Dear Rick:
I have a couple questions about my situation. I am in my mid-40s and divorced. I was divorced last year in a difficult divorce. Under the divorce settlement, I had to pay my ex alimony for a year. Since the alimony was based upon my income, I decided to quit my job so I would have no income. Therefore, for 2018 I have no income whatsoever. I have been living off a small inheritance which I received. My first question deals with my IRA. I read a column of yours a while ago and you seem to suggest that someone in my situation should do a Roth conversion. Does it make sense for me to do a conversion? My second question deals with my new company’s 401(k) plan. Should I do a Roth 401(k) or the traditional?
Thank you.
Ron
Dear Ron:
You are in a unique position and as far as I’m concerned, it is a slam dunk that you should do a Roth IRA conversion. After all, with zero taxable income, you could convert a significant amount of money tax free. Typically, one of the downsides of a Roth IRA conversion is you have to pay taxes on the money converted. However, in the situation at hand, considering that there is no income, a significant amount of money can be converted tax free.
If you find that by converting the entire IRA there will be some tax liability, it may make sense to convert even that money. If some of your conversion will be taxed at the lower tax bracket it may make economic sense to convert that money as well; particularly, if once you start work you’ll be in one of the higher brackets.
I have always been a big fan of Roth IRA conversions, and it’s something I recommend that everyone look at on a year-by-year basis. Many people think that once they retire they’re not eligible for Roth IRA conversions, but that is not the case. In fact, for retirees who may find themselves in lower tax brackets, doing a Roth conversion may make economic sense.
With regards to the Roth conversion many people think that there is an age where it doesn’t make sense to convert to a Roth. As far as I’m concerned, that makes no sense. I don’t care if you’re 28 or 98, in certain situations, Roth conversions make sense and it’s something that more and more people ought to consider.
With regards to the second question of whether you should use a traditional 401(k) or a Roth 401(k), generally in a situation such as yours, I would lean toward the Roth 401(k). My reasoning is that you’ll probably be working for at least another 20 years, and the advantage of having money grow tax free versus tax deferred can be substantial. The downside, of course, is that with a traditional 401(k) you’re putting in pre-tax money while with a Roth 401(k) you’re putting post-tax money. In other words, by doing a Roth 401(k) you are paying a bit higher taxes today. However, I would rather take a short-term hit today for a long-term gain tomorrow. I’ve always been a believer that you cannot save too much money for retirement, because retirement can be longer and more expensive than most people plan for. Therefore, being able to withdraw money tax free versus tax deferred would put more money in your pocket in retirement, exactly where it is needed.
As a reminder, if you are going to do a Roth conversion the transaction must be completed by the end of the year. IRA custodians tend to get very busy near year-end so don’t delay; the time to do the transaction is now.
Good luck!
Rick is a fee-only financial advisor. If you would like Rick to respond to your questions, please email him at rick@bloomassetmanagement.com.