How to Rollover a 401(k) to Roth IRA

11 MIN READEditorial Policy

When making a non-retirement move with your employer-sponsored 401(k), you have four different options. You can cash out your 401(k), but this should be your last option except in cases of financial crisis. You can leave your 401(k) with your old employer if the fees are low and it’s performing well. You can transfer it to your new employer’s 401(k) plan if that plan has lower fees and a better range of investments. Alternatively, you can rollover your 401(k) to an IRA or Roth IRA, which usually has the lowest fees and the most investment freedom. In this article, we’ll walk you through the basics of each option.

Comparison of Roth IRAs and Traditional IRAs

The biggest difference between a traditional IRA and a Roth IRA is when you pay taxes. A traditional IRA is funded with pre-tax dollars, so your contribution generates an immediate tax break because you don’t incur income tax on it each year. However, you’ll have to pay that income tax later at the time of withdrawal. A Roth IRA is just the opposite, as it’s funded with post-tax dollars. Since the taxes have already been paid upfront, you don’t have to pay any income tax later when you withdraw the funds.  

Knowing what tax bracket you’re in now, and anticipating what tax bracket you’ll be in later, will help you determine whether a traditional or Roth IRA is better for you. You’ll have to pay income taxes either way, but will it save you more money to pay them now or later? Typically, a Roth IRA is the better choice if you anticipate being in a higher tax bracket later on at the time of retirement. 

Advantages of 401(k) to Roth IRA Conversion

If you want to fund a Roth IRA there are two requirements. First, you must have taxable compensation, which is any form of income. Second, you are subject to annual limits, which cap the amount of funds you can contribute each year. The higher your annual gross income is, the less you can contribute to your Roth IRA each year. Unfortunately, if your income is too high, you’re not allowed to contribute anything at all. 

For the year 2024, you can contribute up to $7,000 (or $8,000 if you’re 50 or older) as long as your income is no more than $240,000 if married and filing jointly, or $161,000 if filing as single, head of household, or married filing separately. If your income is above these limits, you can still make a partial contribution if your income is between $218,000 and $240,000 if married and filing jointly, or $138,000 and $161,000 if filing as single, head of household, or married filing separately. 

There are only two ways to sidestep the annual income limit and take advantage of funding your Roth IRA as much as you want. You have to either convert a traditional 401(k) into a Roth IRA or convert a traditional IRA into a Roth IRA. This is a huge perk that makes a 401(k) to Roth IRA rollover worth your time and effort. It’s your only option to own a Roth IRA if your annual income exceeds the annual contribution cap.  

When it comes time to start making withdrawals from your Roth IRA, you will be able to make them tax-free since it was post-tax dollars that funded your account. You will also not have Required Minimum Distributions, or RMDs, which is when the IRS requires you to start making withdrawals, whether you want to or not, based on your age. 

Disadvantages of a 401(k) to Roth IRA Conversion

Since your traditional 401(k) funds are pre-tax dollars and a Roth IRA is funded by post-tax dollars, you’re going to have to pay income tax when you convert a traditional 401(k) to a Roth IRA. The conversion amount is considered income for that tax year and depending on how large of a sum you’re converting, this could be a substantial amount. 

If the conversion amount is smaller, you’ll pay your ordinary income tax rate at your current tax bracket. If the conversion amount is quite large, it’s possible that the boost in “income” will bump you into a higher tax bracket and you’ll pay even more taxes. The income taxes on your conversion will be due at the end of the tax year. 

Even though converting your 401(k) to a Roth IRA is a taxable event, in most cases, you still end up further ahead in the long run with that amount put into a Roth IRA. Once you roll over your 401(k) to a Roth IRA it can’t be undone, so you’ll want to be certain about your decision. 

Steps to 401(k) to Roth IRA Conversion

Doing a 401(k) to Roth IRA conversion is a two-step process. First, you’ll roll over your traditional 401(k) to a traditional IRA, and then you’ll convert your traditional IRA into a Roth IRA. Sometimes this process is called a “backdoor” conversion because it’s allowing you to avoid the annual income limits. The overall process is fairly straightforward. 

  • The bank, brokerage, or online investing platform of your choosing will open a traditional IRA account for you. 

  • You will request a direct rollover from your traditional 401(k) to your new traditional IRA and the funds go directly, and electronically, from one account to the other.

    • It’s possible that your 401(k) plan administrator will not do a direct rollover but instead require an indirect rollover.

    • With an indirect rollover a check is made out to you, 20% is withheld for taxes, and you have 60 days to either conduct the rollover process and get the 20% back or have the check considered a distribution subject to income tax. 

    • If doing an indirect rollover, make sure the check is made out to your new account, not to you personally, to avoid any doubt or confusion about whether the transaction is a distribution or a rollover. 

    • Since both your 401(k) and IRA are funded by pre-tax dollars, there are no taxes owed on this rollover. It’s an apples-to-apples transaction and very simple. 

  • Next, your investment advisor will convert your traditional IRA into a Roth IRA, thereby performing a backdoor conversion. 

    • This transaction is called a conversion and not a rollover, because the taxation status of your money is changing. 

    • This is the transaction that you will be required to pay income tax on at the end of the year and is what allows you to make tax-free withdrawals during retirement. 

Whether you have a rollover in mind or you are exploring all your retirement savings options, it’s always a good idea to consult with a retirement expert. The experts at Human Interest are ready to answer your questions and guide you through creating a successful retirement plan.

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.

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