401(k) Rollover: Pick Roth IRA or Traditional IRA
When you leave your job or receive a distribution from a 401(k) plan under a qualified domestic relations order (QDRO) or you are a beneficiary who inherits a 401(k) plan account, you can roll over the account to a personal Roth IRA or a traditional IRA. Which option is better? Here are some factors to consider.
Current Tax vs. Future Tax Savings
The choice is between paying tax now or later. If you make a rollover from your 401(k) account to a traditional IRA, you pay no current tax. (Special rules apply to rollovers of designated Roth accounts, explained later).
The best way to make a rollover to a traditional IRA is to have the plan administrator transfer the funds directly into your IRA. This way there won’t be any automatic withholding on the transferred amount. If you take a distribution, 20% will be withheld, requiring you to ante up that withheld amount if you then decide to make a full rollover within 60 days to avoid tax on the distribution. (You’ll recoup the withholding when you file your income tax return for the year of the distribution.)
However, if you make a rollover to a traditional IRA, you’ll have to start taking taxable distributions at age 70½ (or earlier if you were not the employee who had the 401(k)). Tax deferral won’t last forever.
In contrast, if you opt for a Roth IRA rollover, you must treat the entire account as taxable income immediately. You’ll pay tax now on this amount (federal income tax as well as state income taxes if applicable). What’s more, you’ll need the funds to pay the tax and may have to increase withholding or pay estimated taxes to account for the liability. However, assuming you maintain the Roth IRA for at least five years and meet other requirements, then all of the funds – your after-tax contribution plus earnings on them – are tax free.
There are no lifetime distribution requirements for Roth IRAs, so funds can stay in the account and continue to grow on a tax-free basis. You can leave this tax-free nest egg to your heirs (although they have to draw down the account over their life expectancy).
Personal Factors to Consider
Where are you financially now versus where you think you’ll be when you tap into the funds? Answering this question may help you decide on which rollover option to use. If you’re in a high tax bracket now and expect to need the funds before five years, a Roth IRA may not make sense. You’ll pay a high tax bill up front and then lose the anticipated benefit from tax-free growth that won’t materialize. Conversely, if you’re in a modest tax bracket now but expect to be in a higher tax bracket in the future, the tax cost now may be small compared with the tax savings in the future (assuming you can afford to pay taxes on the rollover now).
Will you need money before your golden years? If you may need funds, all withdrawals from a traditional IRA are subject to regular income tax, plus a penalty if you’re under age 59½ and don’t qualify for a penalty exception. In contrast, withdrawals from a Roth IRA of after-tax contributions (the transferred funds you already paid taxes on) are never taxed. You’ll only be taxed if you withdraw earnings on the contributions; these may be subject to a 10% penalty as well if you’re under age 59½ and don’t qualify for a penalty exception.
Did you obtain the account through inheritance? If so, you can make a direct rollover to either account, but you’ll have to start distributions immediately (regardless of your age). For most beneficiaries, paying tax on the account up front to use a Roth IRA only to have to begin drawing it down works against this option.
It’s Not All or Nothing
You can split your distribution between a traditional and Roth IRA (assuming the 401(k) plan administrator permits this). You can choose any split that works for you (e.g., 75% to a traditional IRA and 25% to a Roth IRA).
Don’t Roll Over Employer Stock
If you hold this investment in your account, it may make sense not to roll it over (you can roll over the balance of the account minus the stock). The reason is net unrealized appreciation (NUA). NUA is the difference between the value of the stock when it went into your account and its value when you take the distribution. You’re only taxed on the NUA when you take a distribution of the stock and opt not to defer the NUA. By paying tax on the NUA now, it becomes your tax basis in the stock, so when you sell it – immediately or in the future – your taxable gain is the increase over this amount. Any increase in value over the NUA becomes capital gain. You can even sell the stock immediately and get capital gain treatment (the usual more-than-one year holding period requirement for capital gain treatment does not apply if you don’t defer tax on the NUA when the stock is distributed to you).
In contrast, if you roll over the stock to a traditional IRA, you won’t pay tax on the NUA now, but all of the stock’s value to date, plus appreciation, will be treated as ordinary income when distributions are taken.
Special Rules for Designated Roth Accounts
If your 401(k) plan had this feature, contributions in these designated Roth accounts can only be rolled over to a Roth IRA. This makes sense since you already paid tax on the funds contributed to the designated Roth account. You don’t pay any tax on the rollover to the Roth IRA.
The Bottom Line
Before making any rollover decision, consider whether to keep your account with your former employer, transfer it to a plan of a new employer or simply take the distribution and pay tax now. (For more on this, read Best Ways to Roll Over Your 401(k).) Keeping your account where it is makes sense if you like the investment options offered through the 401(k) plan. Similarly, transferring funds to a new employer is advisable if you like the investment options in the new plan and that plan allows a rollover. Taking a distribution usually isn’t advisable because you lose the future retirement savings. But if the amount is small and you have a pressing need for it now, the lost savings won’t be significant. If you do decide to make a rollover to a traditional or Roth IRA so you gain maximum control over your retirement savings, work with a knowledgeable tax advisor to decide which rollover option is better for you.
For related reading, see 3 Reasons Your 401(k) Is Not Enough for Retirement and Roth 401(k) Vs. Roth IRA: Is One Better?