Grad student deciding what to do with IRA

[Guest Jennif102]

Hello all,

I have an IRA that was rolled over from an old 401K plan. It has around $24 k in it and it's mostly cash right now because I had to liquidate in order to move it to my new brokerage account. I want to open a Roth IRA and I'm trying to decide if I should convert this traditional IRA into a Roth. I am an MBA student so my only income this year will be a couple thousand from my internship- putting me in what I think is the 10% tax bracket (plus I am taking TONS of loans for grad school so I'm thinking I should not owe taxes for this year)

Here are my questions:

1. What kind of taxes will I owe if I convert to a Roth- also- some of the money in my IRA right now is after tax already, so will I get hit with taxes again on it? I mean, how do they determine on conversion what money is before tax and what money is after tax?

2. Is it worth it to convert or should I just open a Roth seperately now with whatever other money I can scrounge together (or just roll over some of my traditional- not all of it) and continue investing with my traditional IRA as well?

3. Will I even owe taxes this year if I convert to a Roth? My income for the year will literally be like $7500 and I have taken out tons of student loans in order to attend a top MBA program.

4. Is this the best year to do this since its the lowest tax bracket I'll ever be in (I will being working full time again in the fall of 2008)

5. Do I have to liquidate everything in my traditional IRA into cash in order to convert it to a Roth?

thanks in advance for all your advice!!

[masteff]

1. You'd report the conversion distribution on line 15 of form 1040. It's counts as ordinary income, so ordinary income tax. You complete part 2 of form 8606 to determine the taxable portion of the conversion; on that form, the after-tax money counts as basis and is subtracted from the total distribution.

2. It will be decades before you're ever in this tax bracket again. And if you do well in your career and build up a decent retirement income, you might not be in this tax bracket even then. If you can afford to pay the taxes on converting part or all of the IRA, then it might work well for you over time. But at the very least, get that IRA invested in securities and start putting money in Roth.

3. You'll owe some taxes. If you convert the full $24K, this plus your $7.5K other income would give you gross income of about $31.5K. Minus about $8.5K for personal deduction and exemption gives you taxable income of about $23K. This does not include any education tax credit for which you might be eligible. You could do a partial conversion, which would lower the resulting amount of taxable income.

4. See #2.

5. No, not really. You might even decide to stay with the same company that has your IRA right now and they might be able to just move the contents as is. But typically you don't have to liquidate in advance; they can liquidate it all for you on the date of the distribution.

Additional comments:

When you start work somewhere, start putting money into their 401(k), especially if they offer matching contributions. Your first priority would be to get the full match, after that you can decide whether putting more money in your Roth or the 401(k) makes the most sense.

Also, as an MBA grad myself, you'll be tempted to put all your extra money into your student loan payments. Well, think first about maxing your contributions to your retirement. If you invest semi-aggressively, you'll likely get more growth from that retirement money over the long-term than the interest rate you're paying on those student loans.

PS - just noted you referred to having had it in a brokerage account. At your size of account, you should be thinking in terms of a diversified selection of mutual funds. Individual stocks in your size of retirement account are generally considered to have too much risk.

[Guest Jennif102]

Thanks for your prompt response. I really appreciate it.

I guess I"m just wondering how in the world I will decipher what in the IRA is pre tax and what is after tax money? The acct was transferred from a few times from it's original 401k at my old company to a brokerage acct at my new financial services company (they forced us to keep our stuff with them) to an online brokerage acct once I left my last job. I just looked at the account and I see no designated split-out. However, I know I contributed a couple hundred a month after tax for quite a while. But I have no idea how much that was in total . Is it the brokerage company's job to keep this split out somewhere and will they take care of it when I convert to a Roth? Or was I supposed to keep track?

Also, I have another 401K that I started at my last firm- would you recommended just leaving this at the firm since they can't force me out of the plan, or converting it to a Roth as well?

Finally, I saw what you wrote about mutual funds....in general I am just not a fan of them as I have a little bit more risk tolerance (and a solid background in the financial markets). I prefer to invest in a diversified group of ETFs.

Thanks again!

[masteff]

Hmmm, well you need to resolve your basis in the account whether you convert it or not. You may need to do some research. First place to start is confirming that aftertax money was rolled over and not paid out to you by the 401(k). Biggest problem in not knowing the aftertax portion would be if you needed to withdraw money from the Roth before retirement.

I'll put the question on the 2nd 401(k) back on you.... do you like the investment options you have and can you afford the tax burden to convert that much in one year? Otherwise, it's the same thought process as for the other.

And lastly, if you're an educated investor and understand the risks, power to you. Just remember to be diversified.

[txdd]

For the year in which you rolled over your old 401k to your IRA, you should have received a 1099R form from the 401k plan stating your after-tax contributions in Box 5. If this amount was included in the rollover, i.e. not paid to you directly, it is the basis of your IRA's. As you dispose of your traditional IRA's, either by withdrawal or Roth conversion, you will recover this amount tax free in proportion to your total traditional IRA balances. See Form 8606.

[Appleby]

See http://www.retirementdictionary.com/After-...ntributions.htm for filing tips on after-tax contributions to IRAs

[John G]

ETFs - this stands for exchange traded funds.

ETFs are something of a clone of mutual funds. They trade during the day and are priced by market forces rather than end of day NAV (net asset value) like mutual funds. Some ETFs have very low annual expenses... but so do some mutual funds. Most ETFs are viable investment choices, but it is very important that the investor understand what they are buying.

To say you can tolerate more risk and that you prefer ETFs is an odd statement. Within the domain of mutual funds and ETFs, there is a wide range of risks. Both of these investment approaches have some level of diversification, but that ranges from very broad diversification with "Spiders" or S&P500 Index mutual funds to very narrow (but still some level of diversification) with sector specific or country specific type funds and ETFs. The broader defined versions have primarily market based risk - is the market moving up or down - since most ETFs hold equities (aka stocks). More risk with more volatile versions - sector specific (like genetic engineering, software, or retail). More risk with geographically narrow versions - Turkey, Malaysia, Japan portfolios.

WARNING: Some of the newly developed ETFs are not suitable for beginner investors and probably not suitable for inactive investments (such as retirement accounts). There are a number of ETFs that now attempt to achieve 200% of the results of their assets by using leverage. And, there are ETFs that allow you to "short" the defined pool. I seem to recall there was even a commodity style ETF.

The number of ETFs have expanded dramatically in the past two years. It all started with "spiders", "diamonds" and easily understandable investment pools. The ETF trend is toward developing more tightly defined niches with exotic formulations. Caveat emptor! I would argue that some ETFs are much harder to understand than a mutual fund, so ETFs are no short cut to investing. Read the background documents. (most brokerages and Yahoo finance now include research materials on ETFs and Googling is highly recommended by me).

I gave a presentation at InvestFest (a niche investor annual forum of moderate to sophisticated investors that's been held for 5 times) in San Diego earlier this year on ETFs. See the attached power point presentation.

Navigating_The_ETF_Universe_Powerpoint.ppt