Taxation and Regulatory Compliance

Can I Rollover My 401(k) to a Roth IRA While Still Employed?

Learn how to convert your 401(k) to a Roth IRA even while working. Navigate the conditions and financial implications for tax-free retirement growth.

An in-service rollover from a 401(k) to a Roth IRA allows individuals to transfer retirement savings from their employer-sponsored plan into a Roth Individual Retirement Account while still employed. This strategy offers potential tax advantages and increased flexibility for retirement planning. It provides a way to move pre-tax or after-tax 401(k) funds into an account where qualified distributions in retirement will be tax-free.

Eligibility for In-Service Rollovers

Not all 401(k) plans permit in-service distributions, which are necessary for this type of rollover. The decision rests with the employer and is outlined in the plan document. Individuals should contact their plan administrator to ascertain if in-service rollovers are permitted.

Eligibility requirements for in-service rollovers vary by plan. Many plans allow participants to make in-service non-hardship withdrawals once they reach age 59½. Some plans also allow earlier distributions of specific after-tax contributions, even for those under age 59½. These after-tax contributions can often be rolled over without immediate tax consequences on the principal.

The type of funds in the 401(k) (pre-tax, Roth, or after-tax) impacts the eligibility and subsequent tax treatment of the rollover. To determine specific eligibility, individuals should gather detailed information from their employer or plan administrator regarding their plan’s rules on in-service distributions and the types of funds that can be rolled over.

Understanding the Taxable Event

Rolling over pre-tax funds from a traditional 401(k) to a Roth IRA is a taxable event. The entire amount converted from pre-tax contributions and their earnings is treated as ordinary income in the year of conversion. This amount is added to the individual’s gross income for that tax year, increasing their overall taxable income.

Tax liability is calculated based on the individual’s marginal income tax bracket for the year of conversion. A substantial conversion could push the individual into a higher tax bracket, increasing the tax burden on converted funds and other income. Taxes are due by the tax filing deadline for the year of conversion, and estimated tax payments may be necessary to avoid underpayment penalties for large conversions.

Rolling over funds from a Roth 401(k) to a Roth IRA does not trigger additional tax liability. Contributions to a Roth 401(k) are made with after-tax dollars, and qualified distributions from a Roth 401(k) are tax-free. The transfer of Roth 401(k) funds to a Roth IRA is tax-free, but the Roth IRA’s five-year rule for conversions applies to the converted amount.

For after-tax 401(k) contributions, rolling over the principal to a Roth IRA is tax-free, as taxes have already been paid. However, any earnings on these after-tax contributions are pre-tax and taxable upon conversion to a Roth IRA. Consider consulting with a tax professional before initiating a conversion.

Navigating the Rollover Process

Once eligibility and tax implications are understood, the rollover process involves administrative steps. First, contact the 401(k) plan administrator. Inform them of the intent to perform an in-service distribution for a direct rollover to a Roth IRA.

The plan administrator will provide the necessary forms and instructions. Furnish your Roth IRA account details, including the custodian’s name, account number, and routing instructions for electronic transfers. This ensures funds are transferred accurately.

Request a direct rollover (also known as a trustee-to-trustee transfer) to avoid complications. In a direct rollover, funds are sent directly from the 401(k) plan administrator to the Roth IRA custodian. This method helps bypass the mandatory 20% federal income tax withholding that applies if funds are distributed directly to the individual.

After the rollover, confirm with the Roth IRA custodian that funds have been received and correctly allocated. In the subsequent tax year, the 401(k) plan administrator will issue a Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.,” reporting the amount distributed from the 401(k). This form shows the amount converted, which must be reported on the individual’s tax return, typically on Form 8606.

Key Roth IRA Rules After Conversion

Once funds are rolled over into a Roth IRA, they become subject to Roth IRA rules, particularly the five-year rule for conversions. This rule dictates that each converted amount has its own five-year waiting period, beginning on January 1 of the tax year in which the conversion occurs. This period applies regardless of how long the Roth IRA has been established or how long the funds were held in the original 401(k).

If converted funds are withdrawn before this five-year period is satisfied and before age 59½, the taxable portion of the converted amount may be subject to a 10% early withdrawal penalty. However, the principal amount of the conversion, which was already taxed, can be withdrawn penalty-free. The earnings portion would be subject to both tax and penalty if withdrawn prematurely.

This differs from the five-year rule for Roth IRA contributions, which determines when earnings can be withdrawn tax-free. For a distribution from a Roth IRA to be “qualified” (tax-free and penalty-free), two main conditions must typically be met: the account must have been open for at least five tax years, and the account holder must be age 59½ or older, or meet other specific exceptions such as disability or using funds for a first-time home purchase. Meeting these criteria ensures that both the converted principal and any subsequent earnings grow and can be withdrawn completely tax-free in retirement.

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