[This only applies to US students…]
A GREAT piece of advice I got from a friend just before moving to England was to convert any IRA’s (401k’s/403b’s) you have into RothIRA’s while you are a student, and the money WILL NEVER BE TAXED! How is that possible, you ask? It must be a scam. Nope. Here’s how it works…
- A regular IRA is funded pre-tax (that is, you exclude the amount paid in from taxable income), but you are taxed when you withdraw it. A RothIRA is funded post-tax, but you are never taxed when you withdraw it.
- If you are a full-time student you are likely to have very little taxable income. This is especially true if you are studying internationally and your income is excluded from US taxes (after the first year).
- The US tax system allows you to exclude a portion of income from taxes. Last year this amount was $3,400/person in the family plus $10,700/$5,350 (married/single). So, for a married with 2 kids (4 ppl) the exclusion was $24,300, and for a single person it was $8,750.
- The amount converted from an IRA to a RothIRA counts as taxable income in the year of the conversion, but since it is now a RothIRA, you won’t ever pay income tax on it when you take it out.
- So if the amount you convert in any year is less than the income exclusion, that money WILL NEVER BE TAXED!
- Most companies will allow ‘partial conversions’ so you can keep the conversion below the taxable exclusion if you have too much in total to convert.
An example: You are married (no kids) and you or your spouse has $20,000 in an IRA or 401k/403b from an old job.
- If you already have the money in an IRA, your good. If not, convert the 401k/403b to an IRA. It should only take signing a few forms.
- Determine your taxable exclusion. Married no kids should be about $17,500 ($10,700 for being married + $6,800 for being two people [$3,400×2] for 2007). This will be slightly higher each year.
- Subtract out any income you might have that will reduce this. E.g., Taxable interest, foreign earned income*, etc. [*–NB: Only applies to your first year overseas. You have to pay taxes in the US on foreign earned income until you meet the residency rules, which takes about 9-12 months of living somewhere outside the US.] We’ll say you have $1,000 of income. So that leaves you with $16.500 of exclusion.
- Convert $16,500 of your IRA to a Roth in year 1. Convert the remaining $3.500 in year 2.
If you have a large IRA amount that will take more than a couple of years to convert tax free, convert stocks when the market is down because it will allow you to convert more, sooner.