401(k) rollover to an IRA

In a nutshell

One of the most important decisions to make when leaving an employer is what to do with your old 401(k). There are typically several options including leaving it where it is, taking a distribution, rolling it over to a new employer’s plan or rolling it over to an IRA.

• Rolling over your 401(k) to an IRA allows you to keep growing your money in a tax-advantaged account.
• Transferring the money from one type of tax-advantaged account to another can also help you avoid paying income taxes or penalties on the money.
• Consolidating your retirement accounts also helps you keep better track of your retirement goals and progress.

We will go through the various aspects of rolling your 401(k) to an IRA to help you evaluate whether or not this is your best option.

What is a 401(k) rollover?

A 401(k) rollover occurs when you move your money from an employer-sponsored retirement account like a 401(k) to another tax-advantaged retirement account. This could be a 401(k) at your new employer or to an IRA at an outside custodian.

Regardless of the type of 401(k) rollover you are doing, it is important to ensue that you coordinate things with both the 401(k) administrator on the old plan and the IRA custodian or the administrator of the new employer’s plan. This is critical to ensure that you don’t inadvertently do something that will trigger an unwanted taxable distribution potentially resulting in taxes and possible penalties.

What are the advantages of rolling over a 401(k) to an IRA?

Rolling your 401(k) over to another tax-advantaged retirement plan offers several advantages, including:

Taxes

The avoidance of any taxes or penalties that might accompany withdrawing the money from the account. In the case of rolling a traditional 401(k) to a traditional IRA, or a Roth 401(k) to a Roth IRA you are preserving the tax-advantaged status of the money in the 401(k) account. No taxes will be incurred in the course of doing the rollover.

In the case of a rollover from a traditional 401(k) to a traditional IRA, the money continues to grow tax-deferred until withdrawn. In the case of a rollover of a Roth 401(k) to a Roth IRA, the money continues to grow tax-free until withdrawn.

Investment selection

An IRA offers a full range of investment options beyond the generally limited menu of mutual funds offered in most 401(k) plans. Depending upon the IRA custodian, investors may be able to invest at a lower cost than in their old 401(k).

Consolidation of retirement accounts

An IRA can serve as a place to consolidate money from 401(k) plans from former employers. With people changing jobs a number of times over the course of their working life, many people will have a number of old retirement plans to manage. Rolling these old plans into an IRA can make managing this money easier.

The five-year rule for Roth accounts

The five-year rule is a very important concept for Roth 401(k)s and Roth IRAs. In order to ensure that distributions made on or after reaching age 59 ½ are completely tax-free, the five year rule must be met.

• For a Roth IRA, the five-year clock starts at the beginning of the year the first contribution is made to the account.
• For a Roth 401(k)s rolled over to a Roth IRA, the five-year clock for that Roth IRA governs.
• When doing a Roth IRA conversion, each conversion has its own five-year clock.

When withdrawing money from a Roth IRA, there is an ordering rule for distributions around the five-year rule:

• Money contributed to a Roth IRA
• Taxable conversions to a Roth IRA
• Non-taxable conversions to a Roth IRA
• Earnings in the account

The five-year rule is an important consideration when considering a Roth conversion, especially for those who are older. You want to be sure that you are able to satisfy the five-year requirement on any Roth IRA money you will be withdrawing or leaving to non-spousal beneficiaries should you die. This is important when deciding whether to do a Roth conversion when rolling over money held in a traditional 401(k).

What about Roth 401(k) to Roth IRA rollovers?

On the surface, it may seem superfluous to roll a Roth 401(k) to a Roth IRA. Qualified withdrawals from a Roth 401(k) can be made tax-free just as with a Roth IRA. There is one big difference, however. Money in a Roth 401(k) is subject to required minimum distributions once you reach age 72. Even though these distributions will generally not be taxed, they still deplete the amount in the Roth 401(k) account.

Rolling a Roth 401(k) over to a Roth IRA preserves the Roth status of the account while eliminating the need to take required minimum distributions. This allows the money to remain in the Roth IRA until you choose to withdraw it. Alternatively you can allow the funds to remain in the Roth IRA to grow tax-free for your heirs. Roth 401(k) funds rolled over to a Roth IRA will generally not be subject to a separate five-year rule clock.

How to rollover a traditional 401(k) to a Roth IRA

One option you might consider for your traditional 401(k) account is to roll it over to a Roth IRA. In essence, you will be doing a Roth conversion which is a taxable event.

The logistics of this type of rollover will vary a bit by custodian. You may be able to roll the traditional 401(k) money directly to a Roth IRA in one step. Alternatively, you may need to roll these funds over to a traditional IRA first and then do the conversion to a Roth IRA afterwards.

Two important points to keep in mind here. First, you can choose to split the rollover between a traditional IRA and a Roth IRA in any percentage you deem appropriate for your situation. Even if your intention is to ultimately convert the entire amount to a Roth IRA, splitting the rollover between an immediate Roth conversion and a traditional IRA allows you to space out the conversion over several years. This can help ease the tax hit by spreading it out over several years.

The second point is to be sure that you will have the cash available to pay the taxes on the Roth conversion. You do not want to be forced to dip into an IRA account to come up with this cash as this can become very expensive and negate some of the benefits of doing the Roth conversion.

Frequently asked questions (FAQs)

Can you roll over a 401(k) to a Roth IRA without penalty?

The short answer is year. In the case of a Roth 401(k) being rolled over to a Roth IRA there should be no issue that would trigger either a penalty or taxes. This is a rollover of one Roth account to another.

Rolling a traditional 401(k) to a Roth IRA can be a bit trickier. This is a Roth IRA conversion and by definition will trigger taxable income for you in the year of the conversion. If this conversion is done incorrectly by the IRA custodian, this could trigger a penalty as well. It pays to monitor the process and communicate with both the 401(k) administrator and the custodian of the Roth IRA to ensure that all requirements are met.

It is always best to do a trustee-to-trustee transfer as opposed to taking a distribution and submitting the money to an IRA custodian yourself to help avoid triggering a penalty.

Can I move my 401(k) to a Roth IRA?

Yes. In the case of a Roth 401(k), moving it to a Roth IRA should be a rather seamless transaction. Just be sure to do a trustee-to-trustee transfer and communicate with both the IRA custodian and the administrator of the 401(k) plan where the money will be coming from.

In the case of a traditional 401(k) being rolled over to a Roth IRA, this is a Roth conversion and is a taxable event in the year of the conversion.

Should I convert my 401(k) to a Roth IRA?

Whether or not converting your traditional 401(k) to a Roth IRA makes sense will vary for each person faced with the decision based on their unique situation. Some factors to consider include:

• Your income in the current year. If your income is lower than normal it may make sense to do the conversion in the current year.
• What will your projected tax bracket be in retirement?
• How are your other retirement assets divided between Roth and traditional accounts?

Note: if your income is high this year you can always roll the traditional 401(k) money over to a traditional IRA and do the conversion in a year when your income is lower.

Another issue that needs to be considered when contemplating a Roth conversion is whether you have sufficient cash on the side to pay the taxes that the Roth conversion will trigger. If you don’t, you may need to tap an IRA or other retirement account which can quickly make the Roth conversion much more expensive.

How do I avoid taxes on a Roth IRA conversion?

If you do a Roth IRA conversion via rolling a traditional 401(k) to a Roth IRA you generally will need to pay taxes on the amount converted.

An exception to this is a backdoor Roth. Under this tactic, after-tax money is contributed to a traditional IRA and then rolled over to a Roth IRA. Any money converted that is attributed to after-tax contributions will not be taxed. If your traditional 401(k) consists of any after-tax contributions, avoiding some tax on a conversion to a Roth IRA when rolling over traditional 401(k) money may be possible.

Another type of backdoor Roth option is the mega backdoor Roth. Under this scenario, if a company allows after-tax contributions to its 401(k) plan over and above the annual contribution limits, these contributions can be converted to either a Roth IRA upon leaving the company or to a Roth 401(k) while still employed. The conversion is tax-free to the extent the money converted is attributed to pre-tax contributions. Money attributable to earnings would be subject to taxes upon converting.

How much money can I Rollover from 401(k) to Roth IRA

There are no limitations on the amount that can be rolled over from a 401(k) to an IRA. This includes money rolled over to a Roth IRA, either from a Roth 401(k) or a traditional 401(k). In the case of a traditional 401(k) rolled over and converted to a Roth IRA, it's important to keep in mind that the money converted will be taxed.