Should I Roll Over My 401(k) to a Roth IRA?

A 401(k) to Roth IRA rollover is a financial strategy that moves retirement savings from a pre-tax account, where contributions are made before income taxes are calculated, to a post-tax account. This transaction, known as a Roth conversion, has tax consequences and is not suitable for everyone. The decision to execute such a rollover requires a careful analysis of your personal financial circumstances, including your current and projected future income, your investment goals, and your plans for your estate.

Key Factors in the Rollover Decision

The primary consideration in a Roth conversion is the comparison between your current marginal tax rate and your expected tax rate in retirement. By converting, you are choosing to pay income taxes on your retirement savings now, at today’s rates, rather than in the future. If you anticipate being in a higher tax bracket during your retirement years, paying the taxes now could result in long-term savings. This scenario might occur if you expect your income to grow, or if you believe federal and state tax rates will be higher in the future.

Conversely, if you expect your income and, consequently, your tax bracket to be lower in retirement, a rollover may not be advantageous. This is often the case for individuals who anticipate living on a fixed income that is substantially less than their peak earning years. In this situation, deferring the tax liability until retirement allows you to pay taxes at that lower future rate, potentially preserving more of your nest egg.

A benefit of the Roth IRA is the exemption from Required Minimum Distributions (RMDs) for the original account owner. Traditional 401(k)s and traditional IRAs mandate that you begin taking withdrawals at age 73, regardless of whether you need the funds. These distributions are taxable and can increase your taxable income in retirement, potentially pushing you into a higher tax bracket and increasing Medicare premiums. By converting to a Roth IRA, you eliminate RMDs, allowing your investments to continue growing tax-free for your entire lifetime.

This feature provides greater control over your assets and can be a tool for estate planning. If you do not need the funds for your own retirement expenses, the entire balance can be left to your beneficiaries. While non-spouse beneficiaries of a Roth IRA are required to deplete the account within 10 years, the distributions they receive will be tax-free, assuming the five-year holding period has been met. This contrasts with inherited traditional 401(k)s, where beneficiaries must pay income tax on every dollar they withdraw.

Individual Retirement Accounts provide a wider universe of investment choices compared to the limited menu offered by most employer-sponsored 401(k) plans. A 401(k) plan restricts participants to a pre-selected list of mutual funds and target-date funds. An IRA held at a brokerage firm opens the door to options, including individual stocks, bonds, exchange-traded funds (ETFs), real estate investment trusts (REITs), and a broader selection of mutual funds. This expanded choice allows for portfolio customization.

The structure of a Roth IRA also offers unique flexibility regarding access to your money. Converted funds are subject to a separate five-year holding period to avoid a 10% penalty on withdrawals before age 59½. Each conversion has its own five-year clock, making it important to plan withdrawals carefully if you are under the standard retirement age.

The Upfront Tax Cost of a Conversion

When you roll over funds from a pre-tax 401(k) to a Roth IRA, the entire amount is a taxable event. You are moving money that has never been taxed into an account where qualified withdrawals will be tax-free. The total value of the assets you convert is added to your ordinary income for the year the conversion takes place.

This inclusion in your income can substantially impact your annual tax liability. For example, if an individual with a $90,000 taxable income rolls over a $100,000 401(k), their taxable income for that year jumps to $190,000. This increase will likely push them into a higher marginal tax bracket, meaning the last dollars of the conversion are taxed at a higher rate.

The result is a large tax bill that must be paid in the year of the conversion. It is best to have funds available in a separate, non-retirement account to cover this tax liability. Using funds from the rollover to pay the taxes is a poor strategy, as it reduces your retirement savings. It would also likely trigger a 10% early withdrawal penalty on the funds used for taxes if you are under age 59½.

The tax impact is not limited to federal income taxes, as the converted amount is also subject to state and local income taxes. Before proceeding, you should calculate the estimated tax bill by consulting the current tax brackets. This calculation helps ensure you are financially prepared for the immediate cost.

The Rollover Process

First, contact your 401(k) plan administrator to confirm that rollovers are permitted and to ask about their procedures, forms, and any fees. Next, select a financial institution for your new Roth IRA, comparing their investment options and fee structures. Ensure the provider you choose can accept rollover contributions.

You will then formally open the Roth IRA with your chosen institution. This involves completing an account application with your personal information, such as your Social Security number and date of birth. You will also be required to designate beneficiaries for the new account.

A key decision is choosing the rollover method. A direct rollover, or trustee-to-trustee transfer, is recommended. This is where funds are sent directly from your 401(k) administrator to your new Roth IRA provider without you ever taking possession of the money.

An indirect rollover, where the administrator sends you a check, is riskier. Your plan must withhold 20% for federal taxes, and you have only 60 days to deposit the full rollover amount into the new account to avoid taxes and penalties.

After the Roth IRA is established, submit the required distribution paperwork to your 401(k) administrator, providing the details of your new Roth IRA. Monitor the transfer, which can take from a few business days to several weeks. You can track the status by checking your 401(k) for the withdrawal and your new IRA for the deposit.

Once the funds arrive, you must invest them according to your strategy, as they may initially be held in a cash settlement fund. Early the following year, you will receive IRS Form 1099-R from your former 401(k) administrator. This form is essential for correctly reporting the taxable conversion on your income tax return.