Question and background:
I have a 401k that I would like to convert to a Roth IRA. The amount is around $85,000. I have a few questions: Can I convert the entire amount at one time? If so will I owe taxes on the entire amount at my current tax rate? Can I pay the taxes out of the money that is being rolled over? How do I determine the conversion amount for my basis? Can I then withdraw the converted amount and avoid the 10% penalty since I will not owe taxes on the converted amount that is withdrawn?
I'll assume the $85,000 is all pre-tax contributions. Let's walk through your questions one-by-one....
- Can I convert the entire amount at one time?
Yes, but doing so may push you into a higher federal income tax bracket. And don't forget state income tax, if that applies where you live.
- If so will I owe taxes on the entire amount at my current rate?
Not necessarily at your current rate. Rather, at the tax rate for the entire year once you've combined the taxable conversion income with all your other sources of income, less deductions, exemptions, and credits.
- Can I pay the taxes out of the money that is being rolled over?
Roth conversions are most effective when you have other resources (outside the retirement plan) with which to pay the taxes. Further, if you used part of the conversion to pay the taxes, then that amount would not be countable as "converted" and you'd owe the additional 10% federal penalty tax on it if you're under age 59 1/2.
- How do I determine the conversion amount for my basis?
If this is a new Roth IRA, the converted amount will be your basis. If you're converting the 401(k) to an existing Roth IRA that already has contributions and growth, then you'll add the converted amount to your contributions to calculate basis.
- Can I then withdraw the converted amount and avoid the 10% penalty since I will not owe taxes on the converted amount that is withdrawn?
Not necessarily. Roth IRAs have two separate "5 tax year" rules, one for contributions and one for conversions.
With conversions, in order to avoid the 10% penalty tax (on principal) you must leave the converted amount in the Roth IRA for 5 tax years or your age 59 1/2, whichever comes first. And if you convert the $85,000 over multiple years instead of all at once, then each conversion has its own 5 year clock.
Hope that helps. All the best.