If you're considering leaving a job, and you have a 401(k) plan, you need to stay on top of the various rollover options for your workplace retirement account. One of those options is rolling over a traditional 401(k) into a Roth IRA.
This can be a very attractive option, especially if your future earnings will be high enough to knock into the ceiling now placed on Roth account contributions by the Internal Revenue Service (IRS).
But regardless of the size of your salary, you need to do the rollover strictly by the rules to avoid an unexpected tax burden.
You'll still owe some taxes in the year you do this because of the crucial difference between a traditional 401(k) and a Roth IRA:
- A traditional 401(k) is funded with salary from your pre-tax income. It comes right off the top of your gross income. You pay no taxes on the money you deposit or the profit it earns until you withdraw the money, presumably after you retire. Then, you'll owe taxes on the entire amount as you make withdrawals.
- The Roth IRA is funded with post-tax dollars. You pay the income taxes upfront, before it is deposited in your account. You won't owe taxes on that money or on the profit it earns when you withdraw it.
So, when you roll over a traditional IRA to a Roth IRA, you'll owe income taxes on that money in the year you make the switch.
- If you roll a traditional 401(k) over to a Roth, you will owe income taxes on the money that year, but you'll owe no taxes on the entire balance after you retire.
- This type of rollover has a particular benefit for high-income earners who aren't permitted to contribute to a Roth.
- The immediate tax bill can be avoided by allocating after-tax funds to a Roth IRA and pre-tax funds to a traditional IRA.
Converting a Traditional 401(k) to a Roth IRA
As noted above, you haven't paid income taxes on that money in your traditional 401(k) account. That means you will owe the income taxes on the money for the year in which you rolled it over into a Roth account.
The total amount transferred will be taxed at your ordinary income rate, just like salary. (The tax rates as of tax year 2019 range from 10% to 37%.)
How to Reduce the Tax Hit
Now, if you contributed more than the maximum deductible amount to your 401(k), you've got some post-tax money in there. You may be able to avoid some 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.
Alternatively, you can choose to split up your retirement money into two accounts, one a traditional IRA and the other a Roth IRA. That will reduce the immediate tax impact.
This is going to take some numbers-crunching. You should see a competent tax accountant or tax attorney to determine exactly how the alternatives will affect your tax bill for the year.
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 explained later.
Roth 401(k) to Roth IRA Conversions
The rollover process is straightforward if you have a Roth 401(k) and you're rolling it over into a Roth IRA. The transferred funds have the same tax basis, composed of after-tax dollars. This is not, to use IRS parlance, a taxable event.
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 over your 401(k) 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 of opening the new account.
Roth IRAs are subject to a five-year rule. This 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.
The same rule applies for withdrawing converted funds—such as funds from a traditional 401(k) that have been deposited in a Roth IRA.
When the 5-Year Rule Applies
If funds are rolled over from a Roth 401(k) to an existing Roth IRA, the rolled-over funds inherit the same timing as the Roth IRA. That is, the holding period for the IRA applies to all of the funds in the account, including those rolled over from the Roth 401(k) account.
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, 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.
The rules governing the early withdrawal of funds in a converted Roth IRA can be confusing. There are exceptions to the tax and penalty consequences related to whether you are withdrawing earnings versus your original after-tax contributions. There also are certain qualifying life events, notably a job loss.
If you are considering an early withdrawal of funds from your Roth IRA it is important to speak with a qualified tax expert who is familiar with the appropriate IRS regulations.
You can withdraw contributions, but not earnings, from your Roth at any time, no matter what your age is. Remember, you've already paid income taxes on that money.
Note that the early withdrawal penalty was eliminated, just for 2020, as part of the coronavirus relief legislation.
How to Do a Rollover
The mechanics of a rollover from a 401(k) plan are fairly straightforward.
Your first step is to contact your company's plan administrator, explain exactly what you want to do, and get the necessary forms to do it.
Finally, use those forms supplied by your plan administrator to request a direct rollover, also known as a trustee-to-trustee rollover. Your plan administrator will send the money directly to the IRA that you opened at a bank or brokerage.
As an alternative, the administrator can send the check to you, made out in the name of your account, for you to deposit. Going directly is a better approach. It's faster and simpler, and it leaves no doubt that this is not a distribution of money (on which you owe taxes).
If the administrator insists on sending the check to you, make sure that it is made out to your new account, not to you personally. Again, that's evidence that this is not a distribution.
Another option is to take an indirect rollover. In this case, the plan administrator will send you a check made out to you after withholding taxes at a rate of 20%, and you will then record the distribution and the taxes already withheld on your income tax return.
The coronavirus stimulus bill—known as the CARES Act—suspended the 20% income tax withholding for rollover distributions just for 2020.
Funds withdrawn from your 401(k) must be rolled over to another retirement account within 60 days to avoid taxes and a substantial penalty.
A Few Other Options for Your 401(k)
There are a few other options to consider if you are exploring ways in which to rollover your 401(k):
401(k) to 401(k) Transfers
If you're taking a new job, there is no tax bite when you roll over your traditional 401(k) balance to another traditional 401(k) at a new job or, alternatively, roll over a Roth balance to another Roth balance. However, this is subject to the rules that govern your new company's plan.
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 account contains your old employer's company stock, you might have to sell it before the transfer.
A transfer also won't work if your old account is a Roth 401(k) and the new employer only offers a traditional 401(k). If this is the case, you're looking at rolling your Roth into an IRA that you open on your own.
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.
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.
Avoid Cashing Out
Cashing out your account, in whole or in part, is usually a mistake, whether it's a traditional or a Roth account.
- 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 age 59½.
- On a Roth 401(k), you will owe taxes on any earnings you withdraw and be subject to a 10% early withdrawal penalty if you're under 59½ and have not had the account for five years.
Special Rules for 2020
The CARES Act allows those affected by the coronavirus pandemic a hardship distribution up to $100,000 without the 10% early distribution penalty those younger than 59½ normally owe in 2020.
Account owners also have three years to pay the tax owed on withdrawals, rather than owing it in the current year. Or they can repay the amount withdrawn to a 401(k) or IRA and avoid owing any tax, even if the amount exceeds the annual contribution limit for that type of retirement account.
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.
The income caps are adjusted annually to keep up with inflation. In 2021, the phase-out range for a full annual contribution for single filers is from $125,000 to $140,000 (a full annual contribution is $6,000—or $7,000, if you are age 50 or older) for a Roth IRA. For married couples filing jointly, the phase-out begins at $198,000 in annual gross income, with an overall limit of $208,000.
And that is why, if you have a high income, you have another reason 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.)
Investors may choose to divide their investment dollars across traditional and Roth IRA accounts, as long as their income is below the Roth limits. However, the maximum allowable amount remains the same. That is, it may not exceed a total of $6,000 (or $7,000, if you are age 50 or older) split among the accounts.
The Bottom Line
Although they are perfectly legal, complicated tax rules apply to retirement account conversions, and the timing can be tricky. So do not try it without obtaining financial advice first. A professional can help you decide, first of all, whether it's a good idea for you financially and, secondly, how to do it without incurring penalties.
The ideal candidate for rolling an employer retirement fund into a new Roth IRA is a person who does not expect to take a distribution from the account for at least five years. There is a 10% penalty on money withdraw from the Roth within five years of the date of 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 be withdrawn without penalty.