Every Friday is Wisdom Friday. It’s just a way for me to share with my readers the little gems of life that I’ve learned either during the week or living life in general.
It seems like you can’t turn on the TV or read the newspaper without the doom and gloom sentiment all over the news regarding the financial crisis. But there’s actually a silver lining to all this. It will only apply to a small group of people, but it’s totally worth it if you are one of them.
So to whom does it apply? Here is the list — make sure you answer YES to both of them:
- Do you currently own a regular (not ROTH) 401K from your previous employers?
- Is your adjusted gross income (AGI) less than $101,000 in 2008? (This qualifies you for contribution to a ROTH IRA account)
If so, now is a good time to rollover your regular 401K into your ROTH IRA and potentially save a tremendous amount on taxes. I’ll show you what I mean with an example.
Let’s assume you are under 50 years old, make $60K a year, have contributed the maximum in your 401K for the past three years. And let’s assume there is no employer match to make the math a bit simpler. By the end of year three, you would have added $46,000 to your account (that is $15,000 in 2006, and $15,500 in both 2007 and 2008) and saved $11,500 in taxes (25% tax savings on $46,000 is $11,500). Why are you saving on taxes? Because you always use pre-tax money to contribute to your regular 401K.
During the recent market downturn, your portfolio has dropped in value from $46,000 to $30,000. Yikes, but here is where the silver lining comes in. If you roll over the $30,000 in your regular 401K to your ROTH IRA now, you will save in taxes. Depending on how much value has been lost, the savings could be substantial.
As with any rollover from your 401K account (which is funded with pre-tax money) to your ROTH IRA (which is funded with post-tax money), you will need to pay the taxes owed in the transaction amount during the year the rollover takes place. But instead of paying taxes on $46,000 (which is what your portfolio was worth before the financial crisis), you will only need to pay taxes on $30,000 (which is the value now). That is a tax savings of $4,000 (25% tax on $30,000 is $7,500; the $11,500 you would have paid — see calculation above — minus $7,500 you pay now = $4,000).
Your next question may be: why would I even want to consider rolling over my 401K to a ROTH IRA? The answer is your earnings in a ROTH IRA is tax-free upon withdrawal during retirement. Depending on how young you are currently, that could translate to a substantial amount of money saved overall. For more information on ROTH IRA and long term tax savings, check out CNN Money’s piece on Retire Without Taxes.
Please note that I am not a financial advisor, and I highly recommend that you consult one before you make your money decisions. I am just very passionnate about personal finance and love to share with others what I’ve learned over the years. Please share your thoughts in the comment section!
2 comments
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October 23, 2008 at 8:19 am
Tate
For retirees: Selling Low to Buy Low is the result of this recommendation…Bad Idea. Tax burden is minimal, and rolling over now guarantees your losses.
For those still working, other than the inconvenience of having more than one account, why rollover now? Wait for a market recovery, then consider a rollover. Saving taxes by guaranteeing losses. Why?
1. VERY few people are actually in the 35% tax bracket that makes these calculations so dazzling. Most working Americans are in the 15% bracket…If you have a family and/or a home, then the effective net tax bracket after tax credits and deductions can be as low as 5%. So, the tax savings argument is invalid. But more importantly,
2. Once you know your tax bracket, rolling over now and locking in a loss lets you “save” 15-35% (your tax bracket) for every dollar you throw away. Bad Idea.
October 23, 2008 at 9:09 am
Ceres
@ Tate -
That’s an interesting perspective, and thanks for commenting — but I don’t agree with all your assessments.
But first, you raised a good point, so let me clarify that my recommendation isn’t for the retirees. The most lucrative upside to my recommendation is the tax-free growth of your money, so if you are already retired, this doesn’t really apply to you unless you have another 30 years ahead of you to grow that money tax-free.
Second, a dollar loss in this market is a dollar loss whether the money stays in your 401K or if you roll it over to your IRA. The fact that you have already lost money means you have already guaranteed a loss. This is completely independent of where you keep your money. So I don’t agree that by rolling over your money, you are locking in your loss — you locked in your loss when the market plummeted.
With that in mind, I personally would take whatever tax savings I can get even if it’s only 5% because the tax advantage really comes by allowing my money to grow 100% tax free until my retirement 30 years from now.