Do you have either a 401(k) from your previous job or a Traditional IRA? If your answer is yes, and if you want to save thousands of dollars in tax (I’m not kidding), read on.
One of the most painful aspects of putting a hold on your career to go back to school is making negative income. You’re not working any more, and yet business school has so many expenses beyond tuition. If you are used to making a decent salary and watching your bank account balance go up every 2 weeks, seeing the balance going down day after day is going to be really odd. But there’s a silver lining to this.
Did you know that making next to no income has its advantages?
Because your income tax is also next to nothing, making it beneficial for you to convert your 401(k) and your Traditional IRA to a Roth IRA.
Let me explain.
When you contributed money into your traditional 401(k), you received a tax credit which renders your 401(k) contribution pre-tax. And then your account grows with time because your money is in some sort of mutual funds, and when you retire you take the money out to pay for your retirement expenses. Hopefully the funds did well and you end up with way more money than you put in.
The sticky thing is, when you withdraw from your 401(k) you pay an income tax on the distribution. The money withdrawn is treated as ordinary income for income tax assessment. The more you withdraw the more tax you pay.
So in short, a traditional 401(k) allows you to defer paying income tax.
Now, if you chose instead to contribute to a Roth 401(k), you would not receive a tax credit. Instead, your account will grow tax-free: when you withdraw from your Roth 401(k) later, you will not pay any tax. You paid an income tax before you contributed to your Roth 401(k), so you won’t pay tax again. No tax on the investment returns either.
A Roth 401(k) allows you to avoid paying tax on capital gains.
Let’s say you contributed money to a traditional 401(k) because this is the more common option by far. If you’re an MBA, especially one from Anderson (haha), I’m going to bet that you are a high income earner and a savvy investor and consequently will end up with a good amount of money in your 401(k). When it comes time to withdraw your retirement savings in the future, you may have to pay a lot of income tax to Uncle Sam.
What if I tell you you can reduce the pain by paying the income tax now when your income tax rate is low?
Here is the route. You roll over your traditional 401(k) to a traditional IRA and then convert the traditional IRA to a Roth IRA. If you have a traditional IRA, simply convert it to a Roth IRA.
When you do this, you pay an income tax on the amount that you convert from traditional IRA to Roth IRA. And you don’t have to convert all at once – you can stagger the conversion to take the most advantage of the tax brackets and minimize the amount you need to pay.
You see, there are good things about not making very much money … temporarily. After 2 years in school, you’re going to make a lot of money, obviously right ??? Your future tax rates are most likely going to be a lot higher than your present ones, and this is why the best time to convert your traditional 401(k)/IRA balance is when you’re back in school.
More fun stuff later.
-Richard
Richard Anderson 