Moving SEP to Roth IRA Creates Post-Rollover Tax Issues

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Dear Rick:

I have a few tax questions and would like your advice. I recently had my tax return done and I think my preparer may have made some mistakes. Last year, the company I work for terminated its MS and launched a 401(k) plan.

At the time, they said we could either transfer the balance into the 401(k) plan or transfer it to an IRA. I chose to roll the money into a Roth IRA. I felt like I had a choice between a traditional and a Roth IRA. However, my tax preparer told me that the rollover was considered a conversion and that I now had to pay taxes on that money. Is he right ? I would not have done this if I had known that the money would be imposed on me since I do not have the money available.

My options would be to take a cash advance on my credit card, dip into my emergency fund, or take a distribution from my IRA. I am in my late thirties and intend to work long term.

Thank you, JJ

Dear JJ

Unfortunately, I have bad news for you. The money from your SEP that you transferred into the Roth IRA is taxable to you. You are correct that if the money were transferred directly into a traditional IRA, there would be no tax consequences; however, the fact that you transferred it into a Roth IRA is what created the tax liability. Therefore, your tax preparer is correct that you owe money.

Although you have to pay taxes on the money you converted, you might find out later that it was a good financial decision. After all, Roth money grows tax-free, and what’s more, Roth IRA money isn’t subject to required minimum distributions. So even if you don’t want to pay taxes now, in the long run it may be a good decision for you.

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As for where you should get the money to pay taxes, I still think credit cards are a bad choice. The interest you will pay on your credit card will be significant. As you review your options, I would suggest tapping into your emergency fund. This additional tax liability is a good use of your emergency fund and a better option than taking an IRA distribution. Due to your age, IRA distributions would likely incur a penalty, as well as tax consequences. Therefore, I believe that using the emergency fund is the best financial way to pay your tax liability.

I think it’s important that you eventually replenish the money taken from the emergency fund. Emergency funds are essential. In the example that interests us, the emergency fund allows you to manage the tax payable in the most efficient and profitable way. You never know what emergency might arise in the future, so be sure to replace any funds you use.

My general belief is that everyone needs three to six months of living expenses to protect themselves. If you find your emergency fund isn’t enough, it’s a good idea to set up a program to build one up. By the way, if you get a tax refund, using it to fund your emergency fund is a great plan.

Good luck.

Rick Bloom is a paid financial advisor. His website is www.bloomadvisors.com. If you’d like him to answer your questions, email [email protected]

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