Who: This post is for people who are planning to have some years in the near future in which they will be making significantly less income than they currently are. You might just want to take some years off travelling, or you may be leaving your job to pursue a full-time graduate degree.
What: This post will discuss a little tip for decreasing the taxes you pay on your retirement income. The post discusses 401k’s and IRA’s so an elementary understanding of these investment vehicles is understood.



The Premise

When one converts a Traditional IRA to a Roth IRA, the conversion amount is taxed at the converter’s standard income tax rate. For this reason, it becomes worse to make a conversion during years of relatively high income, assuming a variable income from year to year. So why not convert during the year(s) you are in graduate school so you can be charged much less tax than you would if you converted during a time of higher income?

This post will not discuss the nuances of 401k rollovers and IRA conversions, but you are encouraged to stay tuned for future posts on the topic and/or do the research yourself. This post is meant to serve as only an outline for how to save yourself some money on taxes.

How to Do It

1) If you are planning on leaving work to go to graduate school, you should have been (or start to) contributing to a traditional 401k for this plan to work optimally. Once you leave your positive conduct a ROLLOVER on your Traditional 401k to put it into a Traditional IRA. This isn’t difficult, there is just some paperwork to fill out.

2) The next step is to wait until the year in which you made income, is over (assuming the following year is the year you expect to have very little income). For example, if you worked until August 2006 and started graduate school in September 2006, you would want to wait until January 2007 before you perform this step. Step 2 is to CONVERT your traditional IRA to a Roth IRA in the year with little income. If you just want to deal with a Traditional IRA conversion without worrying about 401k’s, then ignore step 1!

Caveats and Benefits

So why are we doing this again? First of all, once the money is in your Roth IRA, it is no longer taxable. When you withdraw it (in retirement) you will owe no taxes on the contributions or the earnings! However, if they remained in a Traditional IRA, you would have to pay taxes at your retirement tax bracket. If your tax bracket now is lower than that, why not convert the IRA so the money becomes “tax sheltered”? This conversion allows you to shelter your money for less than you normally would have been able to!

Does my conversion count as a “contribution” to my Roth IRA that is withdrawable any time? Ah, wouldn’t that be nice? Unfortunately, conversion contributions are counted differently than regular contributions. There is a 5 year holding period before you can withdraw the funds without penalty! Keep this in mind if you’re just looking for a quick way to cash out some money.

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