Did You Move This Money From a 401(k) to a Roth 401(k)? Here’s What to Know

Moving money from a traditional 401(k) to a Roth 401(k) has significant tax implications. Unlike a direct Roth contribution, this conversion requires paying taxes upfront on the transferred amount. While it can lead to tax-free withdrawals in retirement, misunderstanding the rules can result in unexpected costs or penalties.

Understanding how these conversions are taxed, their impact on future distributions, and the necessary IRS reporting steps is essential.

Distinctions Between Traditional and Roth 401(k) Funds

The primary difference between a traditional 401(k) and a Roth 401(k) is how contributions and withdrawals are taxed. A traditional 401(k) allows pre-tax contributions, reducing taxable income for the year, but withdrawals in retirement are taxed as ordinary income. A Roth 401(k) is funded with after-tax dollars, meaning contributions don’t lower current tax liability, but qualified withdrawals—including earnings—are tax-free.

Both accounts have the same contribution limits. In 2024, individuals under 50 can contribute up to $23,000, while those 50 and older can add a $7,500 catch-up contribution. Employer matches must go into a traditional 401(k), even if the employee contributes only to a Roth 401(k), meaning employer contributions will be taxed upon withdrawal.

Both accounts allow tax-deferred investment growth, avoiding capital gains and dividend taxes while funds remain in the account. The choice between the two depends on expected future tax rates. A traditional 401(k) may be better for those expecting a lower tax bracket in retirement, while a Roth 401(k) benefits individuals anticipating higher future tax rates.

Tax Withholding on Conversions

When converting from a traditional 401(k) to a Roth 401(k), the IRS treats the converted amount as taxable income for that year. Federal and, in some cases, state taxes apply. Unlike Roth IRA conversions, where taxes can be paid separately, many employer plans automatically withhold a portion for taxes.

Employers typically withhold 20% for federal taxes, though this may not cover the full tax bill if the conversion pushes the individual into a higher bracket. If additional tax is owed, it must be paid when filing a tax return. Some states, like California, also require withholding unless the individual opts out.

Since withheld taxes don’t go into the Roth 401(k), individuals who want to convert a full balance must cover the tax liability with other funds. Otherwise, the actual conversion amount is lower than intended, reducing long-term tax-free growth. If too much tax is withheld, the excess is refunded when filing a tax return, but this results in an interest-free loan to the government.

Distribution Rules for the Roth Portion

Roth 401(k) withdrawals are tax-free if the account holder is at least 59½ and the Roth portion has been open for at least five years. The five-year period starts on January 1 of the year of the first Roth contribution. If either condition isn’t met, earnings withdrawn may be subject to income tax and a 10% early withdrawal penalty.

The five-year rule applies separately to each employer’s Roth 401(k). Rolling over a Roth 401(k) balance to a new employer’s plan may reset the five-year period unless the new plan allows the original start date to carry over. To avoid this, some individuals transfer their Roth 401(k) into a Roth IRA, which has its own five-year rule but allows prior Roth 401(k) contributions to count toward the holding period.

Unlike traditional 401(k)s, Roth 401(k)s require minimum distributions (RMDs) starting at age 73 unless rolled into a Roth IRA, which has no RMDs. Retirees often transfer their balance to a Roth IRA before RMDs begin to keep their money growing tax-free. Missing an RMD results in a 25% penalty, reduced to 10% if corrected within two years.

Employer Plan Custodial Guidelines

Employers offering in-plan Roth conversions must maintain accurate records to comply with IRS regulations and fiduciary responsibilities under ERISA. One key requirement is tracking the cost basis of converted funds separately from direct Roth 401(k) contributions. Errors can lead to miscalculated tax liabilities and improper distributions.

Recordkeeping systems must reflect the date and amount of each conversion to ensure qualified distributions. Misclassifying converted amounts as direct contributions could allow tax-free withdrawals before meeting the five-year holding requirement, exposing plan sponsors to IRS penalties. Employers often rely on third-party administrators or payroll providers, but ultimate responsibility falls on the plan fiduciary.

Steps for Reporting to the IRS

After converting a traditional 401(k) balance to a Roth 401(k), the transaction must be reported to the IRS. The taxable amount is included as ordinary income for that year, potentially increasing the filer’s tax liability.

Employers issue Form 1099-R, documenting the total amount moved and the taxable portion. Box 2a specifies the taxable amount, while Box 7 contains the distribution code indicating an in-plan Roth rollover. Taxpayers must ensure this information is accurately reflected on their Form 1040. If federal or state taxes were withheld at the time of conversion, those amounts should be reported as tax payments to avoid underpayment penalties.