Summary
When you leave an employer, deciding what to do with your old 401(k) is a significant financial decision. You typically have several options: leaving the funds in your current plan, taking a distribution, rolling them over to a new employer’s plan, or rolling them over to an IRA. Opting to roll over your 401(k) to an IRA can help you maintain the tax-advantaged status of your retirement savings, avoid penalties, and consolidate your retirement accounts for better management. This guide covers the key aspects of rolling over your 401(k) to an IRA to help you determine if this is the best option for your situation.
What Is a 401(k) Rollover?
A 401(k) rollover involves transferring your funds from an employer-sponsored retirement plan, such as a 401(k), to another tax-advantaged retirement account. This new account could be a 401(k) at your new employer or an IRA with an outside custodian. Proper coordination with the administrators of both the old and new plans is crucial to avoid unintended taxable distributions and potential penalties.
Advantages of Rolling Over a 401(k) to an IRA
Tax Benefits
Rolling over a 401(k) to an IRA helps avoid the taxes or penalties associated with withdrawing the funds. Transferring a traditional 401(k) to a traditional IRA or a Roth 401(k) to a Roth IRA preserves the tax-advantaged status of the money. In both cases, no taxes are incurred during the rollover process. Traditional 401(k) funds will continue to grow tax-deferred, while Roth 401(k) funds will grow tax-free until withdrawal.
Expanded Investment Choices
An IRA typically offers a wider range of investment options compared to the limited selection in most 401(k) plans. Depending on the IRA custodian, you may also benefit from lower investment costs.
Account Consolidation
An IRA can consolidate funds from multiple 401(k) plans from previous employers, making it easier to manage your retirement savings.
Understanding the Five-Year Rule for Roth Accounts
The five-year rule is vital for Roth 401(k)s and Roth IRAs to ensure tax-free distributions after age 59 ½. For Roth IRAs, the five-year period starts at the beginning of the year when the first contribution is made. For Roth 401(k)s rolled over to Roth IRAs, the five-year clock of the Roth IRA applies. Each Roth IRA conversion has its own five-year period.
When withdrawing from a Roth IRA, the order is:
- Contributions
- Taxable conversions
- Non-taxable conversions
- Earnings
This rule is crucial for older individuals considering Roth conversions to ensure they meet the five-year requirement for tax-free withdrawals or for bequeathing to non-spousal beneficiaries.
Roth 401(k) to Roth IRA Rollovers
Rolling a Roth 401(k) to a Roth IRA can eliminate the need for required minimum distributions (RMDs) after age 72, allowing the funds to grow tax-free until you choose to withdraw them or pass them on to your heirs. This preserves the Roth status and maximizes the tax advantages.
How to Roll Over a Traditional 401(k) to a Roth IRA
Converting a traditional 401(k) to a Roth IRA involves a taxable event known as a Roth conversion. You can roll the funds directly to a Roth IRA or first transfer them to a traditional IRA before converting. Splitting the rollover between a traditional IRA and a Roth IRA can help spread out the tax burden over several years.
Ensure you have cash available to pay the taxes on the conversion to avoid dipping into the IRA, which could negate some benefits of the conversion.
Frequently Asked Questions (FAQs)
Can You Roll Over a 401(k) to a Roth IRA Without Penalty?
Yes, rolling a Roth 401(k) to a Roth IRA generally incurs no penalties or taxes. However, rolling a traditional 401(k) to a Roth IRA will trigger taxable income. To avoid penalties, ensure proper coordination with the IRA custodian and 401(k) administrator, and opt for a trustee-to-trustee transfer.
Can I Move My 401(k) to a Roth IRA?
Yes, moving a Roth 401(k) to a Roth IRA is straightforward with a trustee-to-trustee transfer. For a traditional 401(k) to a Roth IRA, this conversion is a taxable event.
Should I Convert My 401(k) to a Roth IRA?
Consider converting based on your current income, projected retirement tax bracket, and the distribution of your retirement assets. Converting during a low-income year or spreading conversions over multiple years can be beneficial. Ensure you have cash to pay the taxes triggered by the conversion.
How Do I Avoid Taxes on a Roth IRA Conversion?
Generally, taxes are due on the amount converted from a traditional 401(k) to a Roth IRA. Exceptions include using backdoor Roth or mega backdoor Roth strategies, which involve converting after-tax contributions to a Roth IRA.
How Much Money Can I Roll Over from a 401(k) to a Roth IRA?
There are no limits on the amount rolled over from a 401(k) to an IRA, including Roth IRAs. However, converting a traditional 401(k) to a Roth IRA will incur taxes on the converted amount.
