401(k) Into Roth IRA

If you've ever left a job where you had a 401(k) plan—for another job, to retire, or for any other reason—you're probably aware of the various rollover options for these workplace retirement accounts. One of these options is rolling over into a Roth IRA.

The idea may not come immediately to mind, given that 401(k)s are funded with pre-tax dollars and Roth IRAs with after-tax dollars. But, since the IRS puts income limits on Roth participants, a 401(k) rollover is one of the few chances more affluent savers have to acquire a Roth IRA. And Roths have several advantages over the traditional IRA, the more usual rollover option: Withdrawals from them in retirement are tax-free, and do not have required minimum distributions.

Here are tips if you're planning to convert a 401(k), of either the traditional or Roth variety, into a Roth IRA (and a few other options besides).

Key Takeaways

  • Rolling over your 401(k) or other workplace retirement plan into a Roth IRA has advantages for high-earners who couldn't otherwise open a Roth.
  • If you roll a traditional 401(k) over to a Roth, you'll owe taxes in that tax year on the funds you transfer.
  • Funds rolled over from a Roth 401(k) to a Roth IRA will not be taxed, provided certain timing rules are met.
  • 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.
  • Rolling your 401(k) over to a new Roth IRA isn't a good choice if you may need to withdraw money within five years.

Quick Recap: the Roth IRA

First, a quick refresher on Roth IRAs. As with traditional IRAs, investments within them grow without incurring income tax each year. The main difference between the accounts is that traditional IRAs are funded with pretax dollars—the contribution generates an immediate tax deduction when it's made—whereas Roth contributions are in post-tax dollars, meaning they are not deductible at the time. The payoff, though, comes when investors tap into their Roth retirement funds: Both the contribution and the profits are exempt from federal taxes, and most state taxes as well. In contrast, traditional IRA holders pay income taxes on their withdrawals.

In other words, you either get the tax break on the front end (with the regular IRA) or on the back end (with the Roth). Investors who anticipate being in a higher tax bracket in retirement than they are currently like Roths for that reason: The tax savings makes more sense for them later on.

Roth IRAs and Income Requirements

There's another key distinction between the two accounts. Anyone can contribute to a traditional IRA, but the IRS imposes income cap on eligibility for a Roth IRA: To put it bluntly, they don't want high-earners benefiting from these tax-advantaged accounts. Affecting contributions on a sliding scale, the income caps are adjusted periodically to keep up with inflation. In 2019, single filers can earn no more than $122,000 to make the full annual contribution ($6,000 to $7,000, depending on age) to a Roth IRA; those making $137,000 or more are prohibited from investing in one at all. For married couples filing jointly, the phase-out begins at $193,000 in annual gross income, with an overall limit of $203,000.

In 2020, those limits rise: Single filers can earn no more than $124,000 for a full contribution and the upper limit is under $139,000. For married filing jointly, the figures are $196,000 and $206,000.

Now let's go back to why you might want to roll over your 401(k) to a Roth IRA: Roth income limitations do not apply to this type of conversion. Anyone of any income is allowed to fund a Roth IRA via a rollover—in fact, it's one of the only ways. (The other is converting a traditional IRA to a Roth IRA, also known as a backdoor conversion.)

401(k) funds are not the only company retirement plan assets eligible for rollover. In fact, the 403(b) and 457(b) plans for public-sector and nonprofit employees may also be converted into Roth IRAs.

Investors may choose to divide their investment dollars across both traditional and Roth IRA accounts, as long as their income is above the aforementioned Roth limit of $122,000 ($124,000 in 2020). . However, the maximum allowable amount remains the same. That is, it may not exceed a total of $6,000 or $7,000, split between the accounts.

401(k)-to-Roth-IRA Conversions

While they're perfectly legal, complicated tax rules apply to these conversions and the timing can be tricky. So, don't do them without getting detailed fiscal and financial advice first. The procedure also varies, depending on whether you have a traditional 401(k) or a Roth 401(k).

Traditional-401(k)-to-Roth-IRA Conversions

Converting a traditional 401(k) to a Roth IRA is a two-step process. You first roll over the funds to a traditional IRA; then you convert that IRA from the traditional variety into a Roth IRA.

Now for the bad news. You'll pay taxes on the money (at ordinary-income rates) when you convert to the Roth and, depending on how much is in the account, they could be stiff. That's because you got a tax deduction for your contributions to your 401(k)—they're funded with pre-tax dollars, remember?—and paid no taxes to move it to a traditional IRA, which is also designed to hold pre-tax money. But the Roth is an after-tax animal. So if you roll over contributions made on a pretax basis—as from a traditional 401(k)—the amount involved must be included as taxable income for the year of the rollover.

Now if you contributed more than the deductible amount to your 401(k), 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.

That's why we said get competent advice before trying this, to crunch the numbers. It might not make sense if the tax bite is too big. But think of the long-term benefit: When you withdraw the money from the Roth IRA when you retire, you won't owe taxes. (There's another reason to think long-term: the five-year rule. We'll get to that lower down.)

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

The rollover process is a lot more straightforward if you have a Roth 401(k). In fact, rolling over a Roth 401(k) into a Roth IRA is optimal, simplified by the fact that the transferred funds have the same tax basis in the two vehicles, consisting as they do of after-tax dollars.

If your 401(k) is a Roth 401(k), you can roll it over directly into a Roth IRA without intermediate steps or tax implications. You just have to 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 Roth IRA for your 401(k) funds, or roll them over into an existing Roth.

The Five-Year Rule

We mentioned thinking long-term when you use this strategy. Rolling your 401(k) over to a new Roth IRA isn't a good choice if you may need to withdraw money in the near future—more specifically, within five years.

That's because Roth IRAs are subject to what's known as the five-year rule. In a nutshell, the rule states that to withdraw earnings—that is, interest or profits—from a Roth tax- and penalty-free, you must have held the Roth for at least five years. (You can withdraw contributions from your Roth at any time.) The same goes for withdrawing converted funds—like the ones from your traditional 401(k) that you put first into a traditional IRA and then a Roth IRA.

If funds are rolled over from a Roth 401(k) to an existing Roth IRA, the rolled-over funds can inherit the same timing as the Roth IRA. That is, the holding period for the IRA applies to all of its funds, including the ones just rolled over from the Roth 401(k) account. The same treatment does not apply, alas, to the timing of a Roth 401(k) that's rolled over to a new Roth IRA. If you don't have an existing Roth IRA and need to establish one for purposes of the rollover, the five-year period begins the year the new Roth IRA is opened, regardless of how long you'd been contributing to the Roth 401(k).

If you rolled a traditional 401(k) into a Roth IRA (via the traditional IRA), the clock starts ticking from the date those funds hit the Roth.

Withdrawing earnings early could incur both taxes and a 10% penalty. Withdrawing converted funds early could incur a 10% penalty.

$40,572

The average Roth IRA account balance in 2018, according to the Employee Benefit Research Institute

A Few Other 401(k) Rollover Options

401(k) to 401(k) Transfers

You can avoid a tax bite entirely if you roll your 401(k) balance over to another 401(k) at a new job. Of course, your new plan administrator has to allow such rollovers. 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 401(k) account contains your old employer's corporate stock, you might have to sell it first before the transfer.

A transfer also might not work if your old account is a Roth 401(k) and the new plan only allows for traditional 401(k)s. The optimal deal would be to be able to roll your old Roth 401(k) to a new Roth 401(k). the number of years the funds were in the old plan should count toward the five-year period for qualified distributions, as tax- and penalty-free withdrawals are officially called. However, the previous employer must contact the new employer about the amount of employee contributions that are being rolled over and must confirm the first year they were made. And you should transfer the entire account, not just a part of it.

Cashing Out

Cashing out your account, in whole or in part, is usually a mistake. On a traditional 401(k) plan, you'll owe taxes on all of your contributions plus tax penalties for early withdrawals if you're under 59½. On a Roth 401(k), you'll owe taxes on any earnings you withdraw and potentially be subject to a 10% early withdrawal penalty if you're under 59½ and haven't had the account for five years.

How to Do a Rollover

The mechanics of a rollover from your 401(k) plan are straightforward. First, you pick a place, like a bank, brokerage, or online investing platform, to open an IRA (Investopedia has lists of the best brokers for IRAs and best brokers for Roth IRAs). Let your 401(k) plan administrator know where you have opened the account.

Then, you request a direct rollover, also known as a trustee-to-trustee rollover. This means that your plan administrator sends the money directly to the IRA you opened at a bank or brokerage. Or, they may cut you a check made out in the name of your account, which you deposit. Going directly (no check) is the best approach if the administrator will do it: faster, simpler, and no doubt that this is a distribution (on which you'd owe taxes). If they won't, at least make sure that the check's made out to your new account, not to you personally—again, as evidence this is not a distribution.

You can also do a rollover from a distribution, also called an indirect rollover. In this case, the plan administrator will give you a check made out to you. Taxes will be withheld at a rate of 20%, and you'll have to report the distribution as income on your income tax return. You can avoid taxes if you do a rollover into another retirement account within 60 days and make up the money withheld from another source.

The Bottom Line

Ideal candidates for rolling employer retirement plans into a new Roth IRA are those who don't anticipate a need to take distributions from the account for a number of years. Those who convert a 401(k), of either type, into a new 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.

Those age 59½ or older are exempt from the 10% early withdrawal penalty. So are those who transfer the 401(k) funds into an existing Roth IRA that was opened five or more years ago, which allows the rolled-over 401(k) funds to also be withdrawn without penalty.

And here's another wrinkle to Roths. Along with their contributions, account holders may withdraw up to an additional $10,000 without penalty, provided they use the cash to help finance the purchase of a home, or to pay for college tuition.