Considerations When Rolling Over a 401(k) into a Roth IRA

The two-pronged axis of employee-sponsored pension plans and individual retirement accounts is the stage where, for most Americans, the majority of retirement planning happens. Within that framework, Roth IRAs are renowned for their unparalleled ability to secure tax-free growth.

But there is a catch – contribution limits and restrictions on high-income individuals severely curtail these benefits. The rollover is one of the best-kept Roth IRA secrets – it allows investors to both sidestep Roth IRA income limitations and contribution limits, as well as rake in the benefits of tax-free growth.

A move like this might seem highly technical and complex — after all, with the benefits that we’ve mentioned, it would only make sense. But thankfully, it isn’t so — rollovers are simple to execute and require very little time and effort.

However, there are a fair number of points that should be kept in mind when deciding on a move like this. We’ll cover all of those considerations today – so that you can have a clear overview of the situation before deciding if a rollover is something that would interest you.

When Converting a 401(k) to a Roth IRA Makes Sense

First things first – by far, the most common scenario in which rolling over a 401(k) into a Roth IRA is considered involves an employment transition. While there are numerous choices available when leaving your job (we’ll get into those shortly), this particular method offers unique benefits – so let’s cover the situations when such a move makes sense.

For starters, for investors who expect to be in a higher tax bracket after retiring – whether due to RMDs or other sources of income, footing the tax bill now and enjoying tax-free growth and withdrawals later has some obvious benefits which are quite difficult to find elsewhere. One should also keep in mind the possibility that taxes as a whole will increase in the future – something that seems quite likely when looking at future budget proposals.

Speaking of RMDs or required minimum distributions – the mandatory payments that start at age 72 associated with traditional IRAs – well, Roth IRAs don’t have them. This helps keep down taxable income in retirement and allows for a much greater degree of control.

A lot of 401(k) programs are notorious for high fees and limited investment opportunities. In contrast with that, today, with the rising popularity of easy-to-use stock trading apps, the accessibility of Roth IRAs and the diversity of investment offerings has never been greater.

Along with that, Roth IRAs also pass tax-free to beneficiaries in the case of the holder’s death, and beneficiaries have 10 years to empty the account, while spouses have even more benefits. Those 10 years of growth potentially make them a better choice in the long term when compared to either term or even whole life insurance.

Roth IRAs Have Income Limits

While anyone can contribute to a regular IRA when it comes to Roth IRAs, the IRS does discriminate – and it does so based on annual income. The rationale behind this particular piece of regulation was that it would prevent high earners from somehow abusing the tax-advantaged nature of a Roth IRA as an investment vehicle.

The way that these income limits work is through a process of gradual phasing out. Once a certain threshold (measured in modified adjusted gross income or MAGI) is reached, individuals, can contribute less money to a Roth IRA on an annual basis than those who earn less.

As income grows, the limit grows ever tighter until, at one level of income, investing in Roth IRAs becomes impossible.

The points at which these income caps kick in and come into play aren’t set in stone – they are adjusted each year with an eye toward inflation. For example, in 2021, the phaseout range for single filers began at $125,000 in MAGI, and the point of total exclusion was set at $140,000.

In the same years, married couples who filed jointly saw phaseouts begin at $198,000, with the point of total exclusion being $208,000.

There are two crucial pieces of good news, though — the first is that converting a 401(k) into a Roth IRA sidesteps the issue of income limits completely.

The second is that the income limits have seen consistent increases over the years — with no signs of stopping. And to further sweeten the pot, from 2023 onward, the maximum annual contribution for a Roth IRA will increase from $6,000 ($7,000 if over the age of 50) to $6,500 and $7,500. Roth IRA contribution limits for business owners are also higher.

Remember the Five-Year Rule

The five-year rule is another bothersome piece of regulation that should be kept in mind whenever one is dealing with Roth IRAs. The main advantage of Roth IRAs is their ability to support tax-free growth and tax-free withdrawals after the age of 59 and a half. However, in order to qualify for these tax-free withdrawals, an investor must hold the Roth IRA for at least five years – hence, the five-year rule.

The existence of this rule leads to two things that should be kept in mind. First and foremost, if an investor has a need of the money in his or her 401(k) within the next five years, then rolling over a 401(k) into a Roth IRA might not be the best course of action – thankfully, we’ll also touch on a couple of alternatives below.

The second question is a matter of detail – since the penalties for breaking the five-year rule include a flat 10% fee as a penalty and possible taxes, making a mistake can end up costing you a fortune. This leads us to the second point – when does this five-year waiting period start?

Well, it will depend on your specific circumstances, and things this delicate always merit consulting your retirement advisor or a tax professional, but we’ll try to walk you through a couple of helpful points to help you navigate the issue.

If you already have a Roth IRA, the countdown began when it was opened. If you don’t have a Roth IRA and open one by converting a traditional IRA to a Roth IRA, the five-year waiting period begins once the funds reach the Roth IRA.

But, as always, there are plenty of exceptions to the rules and limitations surrounding Roth IRAs. Make sure to consult a professional whenever you intend on making early withdrawals – there are quite a lot of qualified expenses, including first-time home purchases, education, and disability, that do not incur taxes, fees, or both.

Understand the Tax Consequences

Rolling over a 401(k) into a Roth IRA always comes with tax consequences. Since 401(k)’s are funded with pre-tax dollars, while Roth IRAs are funded with after-tax dollars, any scenario where an investor rolls over a 401(k) into a Roth will result in a larger tax bill.

Thankfully, figuring out what exactly those tax consequences are going to look like is very simple – just take your taxable income and add the value of the 401(k) to it. The amount of tax that investors are liable for is determined by the marginal tax bracket of the final sum.

To figure out exactly how much of a tax bill the rollover will leave you with, simply take the marginal tax bracket of the final sum and multiply it by the value of the 401(k) that is being rolled over.

Keep in mind that 401(k) rollovers can push you up a tax bracket – but in most cases, the long-term benefits of the move far outweigh the temporary drawback of a one-time tax increase.

Let’s use a couple of examples to illustrate. A single filer with a taxable income of $57,000 rolls over a 401(k) worth $14,000. To get the tax bill, we add one to the other for a total of $57,000 + $14,000 = $71,000. This new figure is still squarely within the $41,776 – $89,075 tax bracket that comes with a 22% tax rate. Taking $14,000 and multiplying it by 22% gives us a tax bill of $3080.

The tax cost of a 401(k) rollover isn’t due as soon as the transfer happens – the IRS is perfectly content to wait for you to file your taxes when you usually do.

Investors can also choose to enter a voluntary withholding agreement with their plan administrator – doing so means that the plan administrator will withhold funds equal to the tax bill, saving investors the hassle of more complicated tax filing while being no more expensive.

Alternatives to the Roth IRA

As mentioned near the beginning, although rolling over from a 401(k) to a Roth IRA is a move that makes financial sense for a lot of people when changing jobs, for others, the process simply isn’t worth it. There are, however, plenty of alternatives – so let’s take a minute to chart the possible courses when rolling over to a Roth doesn’t make sense.

Rolling a 401(k) into a Traditional IRA

In the same way that one can roll over a 401(k) into a Roth IRA, one can also roll it over into a traditional IRA. Well, it isn’t exactly the same – the process is much simpler, and the options differ in regard to taxes.

Like a 401(k) itself, a traditional IRA is funded with pre-tax dollars. Should you choose to roll over one into the other, you will owe no additional taxes — but, like always when it comes to traditional IRAs, you will owe taxes once it comes time to withdraw the money.

Rolling a 401(k) into a SEP IRA

One possible situation that we haven’t yet discussed is switching from being employed by another party to becoming self-employed or a business owner. In this scenario, transferring the contents of your 401(k) into a SEP IRA might be the better choice.

What is a SEP IRA? The SEP part stands for simplified employee pension – and it is a self-directed individual retirement account that works quite similarly to a traditional IRA. Like a regular IRA, a SEP offers tax-deferred growth – but you will have to pay taxes when withdrawing the money.

There are two main differences that make up the advantage a SEP has over a regular IRA – for one, the contributions are tax-deductible, and two, the contribution limit is much larger. In comparison with a regular IRA’s contribution limit of $6,000 – $6,500, an SEP’s contribution limit for 2022 is $61,000 and will increase to $66,000 in 2023.

Leaving the Money Where It Is

The benefits of tax-free growth and the freedom to invest in what you choose are strong points for why a rollover could be a good move. However, if your current 401(k) account has low fees and is providing you with good returns, simply leaving the assets where they are can potentially be the most profitable course of action.

Distributions

When you change employers, taking the money from your 401(k) as a distribution is also an option. However, we would caution against this method – for one, penalty fees and taxes might easily apply on the withdrawn sum, leaving you with less money than initially – and secondly, this would represent a wasted opportunity to take advantage of tax-free growth.

Rolling over into a New 401(k)

When transferring jobs, it might be possible to also transfer your previous 401(k) into the 401(k) plan of your new employee. The easiest way to check if this is available is by getting in touch with the plan administrator for the new 401(k) program.

There are some conditions that can apply. For example, some employers require that a certain amount of time while employed has passed before the old 401(k) can be rolled over into the new one. If you choose to go this route, you will not owe any additional taxes.

Steps Needed to Roll a 401(k) into a Roth IRA

Now that we’ve covered all the theoretical, the fine print, and the alternatives, let’s move on to something that is more practical – the very process of rolling over a 401(k) into a Roth IRA. Thankfully, while all of this might sound highly technical and complex, there are only 4 simple steps that you need to take.

1. Opening Both a Traditional IRA and a Roth IRA Account

To start with, to complete the process, you will need both a traditional IRA account and a Roth IRA account.

This leads us to two points – if you already have both, feel free to skip this step, and secondly — what is the traditional IRA used for? Well, you see, assets cannot directly be converted or transferred from a 401(k) to a Roth IRA – they first have to be transferred to a traditional IRA account.

The good news is that opening a traditional IRA account and a Roth IRA account isn’t time-consuming or expensive – the process can usually be wholly completed online and doesn’t take a lot of paperwork, lasting only around 10 minutes. On top of that, most of these accounts do not require initial funding or minimum investment.

Seeing as how the Roth IRA is the final, long-term destination of your money, taking the time to choose a custodian that meets your needs is an effort worth expending. There are two main points to consider here – favorable fees and the range of investment offerings.

2. Requesting a Direct Rollover to the Traditional IRA

Once the first step is taken care of, investors will need to contact the administrator of their current 401(k) plan and request a direct transfer of the funds in the plan to their traditional IRA account. Investors should also take care to request a direct custodian-to-custodian transfer and also emphasize to their current plan administrator that this is a non-taxable transfer.

Once that is done, the plan administrator will give investors a couple of forms. Investors will need to provide details about the account as well as the new custodians and may be required to give specific wire instructions.

Once those forms are filled and submitted, the process has begun – and there is nothing to do but wait – usually no more than a day or two. Keep in mind that wire transfers might incur a small fee – and that wire transfers are the most common method of custodian-to-custodian transfers.

3. Converting the Traditional IRA to a Roth IRA by Means of Backdoor Roth Conversion

The next step begins once the assets from the 401(k) are safely tucked away in your traditional IRA. The next thing to do is to convert or transfer the assets from the traditional IRA to the Roth IRA – and this is done via backdoor Roth Conversion.

Much like the last step, this process entails contacting your custodian or account manager for a Roth conversion form. Once that is filled out, signed, and submitted, it should only take another day or two for the funds to arrive in your Roth IRA.

4. Choose Your Investments – and Choose Wisely

Although the process of a rollover is technically finished by this point, by far the most important part of the entire gambit still lies ahead. After all, you haven’t been accruing a tax bill and doing all that paperwork for nothing.

The main advantage of a Roth IRA – the tax preferential nature of the account, offers a great opportunity. The potential for growth here – particularly for long-term, buy-and-hold investments is immense. However, there is no one-size-fits-all approach – and investors should always take current circumstances into account.

In particular, focusing on investments that will thrive in an economic downturn should be a priority. Although the time horizon for Roth IRAs is quite long, and the United States’ troubles with inflation will eventually pass, the last couple of years have been a harrowing reminder of inflation’s corrosive effect on wealth.

Investing in a way that fights inflation could entail allocating a part of your portfolio to inflation-resistant securities such as TIPS, commodities, or even precious metals.

Conclusion

The idea of rolling over a 401(k) into a Roth IRA might seem like something difficult to execute – what with all the account opening, transfers, and sidestepping of the income limits of Roth IRAs that the process entails.

However, rollovers are standard practice – they are very common, tried-and-tested processes that are one of the more powerful tools for tax-preferential retirement investing available in the United States today.

Although a rollover isn’t the right move for everyone, the pool of people who stand to benefit from such a move is quite large. In this specialized economy, changing jobs is more common than ever – so you never know when you might need to know how to properly perform a rollover.

At the end of the day, even if a 401(k) rollover into a Roth IRA isn’t the best thing to do for your specific circumstances, being able to compare all the different choices and alternatives you have at your disposal will allow you to make the wisest choice with your investments – and we hope that we’ve helped you along in that regard.