Tax consequences of 401(k) to IRA rollovers

After you leave a job, there’s a good chance you’ll have left a 401(k) retirement plan along with your former employer. You have several options for your old employer-sponsored retirement plan, from rolling it over to a new plan or even cashing it out. With each choice comes vastly different consequences.

If you do decide to roll over your 401(k) to an IRA (or Individual Retirement Account), there’s a high probability that you won’t need to pay any taxes – assuming you’ve completed the rollover properly between “like-tax” accounts. You will have to worry about taxes, though, if you try to roll a pre-tax (traditional) 401(k) to a post-tax (Roth) IRA or any other tax-exempt vehicle.

Here, we’ll review the potential tax consequences of a 401(k) rollover and review some guidance as to how to complete one with as little hassle (and unexpected expense!) as possible.

When is a 401(k) to IRA rollover taxed?

The rollover action that will involve some taxation is if you were to roll all or a portion of your traditional, pre-tax 401(k) to a Roth IRA (or, in rare cases, a Roth 401(k)). This is the same as declaring your pre-tax 401(k) as income in the year of rollover; as a result, the entire 401(k) balance is taxed at your highest marginal income tax rate.

For a taxpayer in the highest federal tax bracket – 37% – a $10,000 401(k)-to-Roth rollover could cost you $3,700 in taxes. Ouch!

To avoid this, the key is to ensure you’re rolling your 401(k) retirement account to an IRA account of the same tax status; that is, a pre-tax account must be rolled into another pre-tax account. As an example, a traditional, pre-tax 401(k) could be seamlessly rolled into a traditional, pre-tax IRA at an institution of your choice – all with zero tax consequence. If you’re unsure what the tax status is of your 401(k), you can contact the plan administrator of your old employer plan to verify.

Another way to avoid taxes altogether (at least until you withdraw at retirement age) is to simply leave your 401(k) plan where it is under your old employer’s administration. This is one surefire way to avoid taxes. The downside is that your old 401(k) plan may be laden with high fees and fewer (and sometimes worse) investment options, both of which can cost you big time in the long run. This is why many people choose to roll over into an account at a new financial institution.

Note that there are different rollover options that also can include tax implications. A direct rollover is where your funds are directly transferred to your new IRA provider. It often means the check is made out in the name of that IRA provider but “for the benefit of ” (FBO) you. This is generally the simplest approach. Your 401(k) provider will usually ask you for the name and mailing address of your new IRA provider and your new IRA account number. We also recommend that you take this opportunity to update your mailing address since they may have an old address for you. That’s because you’ll be sent additional documents, including a tax-related document known as a 1099-R that tells the IRS you’re doing a tax-free rollover for your current year’s tax return.

An indirect rollover is where funds are first transferred to you, or a check is made out in your name. You deposit the funds in one of your own accounts, but then you have 60 days to send that money on to your IRA account if you want the rollover to be tax-free. If you don’t deposit the money within those 60 days, the IRS will assess an early withdrawal penalty. This can create a little extra work for you which is why most people opt for a direct rollover.

Regardless of the option you choose, if you have a tax-deferred 401(k), or a tax-deferred IRA, you’ll still be subject to Required Minimum Distributions (RMDs) once you hit age 73.

How much will you pay in taxes on a 401(k) to Roth IRA rollover?

If you decide to roll all or a part of your traditional 401(k) to a Roth IRA, you’ll definitely be hit with taxes on the federal level – and depending on where you live, possibly on the state and local level as well.

In a simplified example, imagine you’ve accumulated $100,000 in your previous employer’s 401(k) plan.

If you make a move to roll the entire balance into a Roth IRA (instead of a traditional IRA), you’ll be liable for ordinary income taxes on the full amount rolled over. This is the same result as if you were to voluntarily perform a Roth conversion on a set of traditional IRA assets.

Let’s say you earn $75,000, are single, and live in New York City. Prior to conversion, you face the following marginal tax rates:

Federal tax rate = 24.00%

State tax rate = 5.97%

NYC tax rate = 3.88%

Taking the sum of the three rates, we arrive at a total marginal rate of over 33%.

We can then apply that combined rate to the amount rolled over to get a sense of where your tax bill for the conversion might land:

33% * $100,000 = $33,000

While of course this is an oversimplified calculation, and your actual rate of tax will be different based on other income and the size of your deductions, it is helpful to see the huge impact of a pre-tax to post-tax 401(k) rollover.

This is all to say that it’s important for you to be especially deliberate when moving money from pre-tax to post-tax accounts because the tax bill could be significant!

Taxes will vary based on your state of residence and a host of other factors, so be sure to consult with a qualified, professional tax advisor before making any big moves to minimize the chance of tax penalties and better understand specific tax treatments and what constitutes taxable income.

When does it make sense to roll a 401(k) to a Roth IRA?

The most straightforward answer to this question is “sometimes.” In the cases where it is done, the decision is made in the context of external factors, like if you expect a higher tax rate in retirement, or if you’re experiencing an unusually low-income year.

Again, if you’re unsure about how this might work in your particular situation, make sure to consult a qualified financial professional to address any rollover tax ramifications before you act.

If you anticipate a higher tax bracket in retirement

If you think you’ll be on the hook for more taxes at retirement age than today, you might think about rolling your 401(k) to a Roth IRA now.

If you choose to do this, you’re effectively volunteering to pay tax at your current rate so as to avoid higher taxes down the line when you finally withdraw money from your retirement income.

In return, you’ll receive a tax-free nest egg with many years’ worth of growth potential. This works out best if you have the funds to cover the rollover tax held in a separate liquid savings account.

If your income for the current year is lower than usual

If you’re in the middle of a lower-than-usual-income year, you can take advantage of lower IRS tax brackets by rolling over all or a portion of your pre-tax 401(k) assets to an after-tax Roth IRA.

Depending on your actual income for the year, you can seize the opportunity to fill up lower brackets (10%, 12%) and thereby lock in a lower rate on your rollover to Roth. For instance, if your income is lower than usual for a particular year, you’ll have more room in the lower tax brackets for money converted to Roth IRA. This can save you a bundle in the long run.

If you aren’t sure how your income will look for the year as a whole, consider first rolling your 401(k) to a traditional IRA and then slowly converting to a Roth IRA at your own pace.

Let Capitalize help with your 401(k) rollover

While most rollovers can end up being pretty straightforward, some can get interesting, expensive, or both. Be sure to connect with a qualified financial advisor, like a Certified Financial Planner (or CFP) if you’re having trouble deciding on a reasonable path forward or want to discuss specific investment choices for your retirement savings, like mutual funds.

Capitalize is here to assist with rolling over your 401(k), so don’t hesitate to contact us if you’d like us to help you with finding the right IRA provider for you and managing your rollover.