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Subject:  Re: Do I have this correct? Date:  4/16/2002  6:10 PM
Author:  AcmeFool Number:  34230 of 98506

For example, if I were in the lowest tax bracket and had managed to accumulate $200k in my 401k (over a period of years), and then wanted to roll it to a Roth upon leaving employment, wouldn't that count as $200k of income, and put me into a much higher tax bracket for that money and possibly any salary for that year?

I highlight a phrase that I think is important here because many people incorrectly believe that the marginal tax rate is the same as the effective tax rate. (I appologize in advace if you know all of this. May people don't really understand it, so I think it is an important point to address.) To start, let me define the two terms...

marginal tax rate: The tax rate on your next dollar of earned income
effective tax rate: The average tax rate on every dollar earned (also known as average tax rate).

When you move into a higher tax braket, you don't pay that tax rate on every taxable dollar earned...only on the successive dollars earned -- up to the limit of that bracket. Let's work with a simple example...

Bob makes $40,000. The brackets in Bob's world are set up such that:

Income Tax Rate
------ --------
$0-$10,000 10%
$10,000 - $50,000 25%

Bob will not be forced to pay $10,000 in taxes as is implied by your phrase; rather, he will pay $8,500 -- $1,000 for the first $10,000 of income and $7,500 for the next $30,000.

This relates very importantly to the idea of recharacterizing a 401(k) or a traditional IRA as the taxes you pay on the recharacterization will not impact the taxes owed on the earned income. Granted, a higher tax bracket will mean more taxes owed on the recharacterization...and the higher the tax bracket, the less likely the recharacterization is to be a good idea. But that is something for each individual to determine for themselves...

I hope that helps.

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