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How to convert a 401(k) to a Roth IRA

Converting a 401(k) to a Roth IRA can help you secure tax-free withdrawals at retirement, but there are some challenges.

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.

How does a 401(k) to Roth IRA conversion work?

Converting a 401(k) to a Roth IRA is essentially transferring money from a pre-tax account to an after-tax account. Pre-tax 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 2021, 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. You can 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.

How to roll over your 401(k)

If your company or former employer allows 401(k) to Roth IRA conversions, take the following steps.

  1. Open a Roth IRA with a brokerage firm or bank. Be ready with your Social Security number, proof of income and external banking information to fund the account.

  2. Contact the financial institution holding your 401(k) plan. Request a direct rollover or trustee-to-trustee transfer of your 401(k) assets to the financial institution holding your Roth IRA.

    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.

  3. Pay taxes on the amount transferred. Taxes are due by the tax filing deadline for the tax year you made the conversion.

When is the best time to roll over a 401(k)?

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.

You can 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.

Cost to convert a 401(k) to Roth IRA

Beyond the taxes you’ll owe on the amount transferred, there may be other costs associated with a 401(k)-to-Roth IRA transfer.

What do I need to pay up front?

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 need to 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.

How to reduce tax

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.

The Five-Year Roth IRA Rule

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.

  • Be at least 59.5 years old
  • Have had your Roth IRA open for at least five years

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.

Should I roll over my 401(k)

While rolling over your 401(k) to a Roth IRA can offer several benefits, there are some points you should consider before moving forward.

  • Eligibility: Some companies don’t allow existing employees to roll over money from their 401(k) plan to another account such as a Roth IRA. Some only allow former employees to roll over 401(k) plan assets. Meanwhile, some companies only allow former employees to roll over 401(k) money to a traditional IRA. If you want to transfer your 401(k) to a Roth IRA, you’d need to roll over your 401(k) to a traditional IRA first in this case.
  • Tax implications: If you’re transferring a 401(k) to a Roth IRA, you need to pay income taxes on any nondeductible contributions and earnings you’re moving. This can mean a sizable tax hit, especially if you’re transferring a large balance and you’re in a high tax bracket. So speak with a tax advisor about how taxes would affect you if you roll over your 401(k) into a Roth IRA.
  • Preferences: Do you want your tax break now or later? A traditional 401(k) or IRA allows you to make tax-deductible contributions while you work. You can’t do this with a Roth IRA. But qualified Roth IRA withdrawals are tax-free on a federal basis. So consider your age and the tax bracket you expect to be in at retirement. Also, be conscious of Roth IRA income limits. After you make a certain amount, you can’t contribute to a Roth IRA.

401(k) rollover alternatives

If you think a Roth IRA isn’t your best option, you have access to other retirement savings vehicles.

  • Traditional IRA: If you roll over your 401(k) to an IRA, you won’t owe income tax on the transfer. Just like with a 401(k), you can make tax-deductible contributions to a traditional IRA. But IRAs typically offer more investment options than a 401(k) plan.
  • New 401(k): If you’re getting a new job, your new employer may offer a better plan with lower fees and a company match. So make sure you consider this offering. You can always roll over an existing 401(k) to a new 401(k) plan. If you’re bent on Roth benefits, check to see if your new employer offers a Roth 401(k) option.
  • Taxable account: These are basic investing accounts. You’ll owe taxes on capital gains, dividends and interest, but there’s no early withdrawal penalty.

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Bottom line

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 be sure to compare brokerages to find the Roth IRA that’s right for you.

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