Moving money from a traditional 401(k) into a traditional rollover IRA can be a very simple process, through which you’ll be able to move money from a previous employer to an outside IRA provider – ideally with no taxes to worry about.
But what if you want to move money from a traditional, pre-tax traditional 401(k) to a post-tax Roth IRA? The tax consequences become much more important, and if the conversion isn’t done with advance planning, it can be quite costly.
Below you’ll find a walkthrough of how the 401(k) to Roth IRA transfer process works, a simple example, and some potential workaround solutions.
First, for the purposes of keeping things as simple as possible, let’s assume you’ve worked at one company for a period of five years, and you’ve managed to stash away $100,000 in your company’s 401(k) plan. This is considered “pre-tax” money; in other words, you received a tax deduction each time you contributed money, so the money has yet to be taxed.
The benefit of this tactic, of course, is tax-deferred growth: your retirement balance will compound faster, and ideally you’ll be left in an advantageous position by the time it comes to retire. Since most people will have a higher tax rate during their working career than they will in retirement, the math works out well for them to take tax deductions when they’re working, and pay tax upon withdrawal when their tax rate is likely to be lower.
If you’ve decided to leave your job, you’ll have the option of rolling over your old 401(k) to an IRA at an external provider of your choice. Using the above example, you’d be rolling over $100,000, or a portion thereof to a provider (or set of providers) you’ve chosen on your own.
If you were to roll this money to a traditional IRA, you would avoid paying taxes for now; this is because a traditional IRA is meant to hold “pre-tax” money in the same way a traditional 401(k) is. You’re not causing any taxable income when you do this type of transfer, which is why many people will decide to move from one traditional account to another when performing a 401(k) to IRA rollover.
Enter the Roth IRA transfer. This is where some people can run into trouble, and potentially cause greater (and more expensive) tax consequences than they might have otherwise intended. When you move money from an old pre-tax 401(k) to a Roth IRA, assuming you’ve converted the entire balance, you’re effectively declaring the entire 401(k) as taxable income in the year of conversion.
If you’re fully employed and earning a healthy salary, the impact of converting a pre-tax 401(k) to Roth can cost many tens of thousands of dollars in tax, and might also push your overall income into a higher marginal tax bracket for the year. This effect is amplified if you live in a high-tax state, like New York or California, which will charge its own rate of tax in addition to your federal obligation.
If we continue the above example, imagine again that you’ve accumulated $100,000 in your employer’s pre-tax retirement account.
If you initiate a full conversion from your 401(k) to a Roth IRA, all $100,000 will be considered taxable income in the year you complete the conversion. This will have various tax consequences depending on your filing status (Single, Married Filing Jointly, etc.) and the other income you earn during the year (salary, freelance income, investment income, etc.), but the general idea is that it will substantially increase your tax bill that’s due the following April.
If we assume you’re a single tax filer and earn a salary of $100,000, this puts you in the 24% bracket for Federal taxation. If, in 2022, you decide to convert your entire pre-tax 401(k) balance to a Roth IRA, you’ll have ordinary income of $200,000 – not counting any other income you may have earned through a side hustle or other freelance work. As a result, your highest levels of income will be taxed at 32%, and you’ll owe on the order of $30,000 in tax as a result of the conversion.
Needless to say, this is something you really need to be sure about before attempting, and you’ll also need to have both a good rationale and the funds available to pay the impending tax bill.
You’ll want to consider carefully certain factors in your financial plan that might make a conversion to Roth sensible in the current year. Among these factors:
While nobody can predict with any real certainty what tax rates will do in the future, we do know there is a plan in place for federal tax rates to rise in 2026. This is connected to the Tax Cuts and Jobs Act of 2017, which significantly reduces federal tax rates for individuals, corporations and estates. All of that said, if you believe your federal tax rate will increase between now and your retirement, it might (literally) pay to get the tax out of the way now and lean in favor of performing Roth conversions. If you believe your tax rate will be lower in retirement than during your working career, it might make sense to defer as much as possible now and gradually take distributions in retirement.
Unless you’re planning on leaving the country, you won’t have much control as to what happens on the federal level. But you will have big control – or at least more control – as to the state you live in. Some states, like Florida, Texas, and Tennessee, boast a 0% tax rate for residents. Others, like New York or California, can have combined state and local rates approaching 15%. One commonly-employed strategy is to work in a state that offers high salaries, defer as much income as possible to retirement accounts, and then retire to a state offering a zero tax rate when it finally comes to drawing down the money.
It’s a good idea to investigate the state and local tax rates where you live now, versus where you might live in retirement. This can have a meaningful effect on your take-home cash, and can really make a difference in retirement quality.
When you’re considering a Roth conversion, you’ll need to pay attention to your total income as well as your annual cash flow. If, in a simple example, you convert $100,000 of pre-tax money in a 401(k) to a Roth IRA, and you’re in the 25% federal tax bracket, you’ll owe $25,000 in tax just on the conversion alone. This amount is far higher if you live in a state where tax rates are high.
Consider performing Roth conversions in years when your income is relatively low. This way, you’ll pay a lower rate of tax on any amounts converted, and spare yourself the unnecessarily high tax bill in absolute terms. Also ensure you have enough cash flow either coming in or stored away to cover any tax associated with your conversions.
There is always a possibility, of course, that your investment’s value while in the Roth IRA fails to perform as expected. If this happens, there is no option to reclaim the taxes you paid upon converting the money to a Roth IRA. Be sure that before you commit to a Roth conversion, you understand that the tax money associated with the conversion will be gone forever, and you’ll then bear the long-term investment risk connected to the funds in the Roth IRA.
If your plan is to convert funds held in a pre-tax 401(k) and invest them in a Roth IRA using well-diversified, broad-market index funds, the probability of losing money over a period of decades is extremely small. Generally, money converted at reasonably low rates of tax (24% or less) usually makes for a sound financial planning decision, though there are other elements (like your state tax rate) that can make the decision more complicated.
Converting your pre-tax 401(k) into a Roth IRA is not mandatory! You’d have to be the one to initiate it and see it through to its completion, so there is no urgency to stop this from happening. If you are considering this type of conversion, keep a few alternatives in mind: