How to convert your 401(k) to Roth IRA

When you leave your job, one of the options regarding your 401(k) account is to transfer your 401(k) funds into a Roth IRA (individual retirement account). It might not be the first thing that comes to mind, as contributions to a Roth IRA are post-tax while those to a 401(k) account are usually pre-tax.

Unlike contributions to a Roth IRA, 401(k) rollovers to a Roth IRA are generally not subject to income limits, but the converted amount is considered taxable income in the year of distribution.

How is a Roth IRA different from a traditional IRA?

You can’t convert a Roth IRA back to a traditional IRA. Hence, you should understand the difference between these two plans before converting your 401(k) account into a Roth IRA.

Traditional IRA: Contributions made to a traditional IRA are tax-free. You pay taxes only when you withdraw the money. Contributions to a traditional IRA are claimed as a deduction when filing your tax return.This results in your contribution to your IRA reducing your taxable income for the year.

The funds in your Traditional IRA keep growing without attracting any tax liability. You can withdraw funds from your Traditional IRA at any time, but after you reach the age of 59 ½, you can withdraw without penalty. The amount of withdrawal gets added to your taxable income. A traditional IRA is also subject to Required Minimum Distributions (RMDs) once you reach age 73. 

Roth IRA: Unlike a Traditional IRA, you cannot deduct contributions made to a Roth IRA from your taxable income. When taking a withdrawal from a Roth IRA, your contributions made after tax are always tax free. However, the distributions from any earnings you receive from a Roth IRA are only tax-free if you are at least age 59 ½ and the Roth contributions started at least five years in the past. 

Like a Traditional IRA, your withdrawals will be subject to a 10% early withdrawal penalty if taken before age 59 ½ (including your tax free contributions). In addition, a Roth IRA is not subject to RMDs. 

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

You can convert your 401(k) account into a Roth IRA through the following steps:

Direct rollover: You can request your employer or plan administrator initiate a direct rollover, commonly referred to as a trustee-to-trustee transfer. Once you complete the necessary documentation, your retirement plan administrator directly transfers the proceeds of your account to the designated Roth IRA.

Human Interest’s Rollover Concierge™ makes it easy to find and rollover your past retirement accounts with just a few clicks, giving you clarity and control over your financial future.

Indirect rollover: Instead of going for a trustee-to-trustee rollover, you can ask your plan administrator to issue you a check for the balance amount of your retirement account. You can then deposit this check into your IRA within 60 days of receiving it. The downside of this option is that taking a distribution directly in cash will require your administrator to withhold 20% in federal taxes up front, plus applicable state taxes. When you do decide to rollover the funds, you can choose to make up these taxes out of your current funds.

Any delay beyond 60 days and/or any amount not rolled over (including tax withholding) will result in taxable income for the year and the IRS will assess a 10% penalty on the remaining amount if you are under 59 ½ years of age.

Rollover 401(k) to Roth IRA tax consequences

The amount of money lying in your traditional IRA account at the time of conversion is considered your contribution, and you must pay taxes on it. You must include this amount in your taxable income for the year in which the conversion takes place. If you choose to roll directly to your Roth IRA custodian, there are no taxes withheld. This means that you may owe taxes when filing your annual Form 1040. It’s important to discuss the options with a financial advisor before making any final decisions.

Moving Roth 401(k) deferrals to a Roth IRA

A 401(k) plan can include a Roth deferral provision. Any funds you have contributed as Roth deferrals are similar to a Roth IRA in that the contributions are made from post-tax money. In this case, there is no “conversion” of these contributions to Roth. Your only choice when rolling Roth funds to an IRA is to open a Roth IRA, even if you decide not to convert any pre-tax funds in your account (which may consist of both deferrals and employer contributions). 

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

You might consider converting your 401(k) account into a Roth IRA in the following situations:

• If your tax liabilities are likely to increase in the future: You might want to make Roth contributions and pay taxes now, so you can make tax-free withdrawals later.

• If you want to postpone withdrawals past age 73: Roth IRAs give you this flexibility.

• If you want to diversify your taxation: If you are not sure how your tax liability will impact your income in the future, you might want to set up a Roth IRA in addition to a traditional retirement account, so you can make both taxable and tax-free withdrawals after.

The five-year rule

Once you reach 59 ½ years, you can withdraw all funds from your Roth IRA tax-free, provided your account is at least five years old. If you’ve set up a new Roth account and want to withdraw funds before five years, the earnings withdrawn will be subject to taxation. In addition, a 10% penalty applies to the gross distribution (including contributions) if you are under 59 ½. Thus, converting your 401(k) account into a Roth IRA may not be a good idea if you think you’ll need the money within five years.

There are exceptions to the 10% penalty if the withdrawal meets another qualified distribution reason (e.g., disability, first-time home purchase).

If you are rolling over your 401(k) funds to an existing Roth IRA, the five-year period begins from the date when you set up your Roth IRA, and the actual rollover date is irrelevant.

The bottom line

Ultimately, the decision to convert your 401(k) to a Roth IRA hinges on your individual financial outlook, particularly your future tax expectations and desire for distribution flexibility. 

As you navigate the complexities of rollovers and conversions, tools like Human Interest’s Rollover Concierge™, in partnership with Capitalize, can alleviate the logistical burden of finding and consolidating your old accounts should you decide to rollover your old retirement accounts into one 401(k) with Human Interest. For more information about what Rollover Concierge can do for you, please contact Human Interest.