Should You Convert Your 401(k) to a Roth IRA?

Upon leaving a job, you have a number of options when it comes to handling your old retirement account. One of these options is to convert your 401(k) to a Roth IRA — which can make sense in a few circumstances — but can also come with severe tax consequences if not considered carefully in advance.

Here, we’ll go over what a Roth IRA is, the advantages and disadvantages to converting money to a Roth IRA, and the other options you have aside from a 401(k) to Roth IRA conversion.

Note: For simplicity, assume all references in this article to “401(k)” refer to a tax-deferred or “pre-tax” 401(k). A Roth 401(k) to Roth IRA conversion is a simpler option, though it won’t be discussed thoroughly here.

What is a Roth IRA?

A Roth IRA is a tax-exempt, independent retirement account. The key term here is “tax-exempt”; you contribute money on an after-tax basis, and the money can grow free from taxation into and through retirement. What’s more, you won’t pay any tax on principal or earnings when you withdraw the money in retirement, assuming the account has been opened for at least five years.

Owning and funding a Roth IRA is not only a mathematically smart idea. It’s also psychologically easing: any money contributed to a Roth IRA has the potential to compound and earn dividends for the rest of your life — and you’ll still incur no tax liability. To know that you have a tax-free fund to cover your spending in retirement is truly a magnificent benefit.

The Roth IRA does come with some points of caution, however. First, contributions are limited to $6,000 annually, though the IRS will allow an additional “catch-up” contribution of $1,000 for those over 50.

Second, to contribute fully and directly to a Roth IRA, you’ll need to fall within certain income limits. For single people, this limit is $125,000, and for married couples, it’s $198,000. Beyond these thresholds, you’ll be restricted in your ability to contribute and may not even be able to contribute at all.

Last, remember that while you likely won’t pay any future tax on Roth contributions or earnings, you don’t escape taxation completely. In other words, money that goes into a Roth has already been taxed, and that will be reflected on your current year (or previous years’) tax returns.

While acts of Congress are uncertain both in timing and nature, there are signals that point to potentially higher taxes in the future. This makes it especially important for you to take advantage of maximizing Roth IRA contributions for all years in which you’re eligible.

What are the benefits and costs of converting my 401(k) to a Roth IRA?

While there will likely be tax consequences, there are benefits to converting a 401(k) to a Roth IRA.

Benefits of converting a 401(k) to a Roth IRA

• You’ll lock in a zero future tax liability. By voluntarily converting your 401(k) to a Roth IRA now, you’ll pay taxes now, but you’ll also give your money an opportunity to grow completely unrestrained by taxes for the rest of your life.
• IRAs tend to be more flexible. Since an IRA is an independent retirement account, you don’t necessarily have to be in any sort of formal employment relationship to open one (though you will have to have earned income to contribute.) Money in an IRA is free of the common restraints that typically come with the standard 401(k) plan you’ll find at your employer.
• You’ll be free to invest in what you want. Most 401(k) plans have set investment menus that you’ll need to choose from; with IRAs, you’ll have significantly more choice in terms of how you can invest your money.

There are also some major costs involved with converting your 401(k) to a Roth IRA.

Drawbacks of converting a 401(k) to a Roth IRA

• You’ll pay ordinary income tax on any amounts converted. This is the big one — if there is one thing you’ll need to keep in mind, it’s that all pre-tax 401(k) conversions to Roth IRAs are taxed at your highest marginal tax rate. The costs of converting can be substantial and immediate, especially if you’re a high earner. Depending on your state of residence, combined federal, state, and local tax rates can run 50% or more, so you’ll need to be very careful before converting any pre-tax 401(k) to a Roth IRA.
• You’ll lose 401(k) plan creditor protections. If you’ve separated from your employer, you might want to sever all ties immediately by moving the money to an outside IRA. While in many cases this does make sense, be sure that you’re ready to relinquish the creditor protections that 401(k) plans afford. For example, your 401(k) would receive a higher level of protection than would any IRA if you were to declare bankruptcy.
• Earnings aren’t accessible tax-free for 5 years. Money that you convert to a Roth IRA will be accessible immediately, subject to a 10% early withdrawal penalty if you’re under 59.5 years old. This is a plus, but any earnings on the newly-converted money won’t be accessible tax-free for five years, beginning from when you roll the money to the Roth IRA.

What are my other options for my 401(k)?

• Roll your pre-tax 401(k) to a Traditional IRA. This is a popular choice because you’ll incur no tax liability when you do this type of rollover. Here, you’re moving money between “like-tax” accounts; when you convert money from a pre-tax 401(k) to a Roth IRA, you’re crossing a barrier that will ultimately result in a large (and current) tax bill.Another benefit to moving your pre-tax 401(k) to a Traditional IRA is future optionality: you’ll be able to decide how much to convert to Roth and, perhaps more importantly, when the conversion(s) occur(s). A popular strategy here is to spread your Roth conversions over many years so as to spread out the embedded tax liability.
• Do nothing and leave your 401(k) alone. Just because you’ve left a job doesn’t mean you’re obligated to take your 401(k) with you. Assuming the costs of the plan and the investment options are to your liking — as well as sufficient from a financial planning perspective — it’s not a necessity to move the account. Converting the plan to a Roth can make sense in certain situations — like if you’re in the middle of a lower-income year — but you don’t need to feel that something bad will happen if you’re happy with your 401(k) plan and do nothing.
• Merge your old 401(k) with your new one. While this won’t apply to everyone, you might have a suitable 401(k) plan at your new job to which you can transfer your old one. Again, the main benefit here is that you won’t incur any tax by doing this (as long as you’re simply merging one pre-tax account with another). This is also an excellent option for those looking to consolidate, avoid taxes and maintain a 401(k) as part of their overall financial plan.
• Convert pieces of your 401(k) plan to Roth over time. Rather than converting your entire pre-tax 401(k) to Roth status in one fell swoop, consider spreading out the conversions over a period of years. This will help you achieve your ultimate goal of getting money into your Roth IRA while also spreading out the tax burden across tax years. This can help preserve liquidity as well as overall cost.