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Ask Dave

401(k) Conversion

Dave explains to Byron why converting a 401(k), which has $6,300 in it, to a Roth IRA is a good plan.

QUESTION: Dave explains to Byron why converting a 401(k), which has $6,300 in it, to a Roth IRA is a good plan.

ANSWER: You don’t cash it out. Do a direct transfer rollover with the broker that has your Roth IRA to a traditional IRA. If you have an extra couple thousand dollars, I would convert it to a Roth IRA when you do that. By doing that, you’ll need the extra couple thousand dollars to pay the taxes created by that. Roll it to a traditional IRA by direct transfer.

What that means is when you’re rolling a 401(k), you don’t want the company you’re leaving to give you a check. If they give you one, they are required to withhold 20%. Let’s say you had a big 401(k) with $100,000 in it. They withhold $20,000, so you have $80,000 in your hand, but you are required to put $100,000 into the new IRA that you open up within 60 days. Only you don’t have $100,000, you have $80,000 because they withheld $20,000.

You’ve gotten yourself into a situation where you’ve made an accidental withdrawal on your IRA or your 401(k) and get penalized and didn’t mean to. The way to avoid that is with a direct transfer rollover. What that means is you go to your broker, or an investing ELP on our website, and pick out the mutual fund that you want to put your new IRA into, that you’re moving your 401(k) money into.

You select the mutual fund, fill out all the paperwork, sign everything, and you do not have to give the broker a check. One of those forms you fill out is a direct transfer form. That form is then sent to the administrator of your 401(k), and they send the money, without withholding a dime, directly to the IRA. They are not required to withhold when it’s a direct transfer.

It keeps you from getting in a cash-flow bind when you are doing an IRA rollover. Do a direct transfer rollover. That’s definitely your best route to go on that, and I’d pick a good mutual fund.

Now once you’ve got it there, if you want to convert it to a Roth IRA, I would since you’re on Baby Step 3. If you can scratch together a couple thousand bucks, which would be about your taxes on $6,300, and be ready for your tax bill next spring when you file your taxes because you’ve converted a traditional IRA to a Roth IRA.

The beauty of that is that you have $6,300 growing tax free, not tax deferred. That’s a big hairy deal later. If you convert that $6,300 to a Roth IRA and you’re 30 years old, and the mutual fund averages 12 percent growth, that money will grow to $747,000 by the time you’re 70 years old.

If it’s in a traditional IRA because it wasn’t converted to a Roth IRA, he pays taxes on that entire amount as he takes it out at retirement. If the tax bill is a third of that amount, that means about $250,000 of it will go toward taxes. Or, he can pay $2,000 now and leave the entire $6,300 in there, it still grows to $750,000 and has no taxes on it.

This little move turns into three quarters of a million dollars tax free and costs him $2,000 out of pocket. This is what we call in finance the time value of money. Would you rather have $5,000 today or $750,000 at retirement? It’s about the same thing. That’s what that money is worth if you invest it. That’s what it becomes. That’s what you’ve got to think about.

Rich people think about these kinds of formulas. They think about things like how $100 a month invested from age 25 to 65 in a decent growth -stock mutual fund in a Roth IRA equals $1,176,000. That’s $100 a month during your working lifetime to retire a millionaire. You don’t just retire okay or eke by on Social Insecurity, which isn’t even enough to support your life and was never designed to be a retirement program that supported you. It was designed to be a supplement at best, and that’s all it is at best.

You can’t live on Social Security and if you do, you’re not living much of a life. A hundred dollars a month makes you a millionaire. I would submit to you that you will have some down times and hard times over your life, but you’ll also have times when you’re prosperous. And if you will start investing, you almost always make enough to save $100 if you just don’t buy the super-duper premium cable package. Or if you buy a car that doesn’t have a car payment. If you don’t consume everything you make and you learn to do what rich people do.

They understand that over time, money seriously grows if you continually do it and continually save it. Just $100 becomes $1,176,000. I could go off for 10 minutes about how no one in America should retire and not be a millionaire. Everyone should retire a millionaire. Isn’t that ridiculous?

But in today’s culture, we are being politically taught to resent success. The president calls it shared prosperity; and you have to have prosperity in order to share it. Isn’t that interesting? You would have it if you changed your actions instead of waiting on him to fix your life. There is no time when a government program does that for you. But when you do it for you, $100 a month makes you a millionaire.

If you think you’re old and it’s too late for you, that just means you have to put in more than $100. It’s not too late for you as long as you’re sucking wind. You can still make positive choices starting today. Ready, set, go.

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