollars into a standard brokerage account instead of an IRA. However, in my example above - you would not be able to direct the $20,000 into a Roth IRA as a conversion - it would have to be treated as a new contribution instead, and fall within the annual contribution limits.
So - Bottom line - the amount you convert is what you pay tax on. You can, however, convert any amount on an annual basis that desire. Partial conversions are most certainly allowed; we do them all the time for clients, so your piecemeal strategy will work just fine as long as you don’t mind doing the extra work. If you are being told otherwise, then you might want to look for a new provider since we have literally done hundreds of partial conversions over the years – or it is a specific policy of your plan provider and rolling to an IRA with a different custodian would probably solve the problem.
An additional item for consideration - if you are over age 55, but under age 59 and a half, then it might make sense to keep your account in your old 401k as long as the investment options are mediocre or better - because you can take withdrawals from it without an early withdrawal penalty. However, if you roll the balance to an IRA, you will lose that early withdrawal feature, since early withdrawals from an IRA (prior to age 59 and a half) incur an extra 10% penalty. Most people forget about this feature – it is actually a listed exception to the early withdrawal penalty and can be a valuable source of income in the event of an emergency or job loss. Here is the link: http://www.irs.gov/Retirement-Plans/Plan-Sponsor/401(k)-Resource-Guide---Plan-Sponsors---General-Distribution-Rules.
Jon Castle http://www.WealthGuards.com
The taxes you pay when you convert a 401(k) or IRA to a Roth IRA are based on the total value at the time of conversion, that includes any amount that represents the company's matching contributions. You will pay tax on the full amount converted.
You have to first rollover the taxable 401(k) balance to an IRA before converting to a Roth IRA. You can do all this directly with Vanguard and they can walk you through the process.
As for doing it piecemeal, that will involve some extra work. When you convert an IRA to a Roth IRA, you must convert the entire balance. So you would have to have the 401(k) balance transferred to multiple IRA's at Vanguard and convert them one at a time over a period of years.
Here is a link to Vanguard's page about 401(k) rollovers and transfers: https://investor.vanguard.com/what-we-offer/401k-rollovers/401k-403b-to-ira-rollover-benefits
Colin, The tax you would pay on a Roth conversion will be based on the value, or more specifically, the amount you convert. Employer contributions would be taxable simply because they have never been taxed. While you mentioned that you want to convert to a Roth 401K with Vanguard, within your existing plan, you may want to consider converting to a Roth IRA at Vanguard. Doing so would provide you a greater number of low-cost Vanguard funds as well as an additional 14,000 fund from within their FundAccess program. These include no-transaction-fee, transaction-fee, load and load-waived funds. Most likely, the funds you like in your existing plan would be available in addition to thousands more. I think you would benefit for having more investment options because the funds you like today, may not be the ones you want tomorrow. Funds can grow too large, their can experience style drift and their performance can decline. With more options, you might find funds you like better, now.
In regard to fees and expenses, I'm not sure whether there would be any additional cost for buying and selling the funds you like in a Vanguard Roth versus your existing 401K. However, since many employers spread the administrative costs of their retirement plans among plan participants, you may be paying additional fees in your existing 401K that would not be there in the Roth IRA. Hope this helps.
I agree with Rich. Unless the employer is footing the plan administrative expenses and is offering lower cost mutual funds than you can purchase inside a self-directed ROTH IRA you should consider a rollover to a ROTH IRA. However, it is possible that the employer's plan does not allow partial withdrawals. If not and you do not want to convert the entire balance in one year then a workaround would be one lump sum rollover to a traditional IRA (this would not be taxable) and then partial conversions from the traditional IRA to the ROTH IRA.
If you want to stay with the 401(k) make sure ROTH conversions are allowed in the plan. Even though a plan offers a ROTH 401(k) doesn't not mean that they will allow conversions. Also, until 2013 a participant under the age of 59-1/2 could not make an in-plan ROTH conversion. Even though the American Taxpayer Relief Act of 2013 made this legal the employer may not have amended their plan to allow conversions for those under age 59-1/2.
Lastly, if creditor protection is an issue for you then remember that the 401(k) may provide better creditor protection than an IRA in your state of residence.
Hope this helps.