The benefits of investing in a Roth IRA rather than a traditional IRA are clear. The biggest of them is that you won't owe federal income taxes on the money you withdraw after retirement. But did you know that after you leave your employer you might be able to convert your 401(k) or other company retirement plan into a Roth IRA?

That was previously prohibited, but the Pension Protection Act of 2006 changed the rules, and the IRS issued guidelines for how to go about it. It's something to consider, once you know how these conversions work and why you might want to make the switch.

Key Takeaways

  • When you leave your employer you may be able to roll over your 401(k) or other retirement plan into a Roth IRA.
  • If you roll it over to a Roth, you'll owe taxes on the income in that tax year.
  • Roth IRAs have other advantages over traditional IRAs, such as no required minimum distributions.
  • You may be able to avoid immediate taxes by allocating the after-tax funds in your retirement plan to a Roth IRA and the pre-tax funds to a traditional IRA.

Roth vs. Traditional IRA

A traditional IRA allows an individual to defer the income tax owed on the portion of income that is saved for retirement. If the person is saving through an employer plan, the money is deducted from pre-tax salary. The self-employed can open an IRA account and contribute pre-tax income to it.

In either case, the tax break is immediate. The person has effectively shielded a percentage of current income from taxation. The taxes will be owed on both the contribution and the profits on it when the money is withdrawn after retirement.

A Roth IRA takes the income taxes up front. The person gets no immediate tax break. That means sacrificing a bit more take-home income during your working years. But when it's time to tap into the funds, both the contribution and the profits will be exempt from federal taxes and, in most cases, free of state taxes as well.

How the Rules Differ

The rules differ a bit between traditional and Roth IRAs.

The annual maximum contributions are the same. In 2019, that means a maximum of $6,000 per year for those under age 50 and $7,000 for those age 50 and over.

There is no income cap on eligibility for a traditional IRA. There is, however, an upper limit for a Roth IRA. In 2019, a single filer can earn no more than $122,000 for full eligibility, though a partial contribution can be made up to $137,000. Singles with an income above that cannot use the Roth IRA.

One important point: You can have both, unless your income is above the Roth limit. The maximum stays the same, at a total of $6,000 or $7,000, but it can be can split between the two types of IRAs.

What the Financial Advisors Say

Some financial advisors suggest that the choice between a traditional IRA and a Roth IRA comes down to whether a person will be in a higher or lower tax bracket after retiring. If the answer is a higher bracket, the Roth IRA is the obvious choice. If it's a lower bracket, go with the traditional IRA.

As if any of us has a crystal ball to tell us what the tax rates will be in the future. That said, it seems unlikely that taxes will go lower than they are in 2019.

How 401(k)-to-Roth-IRA Conversions Work

There are a few basic rules that apply to rolling over your company retirement plan account into a Roth IRA:

  • Company retirement plan assets, including those from 401(k), 403(b), and 457(b) governmental plans, are eligible to be converted into Roth IRAs.
  • Roth IRAs can only accept rollovers of money that has already been taxed, such as the after-tax contributions made to a company plan. Any money you roll over into a Roth IRA that would otherwise be taxable (such as pre-tax contributions to your company plan) must be included in your income for the year of the conversion.
  • You have the option of rolling after-tax money into a Roth IRA and pretax money into a traditional IRA, where it won't be taxed until you withdraw it. Pretax money includes any earnings on your after-tax contributions.
  • Direct rollovers into a Roth IRA will not be subject to mandatory 20% withholding. However, 60-day rollovers are, so it is best to do a direct trustee-to-trustee transfer.

You can roll over your company plan into some other type of retirement accounts—and, conversely, roll many of them into a company plan, if your employer allows it. This summary from the IRS shows which conversions it permits:

1. Qualified plans include, for example, profit-sharing, 401(k), money purchase, and defined benefit plans.
2. Only one rollover is allowed in any 12-month period
3. The money must be reported as income
4. Must have separate accounts
5. Must be an in-plan rollover
6. Any nontaxable amounts distributed must be rolled over by direct trustee-to-trustee transfer.
Source: www.IRS.gov.

A Roth IRA isn't a good choice if you may need to withdraw money in the near future.

When Do 401(k)-to-Roth Conversions Make Sense?

First of all, keep in mind that you'll have to come up with the income tax owed in the year you convert a 401 (k) to a Roth. Based on current income tax brackets, figure on 10% to 37% of the total balance transferred for the federal tax owed, plus your state's share.

The best candidates for rolling an employer retirement plan into a Roth IRA are people who do not foresee a need to take a distribution from the account for many years or don't plan to take any distributions at all. You will have to pay a 10% penalty on any money you withdraw from the Roth IRA, if the following applies:

  • You withdraw funds from the Roth IRA within five years of the conversion
  • You are younger than 59½ and don't qualify for an exception to the 10% penalty

One important exception is that first-time homebuyers may take out up to $10,000 to help finance the purchase of a home, without penalty, if they have held the Roth IRA for five years. Money can also be withdrawn without penalty if it's used to pay for education, such as college tuition.

Finally, if you die before rolling over your company retirement plan, your beneficiaries may have the option of rolling it over into an inherited Roth IRA. By contrast, they cannot convert inherited IRA funds into Roth IRAs.

Beneficiaries should note that a different set of required minimum distribution rules applies to inherited Roth IRAs.