If you've ever left a job where you had a 401(k) plan, you are most likely aware of the various rollover options for these workplace retirement accounts. One of these options is rolling over a 401(k) into a Roth IRA.

Rolling over a 401(k) into a Roth IRA may not be an obvious step given that 401(k)s are funded with pre-tax dollars and Roth IRAs are funded with after-tax dollars. However, since the IRS puts income limits on Roth participants, a 401(k) rollover is one of the few opportunities more affluent savers have to acquire a Roth IRA. Roths have several advantages over traditional IRAs, the more usual rollover option: Withdrawals from these plans in retirement are tax-free, and do not have required minimum distributions.

Here are tips if you are 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 could not otherwise open a Roth.
  • If you roll a traditional 401(k) over to a Roth, you will 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 is not a good choice if you anticipate needing 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 pre-tax dollars—the contribution generates an immediate tax deduction—whereas Roth contributions are in post-tax dollars, which means they are not deductible at the time of contribution. The payoff, however, comes when investors tap into their Roth retirement funds. Both the contribution and the profits are exempt from federal taxes and most state taxes. In contrast, traditional IRA holders pay income taxes on their withdrawals.

In other words, you either receive 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 prefer Roths for that reason: the tax savings make more sense for them later on.

Roth IRAs and Income Requirements

There is another key distinction between the two accounts. Anyone can contribute to a traditional IRA, but the IRS imposes an income cap on eligibility for a Roth IRA. Fundamentally, the IRS does not 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 2020, the phase-out range for a full annual contribution for single filers is from $124,000 to $139,000 (a full annual contribution is $6,000 to $7,000, depending on age) for a Roth IRA. For married couples filing jointly, the phase-out begins at $196,000 in annual gross income, with an overall limit of $206,000.

Why might you want to roll over your 401(k) to a Roth IRA? Roth income limitations do not apply to this type of conversion. Anyone with any income is allowed to fund a Roth IRA via a rollover—in fact, it is 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. 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 $124,000. 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

Although perfectly legal, complicated tax rules apply to these conversions, and the timing can be tricky. So, do not do them without obtaining 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. First, you 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 will 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. This is because you received a tax deduction for your contributions to your 401(k)—remember that they are funded with pre-tax dollars—and you 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 option. So, if you roll over contributions made on a pre-tax 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.

The need to crunch the numbers is why it is important to obtain competent advice before trying this. If the tax implications are too large, the strategy might not make sense. However, consider the long-term benefit: When you retire and withdraw the money from the Roth IRA, you will not owe taxes. There is another reason to think long term, which is the five-year rule that I explain later.

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. This process is simplified by the fact that the transferred funds have the same tax basis in the two vehicles, composed 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 should 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

This strategy should be considered with an eye to the long term. Rolling your 401(k) over to a new Roth IRA is not a good choice if you anticipate having to withdraw money in the near future—more specifically, within five years.

Roth IRAs are subject to the five-year rule. The rule states that to withdraw earnings—that is, interest or profits—from a Roth tax- and penalty-free plan, 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—such as funds from your traditional 401(k) that you first placed in 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 those rolled over from the Roth 401(k) account. The same treatment does not apply to the timing of a Roth 401(k) that is rolled over to a new Roth IRA. If you do not 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 have 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 2016 (the latest figures), 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 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 roll your old Roth 401(k) into 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 (tax- and penalty-free withdrawals.) However, the previous employer must contact the new employer concerning the amount of employee contributions that are being rolled over and confirm the first year they were made. The account holder 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 will owe taxes on all of your contributions plus tax penalties for early withdrawals if you are under 59½. On a Roth 401(k), you will owe taxes on any earnings you withdraw and potentially be subject to a 10% early withdrawal penalty if you're under 59½ and have not had the account for five years.

How to Do a Rollover

The mechanics of a rollover from your 401(k) plan are straightforward. First, a bank, brokerage, or online investing platform opens 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. Your plan administrator sends the money directly to the IRA that you opened at a bank or brokerage. Or, they may provide 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 agree. This method is faster, simpler, and there is no doubt that this is a distribution (on which you owe taxes). If the administrator will not comply with this method, make sure that the check is made out to your new account, not to you personally—again, as evidence that 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 provide a check made out to you. Taxes will be withheld at a rate of 20%, and you will have to report the distribution as income on your income tax return. You can avoid taxes if you do conduct 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 do not anticipate taking 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 withdraw money within five years from the conversion.

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

There is one other wrinkle concerning 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.