Pros and Cons of Rolling Your Pension Into a Roth IRA

You’ll be eligible for tax-free withdrawals but may face a large tax bill first

If you have a traditional defined-benefit pension plan where you work, you may have the option of taking the money as a lump sum when you leave your job or retire. One of the things that you can do with the money is roll it over into a Roth individual retirement account (Roth IRA).

This article looks at the pros and cons of pension-to-Roth IRA rollovers.

Key Takeaways

  • If your employer’s pension plan allows it, you may be eligible to take a lump-sum payment when you leave your job or retire.
  • You can then roll your lump-sum pension distribution into a Roth individual retirement account (Roth IRA).
  • A Roth IRA rollover entitles you to tax-free withdrawals in the future, but you will have to pay tax on the money that you contribute up front.

Rolling a Pension Into a Roth IRA: An Overview

The two major types of employer retirement plans are defined-contribution plans and defined-benefit plans. In a defined-contribution plan, such as a 401(k) or a 403(b), you contribute money out of your paycheck, and your employer may match some portion of your contributions. With a defined-benefit plan, commonly known as a traditional pension, your employer funds the plan and promises you a certain benefit upon your retirement, typically based on your salary and years of service.

With a defined-contribution plan, you get to decide how the money will be invested, within the range of choices offered by the plan. With a defined-benefit plan, your employer makes the investment decisions and is responsible for delivering its promised benefits.

When you leave your job, you can generally take the money in your defined-contribution plan with you. You also may be able to take your defined-benefit plan in the form of a lump sum, if the rules of your employer’s plan allow it. When you retire, your defined-benefit plan may give you a choice of regular payments for the rest of your life or a lump sum right then. The amount of the lump sum will be calculated based on your age, interest rates, the value of the benefits to which you would be entitled in the future, and the extent to which you are vested in the plan.

If you’re leaving your job, you can often leave your pension behind with your employer and begin collecting monthly benefits after you reach retirement age, unless your employer terminates its pension plan in the meantime. In some cases, you’ll have no choice; if your pension is worth $5,000 or less, your employer is allowed to turn it over to you as a lump sum whether you want it that way or not. This is referred to as a cash-out.

Advantages of Rolling Your Pension Into a Roth IRA

Tax-Free Withdrawals

Once your money is in the Roth IRA, you’ll enjoy all of the tax benefits that a Roth provides. After you have had a Roth account for at least five years, your withdrawals will be tax- and penalty-free as long as you’re age 59½ or older. There are also some flexible exceptions to those rules.

More Control Over Investments

With a Roth IRA, you’ll have control over how your money is invested; with your pension, your employer made those decisions. For example, you can invest more aggressively than your employer did, in hopes of a higher return, if you’re willing to take the added risk.

Easier Access to Your Money

Due to its flexible exceptions for early withdrawals, you can take money out of the Roth at almost any time (though there may be taxes and penalties). With your pension, you must generally wait at least until age 59½ to receive anything. Some defined-benefit plans do allow for loans, however.

No Required Minimum Distributions (RMDs)

Non-Roth retirement accounts, such as traditional IRAs, are subject to required minimum distributions (RMDs) after you reach age 72. Your employer’s defined-benefit pension may also require that you begin taking distributions at a certain point. In both cases, you’ll have to pay tax on the money that you receive. With a Roth IRA, by contrast, you never have to take out money during your lifetime, making it possible to leave the entire account to your heirs if you want to and can afford to.

If you’re married, and your pension lump sum would be worth $5,000 or more, you’ll need your spouse’s written consent to take it in that form.

Disadvantages of Rolling Your Pension Into a Roth IRA

You’ll Owe Taxes Up Front

If you decide to roll over your pension lump sum into a Roth IRA, you’ll owe income tax on the money just as you would with any other Roth IRA contribution. After that, the money in your Roth will grow tax deferred and be eligible for totally tax-free withdrawals if you meet the rules.

Responsibility for Investing

Rather than leaving the burden on your employer, you’ll be responsible for deciding how to invest the money in your IRA. You may see this as an advantage or a disadvantage depending on how comfortable you are with managing investments.

No Guarantees

When your money is in a pension plan, your employer promises that you’ll receive benefits of a certain dollar amount starting at some point in the future. While some employers fail to live up to their promises for one reason or another, your benefits may be insured by the federal Pension Benefit Guaranty Corp. Roth IRAs carry no such guarantees.

Pros
  • Tax-free withdrawals

  • More control over investments

  • Easier access to your money

  • No required minimum distributions (RMDs)

Cons
  • You’ll owe taxes up front

  • Responsibility for investing

  • No guarantees

When a Pension-to-Roth IRA Rollover Makes Sense

If your pension lump sum is relatively small, rolling it over into a Roth IRA and paying taxes on the money now could be a worthwhile tradeoff, especially if you’re young and your Roth IRA will have years, even decades, of growth ahead of it. All that money will then come to you tax free at retirement.

With a larger sum, you’ll want to be more careful. One consideration is your tax bracket. Let’s say you’re single and your modified adjusted gross income (MAGI) is $100,000 a year. In that case, your top marginal tax bracket in 2022 is 24%. That bracket ends at $170,050, and any income above that is taxed at 32%. So if you want to roll over a $100,000 lump sum, you would have to pay 24% tax on the first $70,050 and 32% tax on the remaining $29,950.

One way to reduce your tax cost would be to roll your lump sum into a traditional IRA, then convert it in stages into a Roth IRA. You’ll still owe tax on the money that you convert, but you’ll have some control over the tax bracket that it falls into.

With a traditional IRA, you’ll owe no taxes on the rollover as long as you meet the rules for either a direct rollover or a 60-day rollover.

In a direct rollover, the administrator of your pension will transfer the money directly to the financial institution that will be holding your IRA or make out a check to that institution and give it to you to deposit. In a 60-day rollover, the pension administrator will make out the check to you, and you’ll have 60 days to deposit all or some of the money into the IRA; the trustee will also withhold 20% for taxes. If you miss the 60-day deadline, you’ll owe taxes on the full amount.

If you’re close to retirement age, however, you might do better to either leave the pension money with your employer or simply roll it into a traditional IRA and not convert to a Roth. Either way, you’ll end up paying tax on the distributions that you receive, but at that point, you may be in a lower tax bracket.

Can I roll over my pension into a Roth individual retirement account (Roth IRA)?

If the rules on your employer’s defined-benefit pension plan allow it, you may be able to take a lump-sum distribution from the plan when you leave your job or retire. You then would have the option of rolling it over into a Roth individual retirement account (Roth IRA).

Should I roll my pension into a Roth IRA?

A Roth IRA has advantages and disadvantages compared with simply leaving your money in an employer’s pension plan. While the Roth will allow you to take tax-free distributions later (unlike the pension), you will have to pay taxes on the Roth IRA contribution up front.

How much can I roll over from my pension into a Roth IRA?

There are no limits on the amount of Roth IRA rollovers (unlike annual contributions, which are limited).

The Bottom Line

If you have a traditional pension at work, you may have the option of taking a lump sum when you change jobs or retire. You can then reinvest that money. If you roll it over into a traditional IRA, you won’t have to pay any taxes until you make withdrawals. If you choose a Roth IRA, you’ll have to pay tax on the money up front, but your future withdrawals can be tax free. If you decide to go with the Roth, you can reduce the tax impact by depositing the money first in a traditional IRA and converting it into a Roth IRA over a series of years.

Article Sources
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