If you leave a job with a 401(k), you may want to transfer that balance to another retirement account so you can continue investing in a tax-advantaged way. One type of transfer to consider: a 401(k)-to-Roth-IRA rollover or conversion. It involves an irrevocable decision to move the 401(k) balance to a type of individual retirement account (IRA) that allows for future tax-free withdrawals, though it may create an immediate tax liability. Here’s how it works.
What is a 401(k)-to-Roth-IRA rollover?
A 401(k)-to-Roth-IRA rollover is the process of moving 401(k) funds into a Roth IRA. If you want to move traditional 401(k) funds to a Roth IRA, it’s considered a conversion. That’s because you’re converting the pre-tax dollars in your traditional 401(k) to a Roth IRA, which is a taxable event. If you roll over Roth 401(k) contributions to a Roth IRA, this is considered a rollover, not a conversion, and may not be a taxable event. Whether your rollover results in a conversion or not, it generally doesn’t count as a withdrawal as long as the rollover is direct, so you’ll avoid being hit with an early withdrawal penalty. A Roth IRA also offers some attractive tax benefits.
How does a 401(k)-to-Roth-IRA rollover or conversion work?
Because a Roth IRA is funded with after-tax dollars, the transfer process depends on whether you have a Roth 401(k) and/or a traditional 401(k). Check your plan rules for more information on which type you have and when you’re eligible to take a distribution.
Roth-to-Roth rollovers
Since both Roth accounts are funded with after-tax dollars, you won’t owe any income tax on the amount you’ve originally contributed when you transfer it. You’re simply moving the balance that includes both contributions you’ve already paid taxes on and any earnings, which remain tax-deferred and may be tax-free if taken as part of a qualified distribution,1 from the workplace account to an individual account with the same tax treatment.
Traditional 401(k)-to-Roth IRA conversions
Moving money from a traditional 401(k) to a Roth IRA works a little differently. That’s because traditional 401(k)s are funded with pre-tax contributions. With a Roth IRA conversion, you’re switching from a pre-tax account to an after-tax account that has the potential to grow tax-free. Unlike conversions between IRAs (such as moving money from a traditional IRA to a Roth IRA), transferring assets from a workplace plan to a Roth IRA typically involves a rollover because the assets are leaving a workplace plan. One exception is when the conversion is done using a 60-day rollover.
To convert a pre-tax 401(k) to a Roth IRA, you may need to pay income tax on the pre-tax dollars transferred and on any earnings on both pre-tax and after-tax contributions, but not on any after-tax contributions. The upside: Qualified withdrawals of earnings are tax-free after age 59½.1 In fact, you can withdraw your original Roth IRA contributions at any time, tax- and penalty-free. However, each Roth conversion starts a 5-year clock for the converted pre-tax amount, and withdrawals during that period may be subject to a 10% penalty if you’re under age 59½. Withdrawals from a traditional 401(k) or traditional IRA, though, would be taxed at your ordinary income tax rate.
IRA rollover methods
There are 2 ways to approach moving a 401(k) to a Roth IRA:
Direct rollover or conversion
With a direct rollover, the rollover may be completed electronically or by check from your workplace plan to your Roth IRA provider, depending on where your Roth IRA is held. If you’re rolling over a Fidelity 401(k) to a Fidelity Roth IRA, the balance is transferred electronically straight from your 401(k) to the Roth IRA. However, if you’re rolling over a Fidelity 401(k) to a Roth IRA at another financial institution, Fidelity will send you a check made payable to your Roth IRA provider with the funds that you must then forward to your new provider.
Come tax time, you will receive Form 1099-R and need to report the distribution on Form 1040. If you’re converting traditional dollars to Roth dollars, you’ll owe taxes on the converted amount.
Indirect rollover or conversion
This is when the 401(k) administrator sends a rollover-eligible distribution from your employer’s plan made payable to you as a check or a direct deposit. In this case, 20% mandatory tax withholding is applied to the distribution. It’s then up to you to deposit the distribution plus the amount that was withheld into your Roth IRA to avoid having the withheld amount treated as a taxable distribution.
For example, if you’re transferring $20,000 from your 401(k), your 401(k) provider would withhold $4,000. Your check or direct deposit to your checking or savings account would therefore total $16,000. That $16,000 is the amount that would then be deposited into the Roth IRA as part of the rollover. At tax-filing time, you’d receive a 1099-R from your old plan showing how much tax was withheld. Report the amount you rolled over (up to the gross amount of your distribution of $20,000) on your 1040 income tax return. Then, depending on your overall tax liability, you may receive a refund for most of what was withheld.
Beware the 60-day rollover rule. That’s the rule that says you have 60 days from the time you receive the distribution to deposit the money in another retirement account. If you miss the window, that distribution will instead count as a taxable distribution. This means you may owe a 10% early withdrawal penalty on top of taxes if you’re younger than 59½. If you don’t complete the transfer in time, it may be possible to qualify for a waiver depending on your situation.
Benefits of 401(k)-to-Roth-IRA rollovers with a conversion
There are good reasons to consider rolling over your 401(k) balance to a Roth IRA:
Tax-free withdrawals of converted balances
Converting a pre-tax balance from a 401(k) to a Roth IRA may be a taxable event, but this would result in you not needing to pay taxes on this balance later on. Keep in mind, though, that for converted balances, a separate 5-year period applies to determine whether you’ll owe an early withdrawal penalty. If you are younger than 59½, you must wait 5 years from the beginning of the tax year in which you made the conversion before withdrawing the converted balance to avoid a 10% penalty. This is the 5-year aging rule for Roth conversions, and it applies independently to each conversion you make. Depending on your situation, other exceptions to this penalty may apply. This 5-year rule is different from the one that applies to qualified distributions.
Tax-free qualified withdrawals in retirement
A Roth IRA can provide a source of fully tax-free distributions of earnings, assuming you’re at least 59½ and the account meets the 5-year aging rule.1 This rule differs from the one that applies to converted Roth balances, as you must wait 5 years from the start of the tax year you make your first contribution to a Roth IRA for withdrawals to be qualified and, thus, tax- and penalty-free. Note that in addition to turning age 59½ there are other exceptions for the early withdrawal penalty.
Portability
Most IRAs accept rollovers and conversions, so it could be easy to move your money. On the other hand, not all workplace plans will accept a rollover or conversion from a previous employer’s plan, and Roth IRAs cannot be rolled into a qualified plan. So combining your old 401(k) with a new one might not be an option at your new job.
More investment flexibility
You can choose the broker with the investments you want. You aren’t limited to the investment options chosen for you within a workplace plan.
No required minimum distributions (RMDs)
Traditional 401(k)s come with required minimum distributions (RMDs) starting at age 73. You’ll need to take money out and pay taxes, regardless of whether you need the money or not. Roth IRAs and Roth 401(k)s don’t have RMDs.
No income limits
Your income must be under a certain threshold to contribute to a Roth IRA.2 However, there are no income restrictions on who can roll over or convert their 401(k) to a Roth IRA. Similarly, there’s no limit to the amount you may roll over or convert. However, there is an annual limit on how much you can contribute across your traditional and Roth IRAs combined—and depending on your income, you may not be eligible to contribute to a Roth IRA at all.
Drawbacks to 401(k)-to-Roth-IRA rollovers and conversions
Large upfront tax bill for conversions
If you convert a traditional 401(k) to a Roth IRA, any pre-tax contributions and earnings included in the rollover amount count as taxable income for that year. If you’re eligible to contribute on an after-tax basis to your 401(k) plan and decide to convert the after-tax contributions to a Roth IRA, the after-tax contributions are not taxed again when converted, but any earnings on those after-tax contributions are taxable and are treated as pre-tax money as part of the rollover. This strategy is known as a mega backdoor Roth and may be available depending on your retirement plan’s features. In some cases, this may push you into a higher tax bracket.
The 5-year rule applies
To withdraw Roth IRA earnings tax- and penalty-free, you must meet certain requirements, including:
- You reach age 59½ or meet one of the exemptions1 and
- At least 5 years have elapsed from the beginning of the tax year in which you first contributed or converted to your Roth IRA.
Converted funds may have a waiting period
To withdraw Roth IRA converted balances without penalties, you generally must either wait 5 years from the start of the tax year in which the conversion occurred or be age 59½. Other exceptions to the 10% penalty may apply.
No plan loans
Unlike many 401(k)s, IRAs do not offer loans. That means any money you take out counts as a distribution.
Alternatives to 401(k)-to-Roth-IRA conversions
Roll over your money into a rollover IRA if you have a traditional 401(k)
If you have a traditional 401(k), a pre-tax rollover IRA allows you to transfer the balance tax-free and continue tax-deferred growth. A rollover IRA is specifically designed for workplace savings, so they can stay isolated from contributions to other IRAs, making it easier to transfer workplace savings to a different workplace account in the future, if you wish. You’ll only owe taxes when you make withdrawals—and you won’t be taxed on the amount you roll over from a 401(k).
Convert your money to a Roth 401(k)
If your employer offers Roth 401(k)s and permits these types of in-plan conversions, you may elect to keep the 401(k)-style account but swap for the Roth tax treatment. You’ll still need to pay taxes if you’re converting pre-tax dollars, but you may reap the benefits of Roth in retirement. Many plans don’t allow this option though.
Transfer the old 401(k) into your new workplace plan
If your new job offers a 401(k) or other retirement plan, you could see if you may transfer your old 401(k) balance. This can consolidate your savings and allow you to continue investing for the future.
Keep your old 401(k) plan
Keeping the account could allow you to spread your Roth conversions over several years, rather than completing one large one, if your employer’s plan allow (some don’t). That could break up your tax bill and might prevent you from moving into a higher tax bracket. Just know you won’t be able to make additional contributions to the old 401(k), but you could keep your entire balance in the old plan if your old workplace and provider permit. If your new employer offers a Roth 401(k), you could make future Roth contributions there.
Cash out everything
Another option is to cash out your 401(k). You’ll owe taxes on any pre-tax amounts, and you’ll have to withhold at least 20% upfront, plus a possible 10% early withdrawal penalty if you’re younger than 59½. This option may take your money out of the market, which could cause you to miss out on potential future investment gains as well as the benefits of tax-advantaged growth.
How to roll over or convert a 401(k) into a Roth IRA
Follow these steps to convert a traditional 401(k) to a Roth IRA or roll over a Roth 401(k) to a Roth IRA:
1. Open a Roth IRA
If you don’t already have an account, you could easily open a Roth IRA online through a brokerage firm. Even though Roth IRAs have income limits that can restrict higher earners from making contributions, no matter your income, you may open a Roth IRA and roll over or convert money from a different retirement account.
2. Contact your 401(k) plan administrator
Let them know you want to roll over your 401(k) to a Roth IRA. They should provide you with the necessary forms and walk you through the process. If you opt for a direct rollover or conversion, you’ll need to provide your Roth IRA account details.
3. Complete the fund transfer
With a direct rollover, the rollover process depends on where your Roth IRA is held. If you’re moving money from a Fidelity 401(k) to a Fidelity Roth IRA, the funds are transferred electronically into your Roth IRA. If you’re rolling over a Fidelity 401(k) to a Roth IRA at another financial institution, Fidelity sends you a check that you must forward to your new provider. Once the rollover is complete, verify that the funds have been deposited into the correct account.
If you receive a check or direct deposit as part of an indirect rollover, be sure to deposit it into your Roth IRA within 60 days to avoid unnecessary taxes and penalties.
4. Invest your converted or rolled over dollars
Your money isn’t automatically invested once it hits your Roth IRA. You’ll need to place trades with those dollars if you want them invested.
5. Prepare for a tax bill if you converted a traditional 401(k) to a Roth IRA
For a traditional-401(k)-to-Roth-IRA conversion, you should receive Form 1099-R during tax season. This will show the full amount distributed, the taxable amount, and any taxes that were withheld. Roth-to-Roth rollovers, on the other hand, are not taxable events.
Going the conversion route could result in a hefty tax bill, but it might set you up for a more tax-efficient retirement. A financial professional could help you determine whether a 401(k) to Roth IRA rollover is the right strategy for you.