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If you’re leaving your current employer, you may want to convert your 401(k) to a Roth IRA. If your employer permits 401(k) to Roth IRA conversions, you’ll need to pay income taxes on the amount you’re transferring. But qualified withdrawals from your Roth IRA would be tax-free. This is especially appealing if you’re nearing retirement or if you expect your income to be substantially higher at retirement.
You’ll give up the benefit of making tax-deductible contributions into your retirement savings account. So if you expect to retire at a lower tax bracket, it may be more beneficial to enjoy a bigger tax break now and pay a small rate on your withdrawals when you retire.
Converting a 401(k) to a Roth IRA is essentially transferring money from a pre-tax account to an after-tax account. Pretax money is money that hasn’t been taxed yet. So you must pay taxes on the amount you’re converting from a 401(k) to a Roth IRA. The amount transferred becomes part of your taxable income for the year you made the conversion.
Before you begin the 401(k) to Roth IRA rollover, make sure you meet Roth IRA income limits. For 2021, you can’t contribute to a Roth IRA if your modified adjusted gross income (MAGI) is more than or equal to $139,000 — or $206,000 if married filing jointly.
If your MAGI is more than $124,000 — or $196,000 if married filing jointly –– your contribution limit would gradually decrease. For 2022, the general contribution limit is $6,000 — or $7,000 if you’re 50 or older. This means you would not be allowed to contribute up to that limit MAGI breaches these parameters.
Also, make sure your 401(k) plan administrator allows 401(k)-to-Roth IRA conversions. Some companies only allow former employees to transfer money out of the plan, but a few companies allow existing employees to initiate a 401(k)-to-Roth IRA conversion. Check if your employer offers a Roth 401(k) plan.
These basically work the same way as Roth IRAs and offer the same tax benefits. But unlike Roth IRAs, there are no income limits to contribute to a Roth 401(k). If your company doesn’t offer a Roth 401(k) or allows 401(k) to Roth IRA conversions, you can transfer your 401(k) assets into a traditional IRA. Then, you can rollover your traditional IRA to a Roth IRA.
If your company or former employer allows 401(k) to Roth IRA conversions, take the following steps.
In some cases, you may get a check of your 401(k) assets to deposit with the financial institution holding your Roth IRA. If so, you need to deposit it into your Roth IRA within 60 days or you may face an early withdrawal penalty. The process may involve some paperwork from your 401(k) plan administrator and the financial institution that manages your Roth IRA account.
The best time to roll over your 401(k) may be when you leave your job. Some companies automatically roll over your 401(k) to a traditional IRA account in your name at a brokerage firm.
Some allow you to keep your money in the plan. But in this case, your 401(k) would be dormant and you can’t contribute to it anymore. And while investment earnings will continue growing tax-deferred, your account may still be subject to administrative fees.
Convert your 401(k) to a Roth IRA or roll over your 401(k) into a traditional IRA on your own. Plenty of brokerages offer IRA and Roth IRA accounts with low fees, vast investment options and no minimum deposits.
If you roll over your 401(k) when you’re young, time is on your side. You’ll have more time to contribute to your retirement savings and enjoy the benefits of compound interest.
Beyond the taxes you’ll owe on the amount transferred, there may be other costs associated with a 401(k)-to-Roth IRA transfer.
Depending on your 401(k) plan and the brokerage holding your Roth IRA, you may need to pay a one-time rollover fee. These are separate from applicable income taxes owed to the IRS.
When you roll over a 401(k) to a Roth IRA, the amount transferred is considered part of your taxable income for that year. So you’d owe applicable federal income tax on that amount when you file your tax return.
There are some exceptions if you made nondeductible contributions to your 401(k). Nondeductible contributions are contributions you’ve already paid taxes on.
However, a 401(k) plan allows the earnings on any contributions to grow tax-deferred. So you must pay taxes on your earnings even if they were built on nondeductible contributions. These situations can get tricky.
Consider your 401(k) balance is $100,000, and $10,000 worth of that was made in nondeductible contributions. This means 10% of that balance consists of nondeductible contributions.
As a result, only 10% of whatever you transfer from your 401(k) to a Roth IRA is considered nondeductible contributions. You’ll owe income taxes on the rest or what the IRS considers investment earnings.
If you have a large 401(k) balance, you may get hit with a large tax bill after transferring it to a 401(k). But instead of rolling over the entire balance at once, you can make partial 401(k)-to-Roth IRA conversions over a few years. Because you’d be transferring smaller amounts at a time, you’d owe less in taxes throughout.
Speak with an accountant or tax advisor about ways to minimize taxes on 401(k) to Roth IRA transfers.
Qualified withdrawals from a Roth IRA won’t trigger income taxes or early withdrawal penalties. To make qualified withdrawals, you have to meet the following requirements.
The five-year rule technically starts on January 1 of the year you made your first Roth IRA contribution or conversion. So if you made your first Roth IRA contribution in March 2020, you could begin making qualified withdrawals on January 1, 2025 — as long as you’re at least 59.5 years old. Otherwise, you may owe a 10% penalty tax on the earnings you withdrew.
With that said, you’re allowed to withdraw your contributions, but not investment earnings, any time without penalty.
While rolling over your 401(k) to a Roth IRA can offer several benefits, there are some points you should consider before moving forward.
If you think a Roth IRA isn’t your best option, you have access to other retirement savings vehicles.
If your 401(k) plan administrator allows it, you can easily transfer your 401(k) savings to a Roth IRA. Even though you’ll owe income taxes on the amount transferred, you’ll enjoy tax-free withdrawals in retirement. However, fees and other costs can reduce your savings, so compare brokerages to find the Roth IRA that’s right for you.
How long does a 401(k) to Roth IRA conversion take?
That depends on your 401(k) plan administrator and the financial institution you’re opening a Roth IRA with. Most brokerages allow you to open one online within minutes.
But you need to contact your 401(k) plan administrator and request a direct rollover or trustee-to-trustee transfer of 401(k) assets to your new Roth IRA. This may take some paperwork.
What’s the difference between a Roth IRA and a Roth 401(k)?
Both allow your money to grow tax-free and qualified withdrawals are tax-free at retirement. However, there are no income limits on Roth 401(k)s, so even high earners can contribute. Check to see if your employer offers this option.
What’s the difference between a traditional IRA and a Roth IRA?
The main difference lies in tax benefits. With traditional IRAs, you can make tax-deductible contributions now. Your earnings grow tax-deferred, which means you owe income taxes on withdrawals at retirement. You can’t make tax-deductible contributions to Roth IRAs. But qualified withdrawals are tax-free at retirement.
This loophole lets high earners contribute to a Roth IRA even if they make too much.
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