If you’re considering leaving a job, and you have a 401(k) plan, you’ll need to stay on top of the various rollover options for your workplace retirement account. One of those options is rolling a traditional 401(k) into a Roth IRA.
This can be a very attractive option, especially if your future earnings will be enough to knock the ceiling on Roth account contributions by the Internal Revenue Service (IRS) now.
But regardless of the size of your salary, you need to rollover strictly by rules to avoid unexpected tax burden. Since you didn’t pay income tax on that money in your traditional 401(k) account, you’ll pay income taxes for the year in which you roll it into a Roth account. Read on to see how it works, and how you can reduce the tax deduction.
- If you roll over a traditional 401(k) to a Roth, you’ll have to pay income tax on the money that year, but you won’t have to pay any taxes on the entire balance after you retire.
- This type of rollover has a special advantage for high-income earners who aren’t allowed to contribute to a Roth.
- An immediate tax bill can be avoided by allocating after-tax funds to a Roth IRA and pre-tax funds to a traditional IRA.
Converting a Traditional 401(k) to a Roth IRA
Because of the significant differences between a traditional 401(k) and a Roth IRA, you’ll still owe some taxes in the year you rollover:
- A traditional 401(k) is funded with a salary from your pre-tax income. This comes right up to your gross income. You don’t pay any taxes on the money you deposit or the gains you make until you withdraw the money, possibly after you retire. Then, you will have to pay tax on the entire amount at the time of withdrawal.
- Roth IRAs are funded with post-tax dollars. You pay income tax in advance before it is credited to your account. You won’t have to pay any tax on that money or the profit you make when you withdraw it.
Therefore, when you roll over a traditional IRA to a Roth IRA, you will pay income tax on that money in the year you switch.
The total amount transferred will be taxed at your ordinary-income rate, just like your salary. (Tax rates range from 10% to 37% for tax year 2021.) The parentheses did not change for 2022.
how to reduce tax hit
Now, if you contributed more than the maximum deductible amount to your 401(k), you’ve got some after-tax money in there. You may be able to avoid some immediate taxes by allocating pre-tax funds to a Roth IRA and a traditional IRA in your retirement plan.
Alternatively, you can choose to split your retirement money into two accounts, a traditional IRA and a Roth IRA. This will reduce the immediate tax impact.
This is going to take some number-crunching. You should see a competent tax accountant or tax attorney to determine how the options will affect your tax bill for the year.
However, consider the long-term benefits: When you retire and withdraw money from a Roth IRA, you won’t have to pay taxes.
Roth 401(k) to Roth IRA Conversion
The rollover process is simple if you have a Roth 401(k) and are rolling it over to a Roth IRA. Transferred funds have the same tax base, made up of after-tax dollars. It is not a taxable event to use IRS language.
If your 401(k) is a Roth 401(k), you can roll it over directly into a Roth IRA without the intermediate steps or tax implications. You should investigate how to handle any employer matching contributions because they will be in a fellow regular 401(k) account and taxes may be due on them. You can set up a Roth IRA for your 401(k) funds or roll them over to an existing Roth.
five year rule
There’s another reason to think long-term: Roth IRAs are subject to the five-year rule. This rule states that in order to withhold interest or profits from a Roth tax- and penalty-free plan, you must have held a Roth for at least five years.
The same rule applies for withdrawing converted funds — such as money from a traditional 401(k) that has been deposited into a Roth IRA.
Rolling your 401(k) into a new Roth IRA is not a good option if you anticipate withdrawing money in the near future—specifically, within five years of opening the new account.
When the Five Year Rule comes into force
If the funds are rolled over from a Roth 401(k) to an existing Roth IRA, the rolled-over funds receive the same amount of time as a Roth IRA. That is, the holding period for an IRA applies to all funds in the account, including those rolled over from a Roth 401(k) account.
If you do not have an existing Roth IRA and need to establish one for rollover purposes, the five-year period begins in the year the new Roth IRA is opened, even if you are in a Roth 401(k). be contributing. ,
If you’ve rolled a traditional 401(k) into a Roth IRA, the clock starts ticking from the date those funds hit the Roth. Withdrawals early can attract both tax and 10% penalty. Early withdrawal of converted funds may attract a 10% penalty.
The rules governing early withdrawals of funds in a converted Roth IRA can be confusing. There are exceptions related to tax and penalty consequences if you’re withdrawing earnings against your original after-tax contributions. There are also some qualifying life events, notably job loss.
If you’re considering an early withdrawal of funds from your Roth IRA, it’s important to speak with a qualified tax specialist who is familiar with the appropriate IRS rules.
You can withdraw contributions from your Roth at any time, but not earnings, regardless of your age. Remember, you have already paid income tax on that money.
Note that as part of the COVID-19 relief law, for 2020 only, the early withdrawal penalty was abolished.
how to rollover
The mechanics of a rollover from a 401(k) plan are fairly simple.
Your first step is to contact your company’s plan administrator, clearly explain what you want to do, and obtain the necessary forms to do so.
Then, open a new Roth IRA through a bank, broker, or online discount brokerage. (Investopedia has lists of the best brokers for IRAs and the best brokers for Roth IRAs.)
Finally, use the forms provided 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 you opened at a bank or brokerage.
As an alternative, the administrator may send a check drawn on your account name for you to deposit. A better way is to go straight. It’s fast and simple, and no doubt it’s not a distribution of money (which you owe taxes on).
If the administrator insists on sending you the check, make sure it is made from your new account, not you personally. Again, this is proof 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 given to you after withholding taxes at the 20% rate, and you will then record the distributions and taxes already withheld on your income tax return.
Funds withdrawn from your 401(k) must be moved to another retirement account within 60 days to avoid taxes and substantial penalties.
Some Other Options for Your 401(k)
There are a few other options to consider if you’re looking for ways to rollover your 401(k):
401(k) to 401(k) Transfers
If you’re taking on a new job, roll over your traditional 401(k) balance at a new job to another traditional 401(k) or, alternatively, roll the Roth balance into another Roth balance. , then no tax is to be deducted. However, this is subject to the rules that govern your new company’s plan.