Taxes/penalties on conversion to Roth

[Guest Lyric]

I will be getting a share of a 401(k) as part of a divorce settlement. I'm anxious to convert this to a Roth IRA for its long-term benefits, but know that I have to go through a traditional IRA first.

(1) No calculator that I've seen provides for the option of paying part of the conversion tax with outside assets, and the remainder with some of the IRA assets -- or in my case what would have been a 401(k). Does this mean the taxes have to come from a single source? I don't have enough ready cash to pay the whole tax burden, but I don't want to deplete the retirement account either.

(2) If the 401(k) is transferred to me and I roll it over immediately into a traditional IRA, and then convert this into a Roth, will both transactions be penalty-free because of the divorce situation, or only the initial transfer of the original 401(k)?

Thanks.

------------------

Lyric

[Guest cgc]

Dear Lyric,

Since no one tried to answer your questions, I would take a shot.

It is best to do the rollover to traditional IRA as soon as possible to avoid the penalty after 60 days.

If I understood the law correctly, a Roth conversion, since it is an "aftertax contribution", will always pay a tax (this in not penalty) depending on your tax bracket . Thus, you could do partial Roth conversion of your traditional rollover IRA as you generate enough funds (from outside sources) to cover the taxes. Never use a credit card loan to pay the taxes.

If you expect to earn money in the future to cover the taxes, then do additional Roth conversion of your traditional IRA in later years -- do not use your rollover IRA to pay the taxes under any circumstance. I do not think there is a time limit as to when you can do the conversion of your traditional IRA to Roth IRA. The only drawbacks is that you may earn more during the interim and your "principal" for the conversion will be higher.

I am thinking myself of borrowing additional money through home equity to help pay part of the taxes. Since the equity loan interest is deductible, this will lower my AGI too and thus my taxes. I can borrow at 7.75% (for the home equity) from the bank which is much better than using my margin account.

I am interested with another angle of your situation, if you got a "share of the 401k", does this mean that it was your husband's 401k? Is a tax-sheltered account of an individual transferable to another person such as the wife or husband? I would be interested to know the opinion from experts.

-- CGC 990403

[Guest Lyric]

Dear cgc,

Thanks for taking a shot at my questions. I think your idea of converting just a portion of the traditional IRA to a Roth (with taxes paid with other funds) is a good one. Probably what I shall do. I really like the idea of having most of my IRA assets in a Roth rather than a traditional IRA. Tax-free compounding!

Ultimately what matters is not how much tax I pay now (or from what sources), but rather how much better off I will be in the end, upfront taxes notwithstanding. That's why I'm looking for a calculator that can work this out for me. I know it's usually better not to pay the taxes from the account's own assets, but this is not an absolute rule. The end result is what counts. And paying taxes from a mix of sources could work out OK.

To answer your question: yes, the 401(k) is my husband's, and yes part or all of it can be transferred to me as part of a divorce settlement under a QDRO (Qualified Domestic Relations Order). As I understand things: (a) the name on the account can be changed to mine (assuming all of it comes to me), (B) all or a portion of the assets can be transferred to another account in my name (trustee to trustee), or © a share specified in the QDRO can remain in the current account, to be managed by the plan's administrator in my name (particularly useful if it's not a cash figure, but a percentage).

As long as the transfer is done under a QDRO in accordance with the provisions of the 401(k) plan), there is no "early withdrawal" or "rollover" penalty to pay.

This first "conversion" from 401(k) to traditional IRA is thus a freebie for me. My question was whether I can include in the same transaction, as it were, its immediate conversion to a ROTH without having to pay an early withdrawal penalty if some of the taxes come from these assets. Certainly I will owe taxes on it because it would be changing from a tax-deferred account to a tax-free account.

The first question I raised on 20 March expressed my frustration at not finding an online calculator able to figure out returns where taxes on a Roth conversion are paid from a mix of outside funds and the account's own assets -- if I happen to choose to do this. I guess I shall have to speak to an accountant or financial planner (assuming that they have access to better calculators!).

Thanks again for responding.

Lyric