I am 60 years and will be retiring from AT&T on 12.2.2021. I have elected a pension lump sum to be rolled into my employee 401K with Fidelity Investments. I also have a small Roth IRA with Fidelity. My plan is to payoff all debts including our remaining mortgage - appx $160K. My questions is if I withdraw funds from my 401K after retirement, what will be the tax implications (e.g., the tax on $160K+ to payoff debt). If the amount will be significant, can I benefit from a tax break by rolling funds into the Roth IRA to withdraw funds to payoff my bills? Will this potentially eliminate the amount of taxes to be paid?
Please let me know your thoughts.
Whether you take a distribution or convert it to a ROTH IRA the tax is the same. it will add to your income and you pay ordinary income tax on it and it will push you into a higher tax bracket. So be careful. Try to spread it out and take a small amount each year. Like you can take some this year then take more in January or next year.
Not having a home mortgage sounds great in theory, but you may end up paying 20% on the withdrawal, and also lose your interest deduction. If you roll the funds into a Roth, you will pay taxes on them. That is because the 401K funds have never been taxed.
I would suggest talking this over with a financial advisor and coming up with a way to avoid those taxes.
1. Doing a rollover from the pension to the 401(k) -- no tax consequences if you keep it in the pre-tax side of the 401(k).
2. Note that once you separate from service, you have the option of doing a rollover from the 401(k) into a private IRA. A private IRA will have more investment options than the 401(k), but may have higher maintenance fees.
3. Doing a rollover from your 401(k) to the Roth IRA will result in you paying income tax on the money now.
4. Withdrawing from the pre-tax 401(k) for any purpose will also result in you paying full income tax on the money now, regardless of what you plan to do with the money.
Here's where you need to do some real financial planning.
5. Let's say your mortgage rate is 4%, and you itemize your tax deductions including mortgage interest. That reduces the effective mortgage interest rate to around 3.5%. Paying the mortgage off in full is the equivalent of investing your assets with a return of 3.5%. You would probably get a higher rate of return if you left your money in the 401(k), but you might have to invest in less-safe investments (stocks, for example). How safe is your house as an investment, compared to a diversified mutual fund? (Do you live in a declining or up and coming area? For example, my last house was in a very desirable neighborhood in a declining city. It was good for the short term, but my estimation is that over the next 20 years it will eventually decline because the schools are crap and more people move out of the city every year than move in, so eventually there won't be enough demand even in the good neighborhoods to prop up the home values. I could be wrong.)
Paying off the house now might mean paying higher taxes on your 401(k) withdrawal compared to withdrawing small amounts over time to make the monthly mortgage, and the money remaining in the account will continue to grow in value, unless your investments go down (which is always a risk, but which can be mitigated). Paying off the house versus investing is a complex calculation, unless you value peace of mind over all.
6. If all your money was converted to a Roth IRA, you would pay a possibly enormous tax bill now, but you would never pay income tax again. This becomes important when thinking about social security. Suppose you are married filing jointly and you and your spouse bring in $24,000 of social security per year. That's tax-free, and if you withdraw less than $24,000 from a pre-tax 401(k), that's also tax-free. But suppose your lifestyle requires you to withdraw more from the 401(k). If you withdraw more than $24,000 from the 401(k), you will pay 15% tax on the 401(k) AND 10% tax (more or less) on your social security. If you withdraw more than $60,000 from the 401(k) you will pay 22% on the 401(k) AND 18% on the social security.
But, if all your money was in a Roth account, then it's never taxable which means your social security is never taxable either. And the Roth IRA has no RMD once you turn 72.
But what's the best way to get the money into the Roth in the first place, and pay the least taxes you can?
Even the decision to take the lump sum pension payout rather than a monthly benefit is complicated, and depends on your life expectancy, health, future plans and the exact specifications of the pension plan.
You might benefit from consulting a professional financial advisor.