There are a couple of scenarios in which you might consider rolling your Traditional 401(k) account balance into a Roth Individual Retirement Account (IRA).
In some cases, the benefits of such a conversion outweigh the drawbacks, but not always.
Before making a decision, it’s important to understand why you would consider a Roth IRA, what the rules, risks, and potential tax implications are for rolling over a 401(k), and how to make the 401(k)-to-Roth conversion work for you.
As financial advisors in San Antonio, Texas, we see people make mistakes when it comes to these conversions quite often. And a Roth conversion cannot be undone.
If you have questions that aren’t addressed here, let’s talk. What may seem like a simple decision can have a long-lasting effect on your future.
401(k)s and Roth IRAs
One of the biggest differences between the two types of retirement savings accounts is that you make contributions to a Traditional 401(k) account with pre-tax dollars, and to a Roth IRA with post-tax dollars. In other words, your employer takes your 401(k) contributions from your gross income, before taxes. Roth IRA contributions come out of your check after the taxes are calculated.
This tax difference carries into retirement. Because you have not paid taxes on the money in your 401(k), you’ll pay them when you make a withdrawal in retirement. With a Roth IRA, on the other hand, you won’t pay any taxes on the money you withdraw. Taxes are paid on both, but at different times: You pay the taxes up front with a Roth IRA, and on the backend with a 401(k).
If you decide to roll over a 401(k) to a Roth IRA, you’ll have to consider the tax implications. The year you do the conversion, you’ll owe income taxes, taxed at your ordinary-income rate. This can be a significant amount, but there are a few ways to soften the blow.
Although that upfront tax bill might be a bit of a shock when converting a Traditional 401(k), remember that you won’t have to pay taxes again in retirement once it’s converted to a Roth IRA.
When a 401(k)-to-Roth IRA Conversion Makes Sense
Why would you want an extra tax bill? There are a few reasons:
- If you’re leaving your current employer and you can’t or don’t want to leave the money you’ve invested in your existing Traditional 401(k) account
- If you want to take advantage of the Roth IRA’s tax-free distribution rule
- If you expect your future earnings to be above the income cap for Roth IRA eligibility (because income limitations do not apply to 401(k)-to-Roth IRA conversions)
- If you contributed more than the maximum deductible amount to your 401(k), which means those funds were not contributed pre-tax
How to Reduce Your Tax Burden
If you split up the money from your 401(k) and put some in a Traditional IRA and some in a Roth IRA, it can help control the immediate tax hit. You might also be able to allocate the after-tax funds to your Roth IRA if you’d contributed more than the max deductible amount to your 401(k). The pre-tax funds can go into a Traditional IRA.
Make sure you talk to your financial advisor and tax professional to crunch the numbers and determine if a conversion makes sense based on your situation.
How to Set Up the Conversion
After talking with your financial advisor, if you’ve determined that a conversion is the right move for you, the next step is to contact your 401(k) administrator to find out whether you’re allowed to do a 401(k)-to-Roth IRA conversion, and whether you can do it directly. Then, you’ll need to figure out how much you want to convert, whether it’s just a portion of your 401(k) balance in order to control taxes, or the entire balance. There are no annual limits for a conversion, like there are for regular contributions. The next step is to open a Roth IRA (unless you already have one), and provide the information to your 401(k) administrator.
The financial advisors at PAX Financial Group can help you with this.
Direct Vs. Indirect
The simplest way to roll over funds from a 401(k) to a Roth IRA is through a direct conversion, where you instruct your 401(k) administrator to send the funds to a Roth IRA you’ve opened. This is also known as a trustee-to-trustee rollover.
There is the indirect method, in which you request to have a check in the amount of your 401(k) balance sent to you. You then have 60 days to deposit the amount into another plan. Doing it this way not only means additional steps and more work for you, but it also equates to less money, because it’s mandatory that your 401(k) administrator withholds 20 percent of the funds for federal taxes. Even if you intend to put the entire amount into another plan, if you go the indirect rollover route, the administrator has to assume you’re cashing out, just in case you’re tempted to keep the funds, rather than putting them in another retirement account. If this is the case, you will be subject to even more taxes, plus an early-withdrawal penalty.
Five-Year Rule
If you plan to retire soon, or if you expect you might have to withdraw money within the next few years, a Roth IRA is probably not a good strategy for you, because this type of account is subject to a five-year rule. According to the rule, you must have had the account for at least five years to withdraw earnings without paying taxes or penalties, even if the funds were converted from a Traditional 401(k).
The clock starts ticking from the date the rollover funds hit your Roth IRA account.
There are a lot of options to consider, rules to follow, and taxes to think about. Lean on the financial advisors at PAX Financial Group before you make any decisions, to avoid making costly mistakes.
PAX Financial Group is based in San Antonio, Texas and helps clients nationwide. If you’re considering a 401(k)-to-Roth IRA conversion, schedule a no-obligation conversation with our team.
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