Do you expect your 2009 income to be lower than normal because you’ve been forced to take a pay cut, your investments aren’t producing the income they used to, or for other reasons due to the current recession? If so, it may be an opportune time to convert some or all of your 401(k) funds into a Roth IRA. Although the amount rolled over would be taxable, if your tax bracket is lower than normal, it may present an opportunity that should be considered. This can be done by rolling over money from your 401(k) to a Roth IRA, provided both of the following conditions for the year of the rollover are met:
1. Your modified adjusted gross income (MAGI) for Roth IRA purposes is $100,000 or less; and
2. You are not a married individual filing a separate return.
You can elect, with your plan administrator, to do a direct rollover where the funds are transferred directly from your 401(k) account to the Roth IRA account. The plan administrator will complete Form 1099-R so that it properly reflects the rollover to the Roth IRA.
If you choose to receive the 401(k) money and roll it over yourself, simply roll it to a Roth IRA within 60 days of receipt. In this case, the administrator is required to withhold 20% of the distribution for federal income taxes (which is claimed on your tax return just as you do income tax withheld from your wages). So you will have to replace the 20% withheld for income taxes with other funds if you want to roll over the entire amount that was withdrawn from your 401(k) account.
You must include in your gross income the total previously untaxed amount that was in your 401(k) account (up to the amount withdrawn).
A traditional IRA can also be converted to a Roth IRA if the two conditions listed above are met.
The amount of tax you will have to pay on the conversion will be based upon your tax bracket for the year. For instance, if you are in the 15% tax bracket and roll over $20,000 of taxable distributions into a Roth IRA, your Federal tax would be $3,000 (.15 x $20,000). You may be subject to state tax as well.
A word of caution…if you use part of the 401(k) funds to pay the rollover tax, those funds are not treated as part of the rollover and instead treated as a premature distribution subject to an additional 10% early withdrawal penalty.
Example: You are in the 15% tax bracket and take a $20,000 distribution on which $4,000 (.20 x $20,000) is withheld. $1,000 of the withholding deduction is replaced with other funds and $17,000 is rolled over into the Roth IRA. You would be subject to a 15% tax on the entire $20,000, plus a 10% penalty on the $3,000 that wasn’t rolled over. Thus, the total Federal liability created by the rollover would be $3,300. The 10% penalty will not apply if you are over age 59½ when the 401(k) withdrawal is made.
Does your AGI exceed $100,000? If so, you cannot make the conversion in 2009, and will have to wait until 2010 when the AGI limitation will be removed.