Celebrating Over 19 Years of Excellent Service
Call Today : (866) 639-0066
Call Today :
(866) 639-0066
Celebrating Over 14 Years of Excellent Service

Converting 401(k) to IRA

If you’re thinking of Converting 401k to IRA, you might be doing the right thing. Roth IRAs allow you to invest your funds in investments similar to traditional IRAs, but Roth IRAs offer additional benefits that can help you save more money in the long run.

3 Signs That tell you That a Roth IRA could be the Best for You:

  1. You anticipate paying higher taxes when you reach retirement.Roth IRAs are funded with after-tax dollars. It means that you pay tax upfront on funds you are planning to rollover. And the distributions you take from your Roth IRA are tax-free. This feature can be extremely beneficial if you expect to be taxed at a higher rate at retirement.
  2. You don’t want to make withdrawals early.With traditional IRAs, you have to make the required minimum withdrawals when you reach 70 ½. Roth IRAs do not have this compulsion. This means that you can keep your funds in the Roth IRA until you are ready to use them.
  3. You want to increase your tax diversification.The contributions made to traditional IRAs are tax-free. This means you don’t pay taxes on the invested funds until you start withdrawing from it at retirement. However, with a Roth IRA, your contributions are taxed upfront, but after age 59 ½, you can make tax-free withdrawals. Rolling over your traditional IRA into Roth IRA can help diversify your future tax exposure. If you are unsure of how your income and tax will pan out in the future, you can have both these types of accounts for tax diversification.

How To Roll Over Your 401(k) to a Roth IRA

Roth IRA is funded with after-tax dollars (taxes on your contributions are paid upfront, and earnings are tax-free). This means your withdrawals at retirement are free of taxes. Plus, with a Roth IRA, you don’t have to take required minimum distributions (RMDs) like its traditional counterpart. You can leave your money uninterrupted for as long as you want.

Rolling over your 401(k) money to a Roth IRA is a smart decision but a taxable event. Taxes are applied to your contributions and that of your employer and on your earnings (capital gains and dividends). This boost in income pushes you to a higher income bracket, making you liable to pay more tax than if you left the money as it is in your traditional IRA.

Since the rollover changes the taxation of your money, the switch from a traditional IRA to a Roth is called a conversion instead of a rollover.

How To Roll Roll Over Your 401(k) to a Traditional IRA

The 401(k) contributions (employers and employees) are pre-tax. This means you are yet to pay taxes on any contributions and earnings.

Similarly, traditional individual retirement accounts (IRAs) are also tax-advantaged. The money in an IRA is tax-deferred, and you start paying taxes when you retire and start taking distributions.

However, there is a difference. In the traditional IRA, the individuals and not employers send their contributions to their financial institutions. They claim a deduction when they file their taxes.

Paying Taxes on Your Contributions

The contributions in a Roth IRA are taxed upfront;then,the money grows tax-free. But when the money was in your 401(k), it was protected from the taxes. So, to qualify for a Roth, you’ll need to pay tax on the money that’s in your 401(k).

The rollover funds are added to the total taxable income for the year you carry out the rollover. Your IRA’s income isn’t from a paycheck, and therefore the tax on it is not withheld and has to be paid from your pocket.

If you want to avoid a penalty, you can consider making an estimated tax payment before filing the taxes for the year. When you know your estimated tax payment, you can decide whether to pay it in full or split the amount into quarterly payments. Estimated quarterly tax payments are due on or before April 15, June 15, September 15, and January 15 of the next year.If you overestimate your tax payment and end up paying more than you owe, you’ll get a refund.

If you’re considering to roll over a large balance to Roth, your tax bill for the year could be high, pushing you into a higher tax bracket. To avoid getting into this situation, consider converting only part of the traditional IRA over two or more years.

Roth-401(k)-to-Roth-IRA Conversions

The process of a rollover from a Roth 401(k) to a Roth IRA is pretty straightforward, and in fact, optimal. The fact that the transferred funds have the same tax implications and no intermediate steps makes the process even simpler.

However, you may need to handle any employer matching contributions in your regular 401(k) account that may have taxes liable on them. You can either set up a Roth IRA for your 401(k) funds or roll them over into an existing Roth.

The Five-Year Rule

Rolling over your 401(k) to a new Roth IRA is a long term strategy. If you anticipate money withdrawal in the near future (within five years), then rolling over your 401(k) to a Roth IRA is not a good choice.

The five-year rule governs Roth IRAs. The rule states that if you want to withdraw the earning (interest or profits) from a Roth without any tax or penalty, you need to have held the account for at least 5 years. The same goes for the withdrawal of converted funds (from traditional 401(k) to a traditional IRA and then to a Roth IRA).

If the rollover is from a traditional 401(k) to a Roth IRA, the five-year period begins from the date the funds were transferred to the Roth. If you withdraw your earnings early, you may incur taxes and a 10% penalty. You can withdraw contributions, but not earnings, from your Roth at any time.

The early withdrawal rules can be confusing. So, if you are considering an early withdrawal of funds from your Roth IRA, it is wise to consult a qualified tax expert.

vNote: For 2020, as a part of coronavirus relief legislation, the early withdrawal penalty was eliminated.

The Bottom Line

Rolling your 401(k) into a Roth IRA is a smart decision. But, it may not be the right one for everyone. Before you sign the dotted line, make sure you investigate all your options. You should consider speaking to a tax professional for guidance because you may not know what can hurt you when it comes to complex investment vehicles and taxes.