For tax purposes, is it advisable to take a large 401(k) distribution and complete a Roth IRA conversion in a year where you earn very little income?
I retired last year. I recently turned 62 years old and I'm planning on taking my first Social Security benefits beginning in November 2018. I received a $5,000 bonus in February 2018. I have no other income for 2018, aside from interest income that's reflected in a 1099-INT form. For tax purposes, is this an advantageous time to take a large 401(k) distribution, and then complete a Roth IRA conversion? For tax reasons, does it make a difference what year I complete a Roth IRA conversion in – either this year or in a future year?
If this year is an advantageous time to complete a conversion, is there a threshold where the advantages of completing a conversion will be outweighed by the tax consequences of the conversion? Is the total taxable amount the amount of the conversion, plus my bonus amount ($5,000), plus my Social Security? Is it correct that I do not want to exceed a 22 percent marginal rate, or $82,500 plus approximately $10,000 for my single exemption and standard deduction? Does the $92,500 amount keep me at the 22% marginal rate? Should I not include the amount of my single exemption and standard deduction? Will this distribution count as income and thus impact the total Social Security benefits I am eligible for?
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I am going to attempt to answer your questions as well as I can, but (and I can't stress this enough) this is not a decision you want to make based on advice off the of a website forum. Myself and my colleagues are all dedicated to helping but this is a question that requires detailed and individual professional guidance.
You are considering a major irrevocable decision which could have significant and long-term consequences. Without having a copy of your financial documents and a projected 2018 tax return, there is no way to give you a full answer and not violate my fiduciary duty. That being said, here goes with helping you understand the factors related to some of the questions you asked.
To the first question, this COULD be a good year to affect a PARTIAL conversion to a Roth IRA, but the amount may be smaller than you expect. You will want to run a tax calculation to determine the maximum amount you can convert without increasing your overall (multi-decade) taxes. This often means converting enough of your IRA to fill the lower tax brackets, without converting so much it triggers a tax bracket which is disadvantageous to your long-term retirement plan. The exact point where this triggering happens is different for each person.
I recommend you evaluate whether taking Social Security at age 62 is a good idea. Unless you are in poor health, taking Social Security now will likely significantly harm your long-term retirement stability and income.
There is a threshold where the advantages of a conversion are outweighed by the tax consequences, but it will depend on several factors including what your expected tax rate will be in retirement.
Keeping to the 22 percent marginal rate could be advantageous to you, could be too high, or could be leaving money on the table depending on how much you have in your 401(k) and what your expected retirement income and tax rate will be.
Also, the personal exemption no longer exists in the current tax law, and the standard deduction was also dramatically changed with the new tax law.
Your taxable income for 2018 will include the interest income, the 401(k) distribution, the Roth conversion amount, and your Social Security.
If you follow this plan, you could find yourself taxed at the highest marginal tax bracket, depending on how much is in your 401(k). This means you would pay a ridiculously higher tax rate now, to avoid paying lower tax rates over your entire retirement.
Please meet with a fiduciary financial advisor and a CPA before beginning your retirement. The decisions one makes when they enter retirement are irrevocable and can have a profound impact on their retirement. Starting Social Security at the wrong time can cut your potential monthly benefits by nearly half; and taking distributions from retirement accounts or converting to a Roth have significant tax consequences.