What is the difference between a 401k and a Roth IRA?
There are effectively 4 different places in life that trigger income tax. First When you EARN money Second when the money you've invested GROWS each year this growth can be taxed. third when you decide to SPEND the money and fourth at DEATH whatever is left for your heirs can be taxed. I mention these different times of taxation because the only difference between the 401k and the Roth IRA is WHEN you pay the tax.
Taxation of the 401k:
- When you EARN the money and put it into the 401k it is NOT taxed.
- When the money grows each year the GROWTH is NOT taxed.
- When you decide to begin spending the money (usually retirement) it IS taxed.
- Whatever is left over upon your death the balance goes to your heirs and IS taxed.
To summarize taxation of the 401k: You put a small amount away each year. This amount is tax deferred. You do this for many years and the money is all growing without taxation. Once you hit your retirement years it has turned into a LARGE amount of money (hopefully). This LARGE amount of money will all be taxed by either you or your heirs.
Taxation of a Roth IRA:
- When you put an amount away each year you first PAY the tax.
- When it grows each year the GROWTH is tax free.
- When you decide to spend it in retirement it is tax free.
- Whatever is left over for your heirs is tax free.
You effectively pay tax on the small amount of money that goes in and the big amount later is completely tax free! Personally I believe the Roth IRA is too good to be true. I believe when they decide to increase taxes this will be one of the first things to go. Hopefully they will grandfather all the money that is already in the account if and when they change the rules.
So should I or shouldn't I transfer all or some now?First you should realize that you must pay the taxes due on any amounts that you rollover. They don't actually call this transfer a rollover. It is officially called a Recharacterization. Many are wondering if it makes sense to change to a Roth now since their account values have depreciated so much. The upside is if you switch and the account returns to the values it once had then you only paid tax on todays amount which in many cases is only half.
The downside is you need to have enough money at tax time to pay the taxes due. Usually it is best to have this tax money on the outside of your plan. Try not to use the money from your plan to pay the tax. It is a very expensive way to pay the tax.
How much tax will I owe?
Since I'm not a tax advisor I would have to refer you to one. What I can tell you is how the tax brackets work. You need to figure out what percentage rate you will be assessed on the rollover. Here's how taxes work:
- The first taxable income isn't taxed because you have personal exemptions to offset it.
- The next amount of taxable income isn't taxed because you have deductions to offset it.
- If you have more taxable income than allowed for exemptions and deductions you begin paying in the 1o% bracket. Each dollar here is assessed a tax of 10%.
- Still more taxable income? After the 10% bracket is the 15%.
- Next is the 25%
- . . .and up.
Hopefully you get the idea. Look to see which tax bracket you have gotten into without any rollovers. Check to see how much room you have left in that tax bracket. I usually try not to have people go above their current tax brackets. I prefer to have some transferred this year and maybe more next year. Slowly get it over through the course of a few years so that you are keeping taxes as low as possible.
I've developed a spreadsheet to help people with this planning. It is free of charge you just need to contact me if you would like a copy. I've also developed a website that helps you keep your 401k invested according to the market conditions at http://www.ewatch401k.com/ .
Once you go through this entire process yourself you will be the expert when someone approaches you and asks "Can I roll my 401k to a Roth IRA"?
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