Should 401k funds be Roth'd before they recover?

[jgombos]

What is the name of your state (only U.S. law)? Fed

Now that everyones pre-tax retirement plans have bottomed out and are starting to recover, is it a good move to convert them to Roth IRA's?

My speculation is that the value is not going to slowly and steadily increase as it does in a stable economy - it's going to snap back quite quickly. Perhaps it's best to pay the tax while the funds are low, so the relatively rapid increase is all tax free.

Also, normally the converted funds are taxed as ordinary income at the point of conversion. So the question is, can a loss can be declared to offset some of that, because of the beating the funds took.

 

[LdiJ]

What is the name of your state (only U.S. law)? Fed

Now that everyones pre-tax retirement plans have bottomed out and are starting to recover, is it a good move to convert them to Roth IRA's?

My speculation is that the value is not going to slowly and steadily increase as it does in a stable economy - it's going to snap back quite quickly. Perhaps it's best to pay the tax while the funds are low, so the relatively rapid increase is all tax free.

Also, normally the converted funds are taxed as ordinary income at the point of conversion. So the question is, can a loss can be declared to offset some of that, because of the beating the funds took.

Different people have different opinions regarding converting to Roths. I am personally not a fan of converting to Roths.

No, you cannot declare any loss to offset tax. You were never taxed on the money in the first place, so you cannot declare a loss.

 

[jgombos]

No, you cannot declare any loss to offset tax. You were never taxed on the money in the first place, so you cannot declare a loss.

Ouch!

If a taxpayer puts $45k pretax into a fund, and gets $25k back (pretax), that's an overall $20k pretax loss. If the effective tax rate is 25%, that's a $5k loss for the government, and a $15k loss for the taxpayer. Presumably the $15k loss would have been eligible for declaration if the conversion happened before the loss, correct?

Not being able to deduct any portion of losses on pretax funds is a huge disadvantage of 401k plans.. one that I overlooked. Being young, I tend to select higher risk investments. Now I'm thinking 401k's should be converted to Roth annually, so at least any losses can reduce taxable income.

 

[anteater]

Now I'm thinking 401k's should be converted to Roth annually, so at least any losses can reduce taxable income.

Not clear where you are going with this.

The situations in which you can take distributions from a 401k are quite limited - generally separation from the employer.

And you don't have a loss since you don't have a cost basis in pre-tax plans. Conversion to a Roth establishes a cost basis. If you have a loss within the Roth itself, you may be able to take a deduction, but only if you liquidate all of your Roth IRA's. However, it is a miscellaneous deduction, subject to the 2% of AGI floor.

 

[jgombos]

Not clear where you are going with this.

The situations in which you can take distributions from a 401k are quite limited - generally separation from the employer.

I thought the main point to rollovers was to enable employees to be free of dependence on their employers ability to stay in business. If conversions can only be done after leaving the company, that seems to substantially defeat the purpose of it.

Also, I've heard that 401k funds cannot be converted to Roth IRA in parts. All 401k funds must be converted at once, in total, preventing taxpayers from spreading conversion accross multiple years to keep it in a lower tax bracket. Is that not the case?

And you don't have a loss since you don't have a cost basis in pre-tax plans. Conversion to a Roth establishes a cost basis.

Payslips disclose the cost of 401k plans, which would document the cost basis.

If you have a loss within the Roth itself, you may be able to take a deduction, but only if you liquidate all of your Roth IRA's. However, it is a miscellaneous deduction, subject to the 2% of AGI floor.

I know, it doesn't quite give the taxpayer the due relief, but it's something. It's more than the remedy for 401k losses. Although liquidating all Roth funds is a hindering limitation, it may still make sense to do so, in order to offset the loss against taxes. It's a better option than simply having to eat the full impact of a 401k loss.

 

[anteater]

Sorry, but I don't think that you aren't getting this at all.

I thought the main point to rollovers was to enable employees to be free of dependence on their employers ability to stay in business. If conversions can only be done after leaving the company, that seems to substantially defeat the purpose of it.

That's the way the law is written. The main point of rollovers is not the employer's viability. Funds in 401K's are in the care of a custodian. An employer bankruptcy may affect immediate access to 401K funds since usually, in bankruptcy, the plan is ended and that requires a thorough audit and clearance from the IRS. But the 401k funds do not go away.

The main point of a rollover, when you are eligible for one, is to avoid being stuck in a plan that you do not like. A rollover gives the freedom to choose how to invest the funds.

Payslips disclose the cost of 401k plans, which would document the cost basis.

Paystubs have nothing to do with it. If your contributions to the 401k are pre-tax (and most are, although there are circumstances in which after-tax contributions can be made), then there is no cost basis.

I know, it doesn't quite give the taxpayer the due relief, but it's something. It's more than the remedy for 401k losses. Although liquidating all Roth funds is a hindering limitation, it may still make sense to do so, in order to offset the loss against taxes. It's a better option than simply having to eat the full impact of a 401k loss.

Let me try an example:

1) You make pre-tax contributions to a 401k totalling $50,000.
2) The markets go to hades in hand basket and the value of your 401k is now $40,000.
3) You leave your employer and are eligible to rollover your 401K. So, you roll it over to a Roth IRA.
4) You do not have a loss for tax purposes since you have no cost basis in the 401k.
5) You do have taxable income of $40,000, and, therefore, you have a cost basis in the Roth IRA of $40,000.
6) If things continue to go to hades in a hand basket and the value of your Roth IRA declines to $30,000 (and assume that it is your only Roth), you could liquidate it and have a miscellaneous deduction of $10,000 subject to the 2% of AGI floor.
7) The pre-tax contributions of $50,000 to the 401k do not figure into this at all.

Also, I've heard that 401k funds cannot be converted to Roth IRA in parts. All 401k funds must be converted at once, in total, preventing taxpayers from spreading conversion accross multiple years to keep it in a lower tax bracket. Is that not the case?

I will pass on that one to someone with more knowledge. Assuming that you can do a rollover, I don't believe that there is any law that requires a total rollover, but I may be wrong on that. 401k plans can have provisions above and beyond the requirements of the law and it is very possible that the plan might require a total rollover.