Tuesday, October 12, 2010

Simplified - Or Not

Last week I got a letter in the mail from the bank that manages my 401k account from my old job. The notice turned out to be more then just the normal quarterly statement, it was actually informing me that basically all of the investment options were being replaced with target date funds (where the asset mix automatically changes based on your supposed retirement in a given year). The gist was that if I didn't move the money somewhere else, everything would be automatically converted over to whatever fund they thought fit the best based on my age.

After investigating a bit, this seemed like an ideal time to finally roll the account over to my current 401k, eliminating an account and simplifying the number of investments we were carrying. The distribution of types of investments were similar between the two 401ks, but due to the slight differences between which funds were available to which plans, the actual funds were slightly different.

This hadn't really been a problem, per se, but it seemed like time to admit that I had been unnecessarily lazy in not moving the money over the past four years. In discussing this with my dad (intending to debate an IRA versus 401k), he actually brought up that 2010 happens to be the one year window for conversions of 401k accounts to Roth IRAs without income limits (normally 100k even for married filing jointly) and with a deferral for the accompanying income tax over two tax years (2011 and 2012).

The advantage of the Roth IRA, of course, is that it is after tax money that grows tax free. As opposed to the 401k that is pre-tax money taxed on withdrawl. Since no one knows what tax rates will have done by the time I retire, the theory is having money in both types of accounts diversifies your tax exposure. Converting an existing account also gets around the annual contribution limits and the income limits on contributing money in the first place.

The downside (other then the risk that you end up in a lower tax bracket in retirement), of course, is that converting pre-tax money to post-tax money means paying taxes on it. Potentially lots of taxes, depending on what that extra income does to your tax bracket. Thus the two year deferral of taxes is key, since paying taxes on half the conversion in tax year 2011 (calendar 2012) and half in tax year 2012 (calendar 2013) gives you some time to save the money and avoid the penalties that would accompany not having made estimated tax payments in the year of the conversion.

After discussing it with Linzy at length, we decided that while it would have been far better to have done the conversion in January before this year's 30% run-up, it made a lot of sense to do the conversion anyways. Of course, that means that instead of consolidating accounts, I actually ended up with a new account, complicated tax considerations, the need to adjust tax witholding at work for next year, and homework to research totally different investments.

How's that for simplification?

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