Roth IRAs and traditional IRAs carry vastly different tax consequences. With traditional IRAs, contributions are tax-deductible in the year they are made. Contrarily, with Roth IRAs, the withdrawals investors make when they retire are not taxed, making these vehicles a superior option for many eligible retirement savers. Fortunately, thanks to the Pension Protection Act of 2006, workers currently have the option of converting their 401(k) investment accounts into Roth IRAs, and many folks are making the switch.

Roth vs. Traditional IRA

Traditional IRAs let individuals defer the income tax owed on the portion of their saved retirement income. If a person is saving through an employer plan, that money is deducted from his or her pre-tax salaries. Similarly, a self-employed worker who opens an IRA, is not taxed on the money he invests. In both scenarios, the tax breaks are immediate, where both investors are effectively shielding a portion of their current income from taxation. However, taxes will be owed on both the contribution and the profits, once the money is finally withdrawn upon retirement.

A Roth IRA adopts an entirely different tax model, where investors must pay an income tax up front, therefore they don't enjoy any immediate tax breaks. But while they're consequently sacrificing a bit more take-home pay income during their working years, when the time finally comes to tap into their retirement funds, both the contribution and the profits will be exempt from federal taxes, and most state taxes as well.

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

Differences and Similarities

The maximum annual maximum contributions are the same for both types of accounts, where individuals under the age of 50 may currently invest a maximum of $6,000 annually. And those 50 and older may invest up to 7,000 per year.

Although there is no income cap on eligibility for traditional IRAs, for Roth IRAs, a single filer can earn no more than $122,000 for full eligibility. However, a partial contribution can be made for those earning up to $137,000. Meanwhile, singletons with an income above that amount are altogether prohibited from investing in Roth IRAs.

Note: Investors may choose to divide their investment dollars across both types of retirement accounts, as long as their income is above the aforementioned Roth limit. However, the maximum allowable amount remains the same, therefore it may not exceed a total of $6,000 or $7,000, split between the accounts.

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.

What the Financial Advisors Say

Some financial advisors believe the choice between traditional and Roth IRAs should depend on an individual's tax bracket upon retiring. Simply put: for those falling in a higher bracket, the Roth IRA is the obvious choice. Those in lower brackets are better off with traditional IRAs. And although no one can truly predict future tax rates, many doubt that they'll dip below the current 2019 rates.

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

Investors interested in rolling their 401(k) funds Roth IRAs should be mindful of the following:

  • 401(k) funds are not the only company retirement plan assets eligible for rollover. In fact, 403(b) and 457(b) governmental plans may also 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 rolled into a Roth IRA that would otherwise be taxable, such as pre-tax contributions to a company plan, must be included as taxable income for the year of the conversion.
  • Direct rollovers into a Roth IRA will not be subject to a mandatory 20% withholding. However, 60-day rollovers are. Therefore, a direct trustee-to-trustee transfer is the most efficient rollover methodology.

An investor may roll over his company plan into some other type of retirement account, and may conversely roll certain plans into a company retirement account, if the employer allows it, on a case-by-case basis. This following IRS table lists allowable conversions:

1. Qualified plans include 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. There most be separate accounts
5. There must be an in-plan rollover
6. Any nontaxable amounts distributed must be rolled over by direct trustee-to-trustee transfer.

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

Investors should bear in mind that they must produce the income tax owed in the year they convert 401(k)s to Roth IRAs. Based on current income tax brackets, this may range from 10% to 37% of the total balance transferred for the federal tax owed, plus any state tax liability.

Ideal candidates for rolling employer retirement plans into Roth IRAs are those who don't anticipate a need to take distributions from the account for many years to come. Those who convert a 401(k) into a Roth IRA must pay a 10% penalty on any money they withdraw from the Roth, if they take the money out within five years from the conversion. Only those of age 59½ or older are exempt from the 10% early withdrawal penalty.

There is one wrinkle to these rules. Namely: homebuyers who haven't touched their Roth IRAs for at least five years, may withdraw up to $10,000--without penalty, if they use the cash to help finance the purchase of a home, or to pay for college tuition.