How to Convert Your 401(k) to Roth IRA

9 MIN READEditorial Policy

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 from post-tax earnings while those to a 401(k) account are from pre-tax earnings. To qualify for a 401(k) rollover to a Roth IRA, you must meet the Internal Revenue Service’s (IRS) income limits.

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. From a taxation point of view, a traditional IRA resembles a 401(k) plan, where your employer deducts your contribution from your salary before you pay any taxes on it. In the case of an IRA, you need to claim a deduction while filing your tax return, since there is no employer involved. However, the end result is the same: Your taxable income gets reduced by your contribution amount.

The funds in your IRA keep growing without attracting any tax liability. After you reach the age of 59 ½, you can start withdrawing money from your IRA. The amount of withdrawal gets added to your taxable income. A traditional IRA is also subject to Required Minimum Distributions (RMDs) once you reach an age of 70 ½ years. You cannot continue making IRA contributions beyond this age.

Roth IRA: Unlike a traditional IRA, you cannot deduct contributions made to a Roth IRA from your taxable income. However, the distributions you receive from a Roth IRA are tax-free. A Roth IRA is not subject to RMDs. You can postpone taking distributions until the time you want. You can continue contributing to a Roth IRA without any age restriction. All the money you earn from your Roth IRA is completely tax-free.

How to Convert Traditional 401(k) to Roth IRA

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

  1. The first step would be to set up a Roth IRA if you don’t have one already. You can open a Roth IRA with a brokerage firm.

  2. The next step is to transfer all your 401(k) funds into a traditional IRA.

  3. Finally, you can convert your traditional IRA to Roth IRA.

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 IRA.

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.

Any delay beyond 60 days will make you liable for withdrawal taxes and a 10% penalty 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 should include this amount in your taxable income for the year in which the conversion takes place.

If your 401(k) account includes contributions made from your post-tax income, you may end up paying taxes twice. To optimize 401(k) rollover to Roth IRA tax implications, you might want to transfer only your pre-tax contributions to a Roth IRA and allocate the remaining 401(k) balance to a traditional IRA. Using a 401(k) to Roth conversion tax calculator can help you compute your taxes on converting 401(k) to Roth IRA.

Converting Roth 401(k) to Roth IRA

A Roth 401(k) plan is similar to a Roth IRA in that the contributions are made from post-tax money in both the cases. Hence, it is easier to convert a Roth 401(k) account into Roth IRA when compared to traditional 401(k)-to-Roth IRA conversions.

However, taxes may be due on matching contributions from your employer, since such contributions are normally made from pre-tax money and kept in an accompanying regular 401(k) account. You can set up a new Roth IRA and roll over your 401(k) funds to it.

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 make withdrawals at any time: Roth IRAs give you the flexibility to withdraw money whenever you want. They do not bind you with RMDs when you reach 70 ½ years.

  • 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 money from your Roth IRA any time you want, 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 withdrawals might be subject to taxes and penalties even if you are over 59 ½ years. 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.

Withdrawing your contributions, including converted funds, attracts a penalty of 10%, while withdrawing interest and earnings attracts a 10% penalty and taxes.

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.

Having a Roth IRA gives you access to tax-free withdrawals whenever you want. Should you need further help understanding or opening a Roth IRA, feel free to contact our experts today.

We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment education, and integration with leading payroll providers.

Subscribe to our Retirement Roadmap newsletter

Retirement isn’t just a destination. It’s a journey, and we’re here to help you. Our newsletter delivers succinct and timely tips, reviewed by Financial Advisors, to help you navigate the path to financial independence.

By providing your email above or subscribing to our newsletter, you agree to our Privacy Policy. You also elect to receive communications from Human Interest.