Q. Within my 401(k) plan, can I transfer an amount to the
401(k) Roth and pay the taxes from the amount transferred? Or do I have
to pay the taxes from another source? — Randy Gaven, Cornville, AZ
A. You raise a good question, and one that more people should be thinking about. A growing number
of 401(k)s now offer a Roth account, along with the traditional pre-tax
savings plan. A Roth 401(k), like a Roth IRA, lets you put away
after-tax savings, which will grow tax-free. (There are a few
differences between the two types of accounts, as we’ll explain.) You’re
smart to take advantage of the option. Most people keep the bulk of
their savings in tax-deferred accounts, so adding a Roth 401(k) allows
you to diversify, tax-wise. That gives you more flexibility when it comes time to tapping your portfolio in retirement.
Not all 401(k) plans allow you to make a transfer
from a pre-tax account to a Roth–the technical name is an “in-plan
rollover.” But if yours does, you can generally make the transfer over
the phone. (Fidelity, for one, doesn’t allow online transfers, since the
transaction can be a “complicated, confusing process” that merits
guidance from a representative, according to a spokesman).
With a Roth 401(k), you can put away a lot more than you can in a Roth IRA:
those under age 50 can’t contribute more than $5,500 to a traditional
or Roth IRA for 2016, while those 50 and over can’t contribute more than
$6,500. What’s more, Roth 401(ks) aren’t subject to the same income
limits as Roth IRAs—you’re not eligible to contribute to the latter if
you make $132,000 or more if single, and $194,000 or more if married
filing jointly.
Now we come to the catch: taxes. The amount you convert from pre-tax
savings to a Roth 401(k) is usually counted as part of your taxable
income. So what’s the best way to handle that bill? “It’s always a good
idea to pay the taxes from an outside source,” said Richard W. Paul, a
certified financial planner in Novi, Michigan. Using 401(k) money to pay
the taxes will diminish your nest egg and also subject the tax payment
to income taxes, plus an additional 10% early withdrawal tax if you’re
under age 59½. (The in-plan rollover itself isn’t subject to the early
withdrawal tax
It’s best to consult a financial adviser or tax preparer before doing a rollover. A professional can estimate the size of the bill and may be able to identify taxable losses or deductions that can offset the added income. You generally have until April 15 of the year following a rollover to pay taxes on the amount, although there may be certain circumstances when it’s advisable to pay earlier—again, check with your tax expert
Another point to keep in mind is that there are no do-overs when it
comes to in-plan 401(k) rollovers. The amount rolled over into the Roth
can’t be moved back to your pre-tax 401(k) account. “Once they pull the
trigger on the conversion, it’s a done deal,” Paul said. By contrast,
IRA funds may be transferred to a Roth and then back again—this move,
called a “recharacterization,” allows you to undo a conversion to a Roth IRA, if you act within a certain time frame.
Is it worthwhile to pay taxes and switch to a Roth 401(k)? It all depends on whether you expect your tax rate
to be higher in the future than it is now. No one has a crystal ball,
of course. That’s all the more reason to hedge by keeping some money in
both pre-tax and after-tax accounts.
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