As people leave jobs – either by choice or necessity – they often face uncertainty about what to do with their employer-sponsored 401(k) plans. In this article, we’ll explain one excellent option for these situations: converting a traditional 401(k) into a Roth IRA.
Specifically, we’ll cover each of the following topics related to this type of conversion:
- Traditional 401(k) Overview
- Roth IRA Overview
- Benefits of a 401(k) to Roth IRA Conversion
- Converting Your 401(k) to a Roth IRA
- Roth IRA Five-Year Rule Considerations
- Final Thoughts
Traditional 401(k) Overview
A relatively new phenomenon, Congress implemented the traditional 401(k) retirement plan in 1978. Currently, 401(k) plans represent the most popular employer-sponsored retirement plan in the United States, as millions of Americans depend on these accounts for a large portion of their retirement budgets. And, most employers offer some sort of matching benefit to employee contributions to these plans, accelerating retirement savings.
From a tax perspective, the IRS considers the 401(k) to be a “qualified” retirement plan, which means it includes key tax benefits. More precisely, traditional 401(k) plans offer participants a vehicle for deferring income tax payments until retirement. Simply put, when you contribute money to a traditional 401(k) – up to an annual limit – you receive a dollar-for-dollar reduction in your current taxable income. For example, if you contribute $5,000 to a traditional 401(k), your taxable income for the year will be reduced by $5,000.
But, while the IRS giveth, it also taketh away. Traditional 401(k) contributions defer taxes, they don’t eliminate them. Contributions reduce taxable income, and the IRS doesn’t immediately tax account earnings, but plan participants do need to pay taxes on traditional 401(k) withdrawals in retirement. And, these withdrawals typically face ordinary income tax rates. Furthermore, if participants withdraw funds before age 59 ½, they’ll face penalties on top of this tax.
Roth IRA Overview
Unlike traditional 401(k) plans, the Roth IRA – or individual retirement account – is not an employer-sponsored retirement plan. As the name indicates, any individual can open a Roth IRA, though high earners face income-related contribution limits.
As with traditional 401(k) plans, earnings inside of a Roth IRA grow tax free. However, contributions to Roth IRAs are not tax deductible. Instead, people fund Roth IRAs with after-tax dollars, meaning that they pay taxes on the contributions with their current tax filings. While this eliminates an immediate financial benefit, withdrawals from Roth IRAs in retirement are tax free, reducing retirees’ tax bills.
And, due to this after-tax funding, Roth IRAs offer the additional flexibility of allowing plan participants to withdraw their contributions (not account earnings) at any time, for any reason, without penalties.
Benefits of a 401(k) to Roth IRA Conversion
Having provide broad overviews of both traditional 401(k) plans and Roth IRAs, we’ll now discuss the primary benefits of converting this 401(k) variant into a Roth IRA:
- Future tax brackets: Income tax brackets are currently at historic lows in the United States. By paying taxes now on a conversion, people avoid the risks of rising tax rates and the need to pay ordinary income taxes on traditional 401(k) withdrawals in the future, when tax rates have the potential to be significantly higher.
- No RMDs: As the IRS wants its tax revenue, it mandates that traditional 401(k) participants make required minimum distributions, or RMDs, beginning at a certain age. With Roth IRAs, no RMDs exist, meaning participants can take as much – or as little – out as they want in retirement.
- Conversion in conjunction with annual contributions: Every year, the IRS caps the amount individuals can contribute to a Roth IRA. However, when converting a traditional 401(k) into a Roth IRA, the funds from the conversion do not count against this annual contribution limit, meaning participants can “double dip,” contributing the annual amount and the 401(k) conversion funds.
- No income limit for high earners: As stated above, the IRS imposes an income limit on Roth IRA contributions, meaning that if you earn more than a certain amount, you’re not allowed to contribute funds to a Roth IRA. A conversion avoids this limitation, meaning that high earners can use a traditional 401(k) conversion as a way to fund a Roth IRA, despite exceeding normal income limits.
- Withdraw contributions anytime: As discussed, if people withdraw funds from a traditional 401(k) before 59 ½, they must pay taxes and a penalty on those withdrawals. On the other hand, as people fund Roth IRAs with after-tax dollars, they can withdraw those contributions whenever they want. This provides retirement savers tremendous flexibility, as Roth IRA contributions grow tax free, but those contributions can still be used as an emergency fund without penalty.
Converting Your 401(k) to a Roth IRA
Clearly, significant benefits exist to converting a traditional 401(k) into a Roth IRA. For individuals considering this move, here’s how to do it:
- Step 1: Individuals first need to roll over their traditional 401(k) funds into a traditional IRA, a retirement account that also includes pre-tax dollars.
- Step 2: After rolling over funds into a traditional IRA, individuals next convert that traditional IRA into a Roth IRA.
- Step 3: Here’s the bad part. As Roth IRAs are funded with after-tax dollars, individuals need to include the entire amount converted from their traditional IRAs in their taxable income for the year of the conversion. Consequently, if you convert $100,000, you’ll need to increase your taxable income by $100,000 for that year.
NOTE: Individuals should discuss with a tax professional A) whether this move makes financial sense for their unique situations, and B) the most appropriate timing and strategy for such a conversion, as you don’t need to convert all of your traditional 401(k) funds in a single year.
Roth IRA Five-Year Rule Considerations
As a final consideration, retirement savers need to understand the Roth IRA plan’s five-year rule. According to the IRS, in order to withdraw earnings from a Roth IRA without paying taxes or penalties, account holders must have held funds in their Roth for at least five years. And, this rule applies to funds contributed via a traditional 401(k), as well.
Timing-wise, this clock begins ticking as soon as converted funds hit your Roth IRA. Failure to adhere to this timeline means individuals could incur both income taxes and a 10% penalty on withdrawals. Consequently, before converting retirement funds into a Roth IRA, people should consider whether they’ll need those funds within the next five years.
Tremendous benefits exist with a traditional 401(k) to Roth IRA conversion. If you’re thinking about making such a move, a tax professional can help you navigate the specific considerations and best conversion strategy for your unique financial situation.
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