A couple of weeks ago I wrote a post talking about how a lot of folks forget to do a 401k to IRA rollover when they leave their old jobs. Instead, the money just sits in their old company’s 401(k) account, regardless of whether they can find a better plan with more available investments and lower plan costs. In the long run it can mean a difference of thousands of dollars by not switching to a lower cost plan. I’d highly recommend looking into doing a rollover as in many cases it will give you more flexibility and control – as well as saving you money.
One thing that I hadn’t realized was possible to do until I was researching that last post was the fact that in some cases you can do a direct 401(k) to Roth IRA rollover when moving on to another job. If you’re one of those folks who believe that the tax rates will be higher in retirement, it might make sense to look into doing one of these when you separate service with your current company.
401(k) to Roth IRA Rollover
A lot of people don’t realize that you can do a direct 401(k) to Roth IRA rollover. Up until a few years ago you actually couldn’t. You would have had to do a 401(k) to traditional IRA rollover first, and then convert that traditional IRA into a Roth IRA, paying taxes on the conversion in the process.
The Pension Protection Act of 2006 changed the two step process and made it possible for people who were separating service from one company to be able to do a direct rollover of company plan 401(k) funds to an existing Roth IRA account, without going through the extra step of rolling over to a traditional IRA.
So, as of the passage of the PPA, company retirement plan assets, including those from 401(k), 403(b) and 457(b) governmental plans, can now be converted directly to a Roth IRA.
401(k) to Roth IRA Rollover Rules
There are some things you need to remember when doing a direct rollover from a 401(k) to a Roth IRA.
- To do a rollover from a 401(k) to a Roth IRA you must have left the job where you got the 401(k).
- Funds that you’ve rolled over from the 401(k) that would have otherwise been taxed at retirement, must be included as income for the year of the conversion. In other words, you’ll need to pay taxes on those rolled over funds as income since the Roth isn’t taxed at retirement.
- If you’re rolling over to a Roth IRA and will have taxes due – you must pay the taxes with funds from outside of the account. Otherwise, if you’re younger than 59 1/2, you’ll be subject to penalties for early withdrawal.
- Make sure to do a direct trustee to trustee transfer to ensure no funds are withheld for taxes, as is done with a 60 day rollover where 20% is withheld, and you receive a check to do the transfer yourself.
Not All Company Plans Have 401(k) to Roth IRA Option
One thing to note is that unfortunately not all company plans allow or have a provision for a direct 401(k) to Roth IRA rollover. If that is the case with your company plan, you’ll have to go the extra mile and roll the 401(k) over to a Traditional IRA first, and then convert it to a Roth IRA afterwards.
It should be noted that any Roth 401(k) funds, since they are contributed after taxes have been levied, would be able to transfer directly over to a Roth IRA regardless.
Who Does A 401(k) To Roth IRA Rollover Make Sense For?
Typically doing a rollover from a 401(k) to a Roth IRA would make the most sense for someone who has a longer time horizon in order to invest, and for those who anticipate seeing a higher tax rate in retirement. It also makes more sense for those who actually have the cash on hand to be able to pay the extra tax bill that will be associated with adding the converted funds to the AGI when figuring taxes. Make sure to talk with a financial professional before heading down this road in order to fully understand the consequences for your taxes.
Have you done a direct 401(k) to Roth IRA rollover, or are you considering doing one when leaving a job? Tell us your thoughts in the comments.
Last Edited: 17th April 2013