What is a Roth IRA?
A Roth IRA is an after-tax Individual Retirement Account that lets you contribute after-tax dollars up to an annual limit set by the IRS. A Roth IRA allows you to pay taxes on contributions up front, in exchange for the future tax benefit of not paying income tax on investment gains when you withdraw later, as long as you follow the Roth 5-year rules.
Notably, Roth IRA tax rules are different from those for another type of popular retirement account, the Traditional IRA.
The available 401(k) investment options and fees play a large role in determining whether a 401(k) rollover to a Roth IRA (or other rollover IRA) makes sense for you. Tax implications and consolidation options are important to consider as well.
Your old 401(k) plan typically would let you choose your portfolio allocation from a pre-selected menu of mutual funds. Carefully look over the fund options available to ensure that they align with your desired investment strategy and comfort with risk.
But rolling over your 401(k) to a Roth IRA could give you more control by choosing your preferred provider, investment style (robo or self-managed), and investment options (traditional assets such as stocks, bonds, and ETFs, or alternatives like real estate, crypto, etc).
401(k) fees vary substantially depending on which institution your employer works with. There are some 401(k) plans with high custodial fees and funds that have higher-than-average expenses. Other 401(k) providers may offer minimal maintenance fees and low-cost investments.
Roth IRAs can be opened for free through many online providers, but some investment platforms charge a small recurring fee. Roth IRAs give the flexibility to choose low or no-cost investments, or more expensive versions if you desire.
Ultimately, a 401(k) to Roth IRA rollover can give you more options when it comes to choosing your investment fee.
As your career progresses, you’ll likely work for many companies over the years. Each company has their own 401(k) plan that you can contribute to while employed. With each career move, you’ll then need to decide what to do with your old retirement funds.
Although some new plans allow for other retirement accounts to be rolled into them, not all employers allow for this option. A Roth IRA can be an attractive place to hold your retirement savings (other than a current 401(k)) so that all your retirement money is in one place, while helping to ensure your investment strategy is aligned.
Keeping careful track of your rollover funds is one of the key ways to get the most out of them.
If you feel you’ll be in a higher tax bracket at retirement than you are in today or are concerned about the uncertainty of future tax brackets, moving your 401(k) to a Roth IRA is an option to consider since you won’t pay taxes when withdrawing at retirement.
Keep in mind that your personal financial situation greatly influences whether a 401(k) to Roth IRA rollover makes sense for you. There are additional tax considerations to evaluate as well when moving pre-tax dollars from a 401(k) to a post-tax account like a Roth IRA (more on this in a bit).
How to Roll a 401(k) into a Roth IRA
A 401(k) to a Roth IRA rollover follows a multi-step transfer process.
Before starting, confirm whether your old retirement plan is a Traditional 401(k) or a Roth 401(k). Most people have a traditional 401(k), which is generally the default option in workplace retirement savings plans. While fewer 401(k) plans offer a Roth 401(k) option, it’s worth checking to see if yours is one of them.
The type of 401(k) you have determines what rollover process you’ll follow and what the tax implications will be when doing a 401(k) to Roth IRA rollover. Transferring funds from a Roth 401(k) to a Roth IRA has no tax implications because the accounts have the same tax status. However, a Traditional 401(k) is taxed differently than a Roth IRA, so you’ll need to follow a bit of a different process.
In either case, it’s good to know that any rollover you make into a Roth IRA doesn’t impact your annual contribution limit, as you’re just transferring money between accounts.
Roth 401(k) to Roth IRA transfer
First, open a Roth IRA at an institution of your choice. Next, provide the Roth IRA details to your old 401(k) plan provider. This may include the new Roth IRA’s provider’s name, account number, and address. Your old company’s 401(k) plan may require additional steps, such as getting a plan administrator to sign off on the transfer.
Once complete, you’ll choose between a direct 401(k) to Roth IRA rollover or an indirect rollover. A direct rollover means the funds are sent directly to your new Roth IRA provider in the institution’s name, for your benefit. Your 401(k) plan may require that the disbursement is sent to you first before forwarding on to the new institution as an extra security precaution.
An indirect rollover from a 401(k) to a Roth IRA, also known as a 60 day rollover, is when the 401(k) funds are sent directly to you for depositing in a non-retirement account. In these cases, the IRS requires your 401(k) plan withhold 20% of your account balance for taxes that may be due. You’ll then have 60 days to re-deposit the funds to another retirement account or the distribution will be taxed at your income tax rate.
Indirect rollovers take a bit of extra work, so it’s often easier and smoother to do a direct rollover.
Traditional 401(k) to Roth IRA transfer
A Traditional 401(k) can’t be directly transferred to a Roth IRA since these accounts receive different tax treatments. So, you’ll first need to move these funds to a Traditional IRA, where you’ll later be able to convert the account into a Roth IRA.
Once you open a Traditional IRA, you’ll follow a similar process as you would have when moving a Roth 401(k) to a Roth IRA. Once the funds are in a Traditional IRA, open a Roth IRA so you can then convert the account.
401(k) Rollover to Roth IRA Tax Consequences
Traditional 401(k)s and Roth IRAs have different tax statuses and therefore come with different tax implications.
When you contribute to a Traditional 401(k), you receive a tax break in the form of a deduction. For example, if your income is $50,000 and you contribute $5,000 to a Traditional 401(k), you’re only taxed on $45,000 worth of income for the year.
A Traditional 401(k) then grows tax-free until you reach retirement, which is defined as reaching at least age 59 ½ according to the IRS. This is also called tax deferred. When you make withdrawals at that time, you’re taxed at the federal, state, and local tax rates on the full withdrawal amount.
However, a Roth IRA doesn’t give you a deduction when you contribute but has the benefit of tax-free withdrawals at retirement.
Moving funds from a Traditional 401(k) to a Roth IRA changes the tax status and, as a result, there are tax implications by making this transaction. In other words, the IRS essentially requires you to give back the tax deduction made on the original Traditional 401(k) before you can put the funds in a Roth IRA. This allows you to receive the benefit of tax-free withdrawals at retirement age.
The process of moving funds from a Traditional 401(k) to a Roth IRA is called a Roth IRA conversion. The tax impact is determined by the total amount you decide to convert from a Traditional IRA into a Roth account. This amount is added to your taxable income in the year you make the conversion, and is taxable at the federal, state, and local levels. As with many taxes, there is more that goes into how Roth IRA conversions are taxed, so make sure to do your homework first.
Alternative 401(k) Rollover Options
In addition to a 401(k) to Roth IRA rollover, there are several other options you have when deciding what to do with your former employer’s retirement account.
Traditional IRA Rollover
A Traditional IRA has the same tax status as a Traditional 401(k). As a result, you can move your retirement savings to an IRA provider of your choice without triggering tax implications. IRA assets can be easily managed apart from your previous employer.
Convert into a New 401(k)
Your new employer may offer a 401(k) and allow for transfers from outside retirement accounts. Consider the investment options available in your new 401(k) plan (company stock may be one of them) and ask whether your new company will let you transfer in other accounts.
Keep Your Current 401(k)
If you’re pleased with the investment choices and fees in your previous employer’s 401(k) plan, keeping your retirement savings in place is a viable option. Keep in mind, however, that you won’t be able to make new contributions or transfer in other accounts.
Withdraw from Your 401(k)
All 401(k) accounts give you the option to withdraw your funds and receive the proceeds as cash. But remember that if you aren’t 59.5 yet or if you’re not 55 and retired, withdrawals from your 401(k) won’t be considered qualified distributions eligible for penalty-free treatment.
Withdrawing pre-tax contributions from your 401(k) is typically best saved as a last resort, since you’ll have to pay federal taxes — as well as state and local taxes, plus early-withdrawal penalties — if you haven’t yet reached retirement age. You’ll also potentially give up the benefit of additional tax-advantaged investment returns.
However, if you need access to the funds for non-retirement purposes or financial hardship, withdrawing from your 401(k) is something you can consider.
Get Started on a 401(k) Rollover
Regardless of which rollover option you choose, Capitalize is on a mission to make the rollover process easier for everyone. We can show you how a 401(k) rollover works and help manage your rollover from start to finish, giving you peace of mind and providing expert support along the way.