A reader recently wrote in with the following question about converting a 401k retirement plan to a Roth IRA and the tax consequences.
Should you pay for the taxes when converting a 401k retirement plan to a Roth IRA from the proceeds of your plan?
The short simple answer is no! You should not pay for your taxes from money that was in your retirement plans.
Taxes On Your Roth Conversion
You will have to pay taxes when you convert a 401k retirement plan to a Roth IRA. If you use money that was once in your 401k and you are not 59 ½ years old at the time of withdraw, you will not only owe taxes on the money but also owe a 10% early withdraw penalty.
You Will Lose Earning Power
If you are young enough, you will lose a lot of earning power than your investments would have earned in the future if you pay for your taxes from your investments. Your $100,000 401k plan might end up being a $66,000 Roth IRA plan. That missing $34,000 that you paid for in taxes could have earned you a pretty penny over the course of your working life. In fact, $34,000 compounded annually at 8% per year would equate to over a $150,000 nest egg in as little as twenty years.
The Best Place For Your Tax Money
If you are going to convert your 401k plan into a Roth IRA this year, you should have the money already set aside for taxes in a non-retirement account such as a money market fund, certificate of deposit, stocks, bonds, or other mutual funds that are not part of your 401k plan. This can be quite a challenge for people with a large nest egg that they are trying to convert.
There are many things to consider when you contemplate a 401k to Roth IRA conversion. You should take all factors into account, and you should pay special attention to how you are going to pay for your tax liabilities.
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