November 14, 2023
If you are considering leaving a job and have a 401(k) plan, then you need to stay on top of the various rollover options for your workplace retirement account. One of those options is rolling over a traditional 401(k) into a Roth individual retirement account (Roth IRA). This can be a very attractive option, especially if your future earnings will be high enough to knock into the ceiling placed on Roth account contributions by the Internal Revenue Service (IRS).
Regardless of the size of your earnings, you need to do the rollover strictly by the rules to avoid an unexpected tax burden. Since you haven’t paid income taxes on that money in your traditional 401(k) account, you will owe taxes on the money for the year when you roll it over into a Roth IRA. Read on to see how it works and how you can minimize the tax bite.
KEY TAKEAWAYS
- Consider the benefits and implications of rolling over a 401(k) to another type of retirement account if you leave your job.
- You will owe income taxes on the money you roll over from a traditional 401(k) to a Roth IRA that year, but you’ll owe no taxes on withdrawals after you retire.
- This type of rollover has a particular benefit for high-income earners who aren’t permitted to contribute to a Roth.
- The immediate tax bill can be avoided by allocating after-tax funds to a Roth IRA and pretax funds to a traditional IRA.
- Be sure to consult a tax professional if you’re unsure of how conversions work for you.
Converting a Traditional 401(k) to a Roth IRA
You’ll owe some taxes in the year when you make the rollover because of the crucial differences between a traditional 401(k) and a Roth IRA:
- A traditional 401(k) is funded with the salary from your pretax income. It comes right off the top of your gross income. You pay no taxes on the money that you contribute or the profit that it earns until you withdraw the money, presumably after you retire. You will then owe taxes on withdrawals.
- A Roth IRA is funded with post-tax dollars. You pay the income taxes upfront before it is deposited in your account. You won’t owe taxes on that money or on the profit that it earns when you withdraw it.
So, when you roll over a traditional 401(k) to a Roth IRA, you’ll owe income taxes on that money in the year when you make the switch.
The total amount transferred will be taxed at your ordinary income rate, just like your salary. Tax brackets for 2023 range from 10% to 37%, and 12% to 35% for 2024.
How to Reduce the Tax Hit
If you contributed more than the maximum deductible amount to your 401(k), you have some post-tax money in there. You may be able to avoid some immediate taxes by allocating the after-tax funds in your retirement plan to a Roth IRA and the pretax funds to a traditional IRA.
Alternatively, you can choose to split up your retirement money into two accounts: a traditional IRA and a Roth IRA. That will reduce the immediate tax impact.
This is going to take some number-crunching. You should see a competent tax professional to determine exactly how the alternatives will affect your tax bill for the year.
Roth 401(k) to Roth IRA Conversions
If your 401(k) plan was a Roth account, then it can only be rolled over to a Roth IRA. The rollover process is straightforward. The transferred funds have the same tax basis, composed of after-tax dollars. This is not, to use IRS parlance, a taxable event.
However, you should check how to handle any employer matching contributions, because those will be in a companion regular 401(k) account and taxes may be due on them. You can establish a new Roth IRA for your 401(k) funds or roll them over into an existing Roth.
The Five-Year Rule
You can withdraw contributions, but not earnings, from your Roth at any time, no matter what your age is. Remember, you’ve already paid income taxes on that money.
But Roth IRAs are subject to the five-year rule. This rule states that to withdraw earnings—that is, interest or profits—from a Roth IRA, you must have held the Roth IRA for at least five years. The same rule applies for withdrawing converted funds—such as funds from a traditional 401(k) that have been deposited in a Roth IRA.
When the Five-Year Rule Applies
When funds are rolled over from a Roth 401(k) to an existing Roth IRA, the rolled-over funds inherit the same timing as the Roth IRA. In other words, the holding period for the IRA applies to all of the funds in the account, including those rolled over from the Roth 401(k) account.
If you do not have an existing Roth IRA and need to establish one for purposes of the rollover, the five-year period begins the year when the new Roth IRA is opened, regardless of how long you have been contributing to the Roth 401(k).
If you rolled a traditional 401(k) over to a Roth IRA, the clock starts ticking from the date when those funds hit the Roth. Withdrawing earnings early, typically before age 59½, could incur taxes and a 10% penalty. Withdrawing converted funds early could incur the 10% penalty.
The rules governing the early withdrawal of funds in a converted Roth IRA can be confusing. There are exceptions to the tax and penalty consequences related to whether you are withdrawing earnings vs. your original after-tax contributions. There are also certain qualifying life events, notably a job loss. Check the rules before withdrawing early funds.
Tip: Rolling over your 401(k) to a new Roth IRA is not a good choice if you anticipate having to withdraw money in the near future—more specifically, within five years of opening the new account.
How to Do a Rollover
The mechanics of a rollover from a 401(k) plan are fairly straightforward. Your first step is to contact your company’s plan administrator, explain exactly what you want to do, and get the necessary forms to do it.
Then, open the new Roth IRA through a bank, a broker, or an online discount brokerage. (Investopedia has lists of the best brokers for IRAs and best brokers for Roth IRAs.)
Finally, use the forms supplied by your plan administrator to request a direct rollover, also known as a trustee-to-trustee rollover. Your plan administrator will send the money directly to the IRA that you opened at a bank or brokerage.
Alternatives
As an alternative, the administrator can send the check to you, made out in the name of your account, for you to deposit. Going directly is a better approach. It’s faster and simpler, and it leaves no doubt that this is not a distribution of money (on which you owe taxes).
If the administrator insists on sending the check to you, make sure that it is made out to your new account, not to you personally. Again, that’s evidence that this is not a distribution.
Another option is to take an indirect rollover. In this case, the plan administrator will send you a check made out to you after withholding taxes at a rate of 20%, and you will then record the distribution and the taxes already withheld on your income tax return.
Warning: Funds withdrawn from your 401(k) must be rolled over to another retirement account within 60 days to avoid taxes and a penalty.
A Few Other Options for Your 401(k)
There are a few other options to consider if you are exploring ways to roll over your 401(k).
401(k) to 401(k) Rollovers
If you’re taking a new job, there is no tax bite when you roll over your traditional 401(k) balance to another traditional 401(k) at a new job or, alternatively, roll over a Roth balance to another Roth balance. However, rollovers are subject to the rules that govern your new company’s plan.
It might not be feasible if the assets in your old plan are invested in proprietary funds from a certain investment company and the new plan only offers funds from another company. If your account contains your old employer’s company stock, you might have to sell it before the transfer.
A transfer also won’t work if your old account is a Roth 401(k) and the new employer only offers a traditional 401(k). If this is the case, then you need to roll your Roth 401(k) into a Roth IRA that you open on your own—or leave it in your current employer’s plan, if that’s permitted.
The optimal scenario would be to roll your old Roth 401(k) into a new Roth 401(k) at your new employer. The number of years when the funds were in the old plan should count toward the five-year period for qualified distributions. The previous employer must contact the new employer concerning the amount in employee contributions that are being rolled over and confirm the first year when they were made. The account holder should transfer the entire account, not just a part of it.
Avoid Cashing Out
Cashing out your account, in whole or in part—whether the account is traditional or Roth—is usually a mistake.
- On a traditional 401(k) plan, you will owe taxes on all of your contributions, plus the 10% for early withdrawals if you are under age 59½.
- On a Roth 401(k), you will owe taxes on any earnings that you withdraw and be subject to the 10% early withdrawal penalty if you’re under age 59½ and have not had the account for five years.
401(k) funds are not the only company retirement plan assets eligible for rollover. The 403(b) and 457(b) plans for public-sector and nonprofit employees can be converted into Roth IRAs as well.
Roth IRA Income Limits
Anyone can contribute to a traditional IRA, but the IRS imposes an income cap on eligibility for a Roth IRA. Fundamentally, the IRS does not want high earners benefiting from these tax-advantaged accounts. In 2024, the annual contribution limit for IRAs is $7,000 or $8,000 if you are age 50 or older. For 2023, the limits were $6,500, or $7,500 if you are 50 or older.
The income caps are adjusted annually to keep up with inflation. In 2024, the income phase-out range for taxpayers making contributions to a Roth IRA increased to $146,000 to $161,000 for single and head of household filers. For married couples filing jointly, the income phase-out range is $230,000 to $240,000.
In 2023, the phaseout range for a full annual contribution for single filers was a modified adjusted gross income (MAGI) ranging from $138,000 to $153,000 for a Roth IRA. For married couples filing jointly, the phaseout begins at $218,000, with an overall limit of $228,000.
And this is why, if you have a high income, you have another reason to roll over your 401(k) to a Roth IRA. Roth income limitations do not apply to this type of conversion. Anyone, regardless of income, is allowed to fund a Roth IRA via a rollover—in fact, it is one of the only ways. The other way is converting a traditional IRA to a Roth IRA, also known as a backdoor conversion.
Each year, investors may choose to divide their funds across traditional and Roth IRAs, as long as their income is below the Roth limits. But the maximum allowable contribution limits remain the same.
What Are the Benefits of a Roth Individual Retirement Account?
A major benefit of a Roth individual retirement account is that, unlike traditional IRAs, withdrawals are tax-free when you reach age 59½. You can also withdraw any contributions, but not earnings, at any time during the contributed tax year, regardless of your age.
In addition, IRAs (traditional and Roth) typically offer a much wider variety of investment options than most 401(k) plans. Also, with a Roth IRA, you don’t have to take required minimum distributions (RMDs) when you reach age 72.
Should I Convert my 401(k) to a Roth IRA?
Converting a 401(k) to a Roth IRA may make sense if you believe that you’ll be in a higher tax bracket in the future, as withdrawals are tax free. But you’ll owe taxes in the year when the conversion takes place. You’ll need to crunch the numbers to make a prudent decision.
How Are Roth Conversions Taxed?
The amount rolled over is subject to income tax. It will be taxed at your ordinary income rate for the year when the conversion takes place.16 If you can, pick a year when your income is lower than usual.
The Bottom Line
Although they are perfectly legal, complicated tax rules apply to retirement account conversions, and the timing can be tricky. The ideal candidate for rolling an employer-sponsored retirement fund into a Roth IRA is a person who does not expect to take a distribution from the account for at least five years.
Those ages 59½ and older are exempt from the 10% early withdrawal penalty, as are those who transfer the 401(k) funds into an existing Roth IRA that was opened five or more years ago. This exemption allows the rolled-over 401(k) funds to be withdrawn without penalty.
This article was originally published in Investopedia on November 12, 2023, written by Cathy Pareto
1. https://www.investopedia.com/articles/retirement/08/convert-401k-roth.asp
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