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Hi,

Please let me know if I have this correct.

a) DF contributes the max to his 401K
b) when he leaves his current company we can transfer it (or roll it over, or whatever the proper term is) to a traditional IRA.
c) we can then pay the taxes on that money and recharacterize (I hope that's the right word) it to a Roth IRA
d) all that money can then grow for 33 years (DF is 26) and we won't ever have to pay more taxes on it.
e) BUT if DF isn't eligible to contribute to a Roth this year (income too high) we can't recharacterize the IRA, but next year after we are married (sometime in April 2003) and filing jointly, he will be eliglble to contribute to a Roth IRA again and can recharacterize at that time.

If I have all that right, I think this may be the greatest thing since sliced bread!

Ok, on to part 2.

I have about $30,000 in a traditional IRA plus about $10,000 in a 401K that I am in the process of transferring to the IRA. I would like to recharacterize this to a Roth IRA this year, before we are married, so that the taxes aren't based on our joint income. But I'm not working. Do I have to have "earned" income to be able to recharacterize? If DF isn't eligible to recharacterize because he makes too much money to contribute to a Roth this year, then wouldn't the opposite be true? If I make too little (nothing) to contribute am I also not eligible to recharacterize? Do I need to go out and get a job so that I will be eligible to switch my IRA to a Roth? If I do have to earn some money, how much do I need? Does any of this make any sense?

Thank you for your help!!!

Karen
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This post is all about Part I.

A little terminology issue here.

If you have a Traditional IRA, you can convert it to a Roth IRA if your income falls within limits based on your filing status. These limits are not all the same as the limits for contributing to a new Roth IRA.

But if you change "recharacterize" to "convert", and change "eligible to contribute" to "eligible to convert", then your intuition is correct.

A small point on (d): Withdrawals from an IRA are tax-free as long as the circumstances of the withdrawal match what the IRS allows. However, tax laws may change in the future to narrow the definition of allowable withdrawals.

Another point on (d): You probably won't be withdrawing the whole IRA balance right at age 59. In fact, since the IRA is tax-deferred, you may wish to wait as long as possible before withdrawing from it!
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Now on to part 2.

You have money in a Traditional IRA that you would like to convert to a Roth IRA. As long as your income is below the IRS guidelines for single people, you are allowed to convert. No minimum income is required. You are correct that the best time to convert is in a year when you're not working. Just make sure you have the money outside the IRA available to pay the taxes.


[Recharacterize means to undo a conversion, or to designate a contribution to one type of IRA as actually going to another type of IRA. You don't need this.]
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If you have a Traditional IRA, you can convert it to a Roth IRA if your income falls within limits based on your filing status. These limits are not all the same as the limits for contributing to a new Roth IRA.


Hi,

Thank you for replying so quickly, with such good info. and for correcting my terminology. I kinda thought I was using the wrong words, but didn't know the right ones.

If the limits for converting are not the same as the limits for contributing, where can I find out the limits for converting? I have been reading publications on the IRS website, but haven't found any information about converting......... but I thought it was called recharacterizing, so I have to look again now that I have the correct terminology.

Do people know about this conversion stuff? I was excited about them raising the amout that you can contribute to a Roth IRA, so you can imagine how ecstatic I am about being able to put thousands and thousands of dollars into the Roth just by paying the taxes on it*. I sorta feel like I'm cheating.......... this is a way to totally get around that maximum contribution thing. I think this will have a SIGNIFICANT positive impact on my retirement planning!

WOO HOO!!!

Thank you!!!

Karen

* I mean by contributing to a 401K, transferring it to a traditional IRA, and then paying the taxes to convert it to a Roth.
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Hi again,

I think I may have just found the answer to my question about income limits for converting.

From the IRS website (I don't know what publication, it was in a FAQ):

You can convert amounts from a traditional IRA into a Roth IRA if, for the tax year you make the withdrawal from the traditional IRA, both of the following requirements are met.

1.Your modified AGI (explained earlier) is not more than $100,000.

2.You are not a married individual filing a separate return. (See Lived apart from spouse under Filing status, in chapter 1.)



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imagine how ecstatic I am about being able to put thousands and thousands of dollars into the Roth just by paying the taxes on it*. I sorta feel like I'm cheating.......... this is a way to totally get around that maximum contribution thing.

This brings up a question... is this treated as income and taxed regularly as such when you convert?

If it is, then IMO it's not a good option... depending on how much is in there, that could bump you up more than one tax bracket it seems to me.

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?

B

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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?

Indeed it would. However you are not obligated to convert the whole thing at once. Only convert as much as you have outside funds to pay the taxes for, and that won't bump you out of your current bracket.
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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.

ACME
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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.)

No need to apologies. I did know that, but I've met many people who didn't understand it, and looking back at my post, it does seem I didn't know it (I really didn't mean it to read that way! :P ). Thanks for the reminder of an important distinction.

I actually learned this back when I was young and foolish (small f) after my father died and I was a beneficiary of his pre-tax retirement monies, which by law had to be taken out within 5 years of his death. Let's just say the first year I didn't give any thought to the tax implications of taking out (read: adding to my income) $40,000. The accountant (a family friend) read me a riot act that would have put a marine drill sergeant to shame! *shudder*

Anyway, I' older and much wiser (and more Foolish) than I was way back then, and having learned my lesson, I now pay particularly close attention to tax matters. *rueful grin*


B

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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

I think you're confusing "conversion" and "recharacterization".

Both those terms apply only to IRAs.

A conversion is when you have a traditional IRA and desire to convert it, in whole or in part, into a Roth IRA. The amount you convert is included in your AGI. I believe this is what you were referring to, except that 401(k)s cannot be converted -- they must first be rolled over into a Traditional IRA.

A recharacterization is when you want to undo a conversion, or when you decide that money you contributed to an IRA of one type during the current tax year should instead have been contributed to an IRA of the other type. For instance, if you contribute to a traditional IRA in May in hopes of getting the tax deduction, and then in August you get a job with a retirement plan, you'd lose the tax deduction. So you could recharacterize your contributions to that traditional IRA and make it as if they'd been in a Roth IRA from day one.
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I think you're confusing "conversion" and "recharacterization".

You are correct that I used the wrong word...however, that was not really the point of the post. I was simply pointing out the possible error in the way the original poster was thinking about taxes.

ACME
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