The Tax Implications of a 401k Roth Conversion

A 401(k) to Roth conversion involves moving funds from a traditional, pre-tax 401(k) into a Roth account. This allows the money to grow and be withdrawn in retirement tax-free. The trade-off is an immediate tax event in the year of the conversion.

Understanding the Tax Implications

The pre-tax amount moved from a traditional 401(k) is added to your ordinary income for that tax year. For example, if you convert $50,000 while in the 24% federal tax bracket, you will owe an additional $12,000 in federal income tax for that year. This tax is due during the filing season when you report the conversion.

Including the converted amount in your taxable income can also push you into a higher marginal tax bracket. A large conversion could elevate a portion of your income from the 24% bracket into the 32% bracket, meaning those dollars are taxed at a greater rate. Most states with an income tax also treat the converted amount as taxable income, which can add a state tax bill to the federal obligation.

If your traditional 401(k) contains both pre-tax and after-tax (non-Roth) contributions, the pro-rata rule determines the taxable portion of the conversion. This rule requires any converted amount to consist of a proportional mix of the pre-tax and after-tax dollars in the account. You cannot choose to convert only the after-tax funds to avoid taxes.

For example, if your 401(k) holds $80,000 in pre-tax funds and $20,000 in after-tax funds, 80% of any conversion will be taxable. If you convert $25,000, then $20,000 of it is taxable income. If you first roll your 401(k) into a traditional IRA and then convert, the pro-rata calculation will aggregate all of your traditional IRA balances, altering the tax outcome.

Key Considerations Before Converting

A Roth conversion is often driven by the belief that your income tax rate will be higher in retirement than it is today. By paying taxes on the conversion now at your current rate, you can make tax-free withdrawals later when you might face a larger tax burden.

You should plan to pay the resulting tax bill with funds from outside your retirement accounts. Using the converted money to cover taxes reduces the principal that benefits from tax-free growth. If you are under age 59 ½, that amount will also be subject to a 10% early withdrawal penalty on top of ordinary income tax.

You must also be aware of the IRS’s two five-year rules. The first rule determines when earnings can be withdrawn tax-free from any Roth IRA. You must wait five years after your first contribution to any Roth IRA before you can withdraw investment earnings tax-free, even if you are over age 59 ½.

The second rule applies specifically to converted funds. For those under age 59 ½, each conversion has its own five-year holding period. Withdrawing any part of the converted principal before this period ends could result in a 10% early withdrawal penalty. This penalty does not apply to withdrawals of converted funds once you are over 59 ½.

The Conversion Process

The conversion process depends on the specific rules of your 401(k) plan. Contact your plan administrator to understand your options and get the required documentation or instructions. There are two common methods for conversion.

An in-plan Roth conversion, if permitted by your employer’s plan, lets you move funds from your traditional 401(k) to a Roth 401(k) within the same plan. This internal transfer is a taxable event but keeps your savings consolidated.

The other method is a rollover to an external Roth IRA. This involves moving funds from your 401(k) into a Roth IRA at a separate financial institution. This path offers a wider range of investment options and greater account flexibility. For either method, you must specify the dollar amount to convert.

Reporting the Conversion on Your Tax Return

Your 401(k) plan administrator or IRA custodian will send you Form 1099-R, which details the gross amount of the distribution from your traditional account. You must report this transaction to the IRS on your annual tax return.

The taxable portion of the conversion is reported on Form 1040 and included with your other sources of ordinary income. This increases your adjusted gross income (AGI) for the year, which is used to calculate your total tax liability.

If you have made after-tax contributions to a traditional 401(k) or IRA, you must use IRS Form 8606 to calculate the taxable amount. This form tracks your basis in after-tax contributions to determine the taxable portion of your conversion. Failing to file Form 8606 when required can lead to the entire conversion amount being taxed, plus potential penalties.