The benefits of investing in a Roth IRA are clear. Among them are the tax-free growth of your assets and the fact that you don't have to take required minimum distributions during your lifetime, as you would with a traditional IRA or 401(k). 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 Roth IRA?

Though that was previously prohibited, the Pension Protection Act of 2006 changed the rules, and in 2008 the IRS issued its first set of guidelines for how to go about it. This article explains how these conversions currently work and why you might want to consider making 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.
  • Roth IRAs have some advantages over traditional IRAs and 401(k) plans, 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.

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

These are the basic rules that apply to rolling over your company retirement plan account into a Roth IRA, and include some further IRS guidance issued in 2014:

  • 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 any after-tax contributions you made to your 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 also 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 trustee-to-trustee transfer.

You can also roll over your company plan into some other types 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 in any 12-month period
3. Must include in 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.
7. Applies to rollover contributions after December 18, 2015

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?

The most suitable candidates for rolling an employer retirement plan into a Roth IRA are usually individuals who will not need to take distributions from the account for many years—or who don't plan to take any distributions at all. This is important to remember because 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, and
  • You are younger than 59½ and don't qualify for an exception to the 10% penalty

One 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.

Another important consideration, of course, is whether you have the money to pay any income taxes you'd incur as a result of the conversion.

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.