Episode 74 – DCP conversions: pretax to Roth
There are a lot of reasons people choose to convert money within their DCP account from pretax to the Roth option. We discuss the process of how this is done as well as the pros and cons, including timing and tax rules.
Episode transcript:
[music intro]
Jenny
Welcome back to Fund your Future with DRS. Well, we’ve been getting questions lately about rollovers for DCP and specifically questions around moving money from a pretax account to a Roth account. We have a number of members who have both types of accounts, and there’s some important things to know about moving money between the two accounts. So, we’ve invited Devi back to the podcast, who works on the DCP team here to tell us a little more. Well, welcome, Devi.
Devi
Thank you. It’s good to see you again.
Jenny
Yeah. So, to kick it off, start us off with what is a Roth conversion and how do Roth conversions work?
Devi
So, some members think when they do a Roth conversion, they’re moving their money into a Roth IRA, which is not correct. So, what you’re actually doing is taking the money in your DCP account that is pretax, and paying the taxes on that money so that it can be converted to the Roth after tax. But it’s still within your DCP 457(b) plan.
Jenny
Excellent. Yeah, I know that I have a pretax and a Roth account in DCP, and I’ve thought about rolling some stuff over, but I definitely need to, talk to a tax advisor first about what to do there. But we’ll get into that later.
Seth
So, Devi, why would someone want to do a Roth conversion?
Devi
So, there’s a lot of different reasons for that. But the biggest one we hear about is tax free gains. So, when you convert your pretax dollars to Roth and you meet that five-year minimum eligibility period and you’re at least age 59.5, you can withdraw that money and any investment gains tax free in retirement. And so of course, the longer those after tax Roth dollars are in your account creating investment gains, the more you can capitalize on that in retirement.
Jenny
Yeah, I like this idea. So, if someone was thinking about doing this and converting over their money from pretax to the Roth, when could they do that?
Devi
So, members can convert their money from pretax to Roth at any point in time while they’re active, after they’ve separated or even in retirement.
Jenny
Do they have to do all of the money? Or it could just be like a portion of it?
Devi
Members can choose how much they want to convert so they can do, some or all of their pretax account balance, whatever works best for them.
Seth
And then can I only do it once?
Devi
You can do a Roth conversion as many times as you want. And actually that’s a great strategy for breaking up those taxes that you’ll need to pay on the conversion in that tax year. So, you can choose a set amount and convert that from pretax to Roth in one tax year. Pay the taxes on that, get your 1099, get everything sorted out, and then in future years you can do more conversions to spread out those taxes.
Jenny
Right. Because the Roth option just became available a few years ago for DCP, we know that a lot of folks may have a larger chunk of change in their pretax account than in, say, like a Roth account, or they may have no Roth funds at all yet.
Devi
That’s true. Yeah.
Jenny
And then does the Roth conversion count toward your annual limit for DCP?
Devi
It does not, because you’ve already contributed this money to your DCP. You’re just changing the tax type from pretax to Roth by doing the conversion. So, it does not count toward your annual limit.
Seth
And then once a person has money in their Roth portion of their DCP account, when can they withdraw the money out of their account?
Devi
So, they can take the money out after, five years and age 59.5, tax free. If they are separated from service, they can withdraw that money. Or if they are aged 59 and half and still active, they can also withdraw the Roth dollars, but they’re going to pay taxes on those investment gains. So, if you want to withdraw it tax free, you got to wait until you meet that five years and age 59.5.
Jenny
And then sometimes folks have questions about like if they change their mind, maybe they end up moving all of their pretax money over to Roth and then maybe want to convert some back. Is that a possibility?
Devi
So, once you have, completed the Roth conversion, it’s a permanent change and it moves pretty quickly. It usually happens about 5 to 7 days after you submit the request form. So, you want to make sure that it is something that you truly want to do, and that you’re ready to convert those funds from pretax to Roth. Because once you’ve set that in motion and made the request, you really can’t reverse the process and put the money back into your account.
Seth
And then this is something that I’ve been thinking about a lot, but is doing this Roth conversion right for everybody?
Devi
It depends on your situation. So, there’s a lot of opinions out there about, pretax and Roth-ification and there’s no one answer that’s right for everybody. So as long as you’re willing to wait that five year holding period to pull those Roth dollars and investment gains out of your account, then that’s something that could benefit you in retirement.
And of course, the longer you leave the money invested in the market, the more gains it’s going to generate over time, and then the more money you’ll have to pull tax free in retirement. And there’s a lot of opinions out there with financial advisors and financial experts about whether contributing to Roth earlier in your career or right before retirement works better. It just again, depends on your situation.
Jenny
Yeah. One of the ways I’ve heard to think about it is: do you want to pay the taxes now, or basically pay the taxes later? And so, thinking about that, if you’re going to be in potentially a higher tax bracket later on, sometimes it makes more sense to do more Roth now. But then you could also convert the money over later.
Devi
Exactly. So, some people have higher earnings now while they’re actively employed. And so, doing that Roth conversion and paying the additional taxes could bump them into a higher tax bracket now. And then there’s other folks that looking toward their retirement, they realize that they’re actually going to have more income in retirement. And so, being able to have those, tax free dollars available and also not paying RMDs or required minimum distribution on those Roth dollars is going to really be a benefit in retirement.
Seth
I was just going to bring up the required minimum distribution point, because I think for a lot of people, they save and they save and they save in these pretax accounts, and then they get to age 70 or 73, you know, whatever the RMD age is for the person. And they realize, “oh my gosh, now I have to start taking money out of this account and I’m going to pay taxes on it.”
And so it might be, you know, an extra $100,000 that is income that they then owe taxes on and that they don’t control when they’re able to take it out. So, for those folks, they might have wished they had done a Roth conversion earlier in their career.
Devi
Exactly.
Seth
Can we just walk through an example of how this would work? So, I’m a DCP member. I’ve got my account and it’s getting close to the end of the year. And right now I only have pretax money in it. And I decide I’m going to convert $10,000 to Roth. So, I fill out the form on the Voya website…Is that right?
Devi
We actually have the pretax to Roth conversion form available on the DRS website in the form section. You can download that form, fill it out. You’re going to send that form to Voya Financial not to DRS. Once Voya Financial has your completed form in good order, which means all of the information is accurate and they have everything they need to process your request.
They’re going to take that pretax money, liquidate it from your account, and then those dollars are now going to be attributed to the Roth or after tax portion of your account. And then you’re responsible for paying the taxes on that at the end of the year. So, DRS and Voya do not pay those taxes for you. They do not tax that money.
So, if you want to take, say, $25,000 and convert it from pretax to Roth, you’re going to have to pay that $25,000 when you file your taxes. You will receive a 1099 from Voya, though, showing that the conversion took place.
Seth
Right. So, if I do this conversion at the end of this year, $25,000 moves from my pretax bucket to my Roth bucket. So now I see $25,000 invested and in my Roth DCP account. And then come next, late January early February, I get a 1099 in the mail from Voya that shows $25,000 of income that I have received. Sort of. It was income that I’m going to have to report on my taxes. And then I’m going to have to pay taxes on that $25,000 from some other source.
Devi
That’s correct. Because if you hit the rewind on that, when you put those pretax dollars into your DCP, you were contributing that from your pay before you were taxed on those earnings. And so now the IRS is going to look at that as taxable income for that tax year. We do tend to see a lot of people requesting Roth conversions toward the end of the year, because they’re looking at their taxable income for the year.
They have a good idea of how much wiggle room they have in there before they’re bumped up to the next tax bracket. And so that may be a good time to consider doing a Roth conversion. But you can do it at any time of the year. You do want to make sure though, because we get a lot of late requests in December, usually around mid-December.
By that point in time, it could be too late. So, you want to make sure that you have that decision made and you’re getting your paperwork into Voya by late November, the very first days of December at the latest, so that there’s enough time to process that.
Seth
I really appreciate your point that when that money went into the account, it didn’t show up as income on my taxes. And so now that that money is in the Roth part of my account, that income is going to show up on my taxes and yeah, as you said, depending on what tax bracket I’m in will determine how much in taxes I have to pay on that total amount that I converted.
Jenny
Yeah. And I really appreciate the timeline example too. Kind of that idea, like you said, when people are looking at their taxable income for the year and thinking about maybe doing that, then getting in that paperwork before really the end of November.
Seth
Yeah. It also makes sense because when you’re doing it at the end of the year, you’re reminded that maybe I’ve already taken enough out of my other paychecks that I’m going to be getting a refund so that money can help go pay for the taxes that are going to be paid on my Roth conversion. It’s kind of weird because most of us are used to paying taxes out of our paychecks.
Generally speaking, as a standard hourly employee, they’re taking a certain amount out of my paycheck every month, and that’s going to the IRS and some of that I may get back if I’ve had too much withheld, and I might end up owing a little bit more. But this Roth conversion is like it’s almost like you worked as an independent contractor or something.
It’s some additional income that you have to report on your taxes that hasn’t had any taxes withheld on it. And so, you have to figure out where are you going to get that money to pay the taxes when you file your taxes by April 15th of the following year.
Jenny
Yeah, that’s a great way to think about it. There’s like money from maybe an independent contractor or something else. You haven’t paid taxes on this money yet.
Seth
Yeah. The IRS doesn’t know about it yet.
Devi
The other advantage to doing a Roth conversion earlier in the year is that gives you time to save up the amount of taxes that you’ll need to pay that tax bill by the end of the year. So, if you decide you want to do that conversion, you do it in the first quarter of the year. Then you can start tucking money away and have that ready to go. When you file your taxes.
Seth
You’re planning for it in advance. Yeah, that makes that makes sense. Is there anything else our listeners should know? I mean, maybe I’m personally thinking about doing a Roth conversion this year, but what other questions should people be thinking about or what else should we know?
Devi
Yeah, another benefit of doing a Roth conversion is for estate planning. So, a lot of folks are planning to, pass on some of their contributions and assets to children or grandchildren, organizations, trusts, and so doing a Roth conversion can help maximize, that inheritance that’s being left to your heirs.
Seth
That’s great, because you you’ve already paid the taxes, so your heirs aren’t responsible for the taxes down the road.
Jenny
So, in your example, yes, you could potentially convert the pretax money to Roth and then you’re paying the taxes on it now. And then when you pass, your beneficiaries inherit the Roth money. But then they don’t have to pay the taxes on it.
Devi
That’s correct.
Jenny
Really good for people to think about. And definitely, you know, we recommend talking with a tax professional about what is best for your situation.
Devi
Absolutely. And it’s great to have diversified, income in retirement. So, if you have a combination of pretax and Roth in your account for DCP, then you’re going to have a lot of flexibility, to manage your income in retirement. So, again, that’s a decision that everyone needs to make for themselves. It does give you additional options now that we have both the pretax and the Roth after tax option.
And I love that visual of the two buckets, that really, hit home with me, and I could picture that in my mind.
Seth
I think Jenny made that. I want to make sure to give her credit for the faucets filling up the bucket. So for people who haven’t seen that on our website, it is a very nice graphic on the Roth DCP page to help understand how the limits interact with each other.
Jenny
Yes, we’ve got I think we’ve got a whole ‘nother episode about DCP annual limits. It’s basically that, you know, if the limit is I can’t remember what it is for this year…
Devi
It is $23,500 for participants under the age of 50. For participants over age 50, it is $31,000 this year.
Jenny
Right. So just as a reminder with like those limits. So, if the limit for this year is $23,500, you can put in a little bit of pretax, a little bit of Roth, maybe it’s $10,000 and $13,500. But you can’t go over that $23,500 between the two of them.
Seth
All right. Thanks for joining us Devi.
Devi
Thank you so much. It was great speaking with you.
Jenny
Thank you.
[music outro]
Disclaimer
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