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Q: Dan, I am hoping you can shed some light on tax strategy for Roth conversions vs. just taking 401(k) distributions. My husband is 60 and retired with a 401(k) and an inherited IRA and plans to take Social Security at 62. I am 50, still working, and have a 401(k) and a rollover IRA.
The plan is for me to leave work in 18 months, and for us to live off savings as a bridge to when we start Social Security and my pension that starts at 56. If we use bridge money alone, it can cover our costs for six years. We are currently above the income limits for Roth contributions but expect to be in the 12% bracket initially in retirement.
How bad is it if I withdraw from my 401(k) during the pandemic?
Would either of us benefit from Roth conversions or is it better in our bridge money/low income years to fill the tax bracket by liberating funds from his 401(k) and then reinvest that in a brokerage account since we do not want to spend it yet? (The 15% capital-gains tax is not favorable compared with 12% tax bracket but is vs. 22% which we will bump into at some point.)
A.: There is a lot to unpack here. You should discuss the details with your adviser but here are some quick points:
The tax effects are the same whether he pulls money from his 401(k) to add to the bridge account or converts those amounts to Roth IRA. The difference is that taxes can be avoided as the Roth grows and when you take money out. With a taxable bridge account there could be tax consequences as you earn and when you pull funds for spending.
Since he is already 59½, I’d lean toward converting his 401(k) to a Roth IRA. When one converts to a Roth IRA before 59½, the five-year rule for conversions must be dealt with to avoid a 10% penalty.
To the extent you are in the 12% bracket, long term capital gains are taxed at a zero rate not 15%.
Social Security is taxable based on your income. When either of you pass away, the larger of your two Social Security checks is all the survivor gets to keep. If his benefit is significantly larger than what you will receive, you as the younger spouse may wish to have him delay as long as possible, even to 70 perhaps, because that will be the check that is payable to the survivor who is statistically more likely to be you.
With your income currently high, converting to a Roth or otherwise incurring taxable income from distributions from his 401(k) is not as attractive. However, during that period in which you are not working and are living off bridge money, executing Roth conversions to fill up that 12% bracket may be good for his 401(k) money. Converting more and paying 22% could also be beneficial, but I’ll leave that to your adviser to assess.
Note: I would consider rolling his 401(k) to an IRA to make conversions easier. Plus, rolling to an IRA then converting will start the clock on the five-year rule on earnings in a Roth account which is applicable if he has never had a Roth IRA. His inherited IRA cannot be converted to a Roth IRA so you will need to incorporate the Required Minimum Distributions (RMD) he has on the inherited IRA into your plans.
Conversions will mean less RMD when he hits 72 and a pool of tax-free money in the Roth IRA. That can come in handy since you are still several years away from 59½ when the 10% penalty on 401(k) and IRA withdrawals is no longer an issue.
If you have a question for Dan, please email him with ‘MarketWatch Q&A’ on the subject line.
Dan Moisand’s comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.
