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!