If you are considering leaving a job and have a 401(k) plan, then you need to stay on top of the various rollover options for your workplace retirement account. One of those options is rolling over a traditional 401(k) into a Roth individual retirement account (Roth IRA). This can be a very attractive option, especially if your future earnings will be high enough to knock into the ceiling placed on Roth account contributions by the Internal Revenue Service (IRS).
Since you haven’t paid income taxes on that money in your traditional 401(k) account, you will owe taxes on the money for the year when you roll it over into a Roth IRA. Read on to see how it works and how you can minimize the tax bite. Consider the benefits and implications of rolling over a 401(k) to another type of retirement account if you leave your job.
This type of rollover has a particular benefit for high-income earners who aren’t permitted to contribute to a Roth. The immediate tax bill can be avoided by allocating after-tax funds to a Roth IRA and pretax funds to a traditional IRA.Be sure to consult a tax professional if you’re unsure of how conversions work for you.
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It comes right off the top of your gross income. You pay no taxes on the money that you contribute or the profit that it earns until you withdraw the money, presumably after you retire. You will then owe taxes on withdrawals. A Roth IRA is funded with post-tax dollars.
You won’t owe taxes on that money or on the profit that it earns when you withdraw it. So, when you roll over a traditional 401(k) to a Roth IRA, you’ll owe income taxes on that money in the year when you make the switch. The total amount transferred will be taxed at your ordinary income rate, just like your salary.
If you contributed more than the maximum deductible amount to your 401(k), you have some post-tax money in there. You may be able to avoid some immediate taxes by allocating the after-tax funds in your retirement plan to a Roth IRA and the pretax funds to a traditional IRA. Alternatively, you can choose to split up your retirement money into two accounts: a traditional IRA and a Roth IRA.
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This is going to take some number-crunching. You should see a competent tax professional to determine exactly how the alternatives will affect your tax bill for the year. If your 401(k) plan was a Roth account, then it can only be rolled over to a Roth IRA. The rollover process is straightforward.
This is not, to use IRS parlance, a taxable event. However, you should check how to handle any employer matching contributions, because those will be in a companion regular 401(k) account and taxes may be due on them. You can establish a new Roth IRA for your 401(k) funds or roll them over into an existing Roth.
Remember, you’ve already paid income taxes on that money. But Roth IRAs are subject to the five-year rule. This rule states that to withdraw earnings-that is, interest or profits-from a Roth IRA, you must have held the Roth IRA for at least five years. The same rule applies for withdrawing converted funds-such as funds from a traditional 401(k) that have been deposited in a Roth IRA.
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In other words, the holding period for the IRA applies to all of the funds in the account, including those rolled over from the Roth 401(k) account. If you do not have an existing Roth IRA and need to establish one for purposes of the rollover, the five-year period begins the year when the new Roth IRA is opened, regardless of how long you have been contributing to the Roth 401(k).
Withdrawing earnings early, typically before age 59½, could incur taxes and a 10% penalty. Withdrawing converted funds early could incur the 10% penalty. The rules governing the early withdrawal of funds in a converted Roth IRA can be confusing. There are exceptions to the tax and penalty consequences related to whether you are withdrawing earnings vs.
As an alternative, the administrator can send the check to you, made out in the name of your account, for you to deposit. Going directly is a better approach. It’s faster and simpler, and it leaves no doubt that this is not a distribution of money (on which you owe taxes).
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Again, that’s evidence that this is not a distribution. Another option is to take an indirect rollover. In this case, the plan administrator will send you a check made out to you after withholding taxes at a rate of 20%, and you will then record the distribution and the taxes already withheld on your income tax return.
There are a few other options to consider if you are exploring ways to roll over your 401(k). If you’re taking a new job, there is no tax bite when you roll over your traditional 401(k) balance to another traditional 401(k) at a new job or, alternatively, roll over a Roth balance to another Roth balance.
It might not be feasible if the assets in your old plan are invested in proprietary funds from a certain investment company and the new plan only offers funds from another company. If your account contains your old employer’s company stock, you might have to sell it before the transfer.
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If this is the case, then you need to roll your Roth 401(k) into a Roth IRA that you open on your own-or leave it in your current employer’s plan, if that’s permitted. The optimal scenario would be to roll your old Roth 401(k) into a new Roth 401(k) at your new employer.
The previous employer must contact the new employer concerning the amount in employee contributions that are being rolled over and confirm the first year when they were made. The account holder should transfer the entire account, not just a part of it. Cashing out your account, in whole or in part-whether the account is traditional or Roth-is usually a mistake.
On a Roth 401(k), you will owe taxes on any earnings that you withdraw and be subject to the 10% early withdrawal penalty if you’re under age 59½ and have not had the account for five years. 401(k) funds are not the only company retirement plan assets eligible for rollover.
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Anyone can contribute to a traditional IRA, but the IRS imposes an income cap on eligibility for a Roth IRA. Fundamentally, the IRS does not want high earners benefiting from these tax-advantaged accounts. In 2023, the annual contribution limit for IRAs is $6,500 or $7,500 if you are age 50 or older.
The income caps are adjusted annually to keep up with inflation. In 2023, the income phase-out range for taxpayers making contributions to a Roth IRA increased to $138,000 to $153,000 for single and head of household filers. For married couples filing jointly, the income phase-out range is $218,000 to $228,000.