What you need to know about converting your 401(k) to a Roth IRA
There are generally two types of tax advantages a retirement account can have: You can pay taxes later but not now with a pretax 401(k) plan or traditional IRA, or you can pay taxes now but not later with a Roth IRA if certain conditions are met. And in some cases, you can start with one type of account and change to another—for example, you can convert a pretax 401(k) account to a Roth IRA. If you have retirement accounts from former employers, we’ll explain why and how you might consider changing from pretax to Roth.
Do you have retirement accounts from former employers?
When people get a new job, they often leave their savings in the retirement plan with their former employer. Did you know that you don’t have to? You typically have four options for what to do with a retirement account that’s with a former employer1:
- Do nothing—Your money stays in your former employer’s retirement plan2
- Move the money (roll it over) to your new employer’s retirement plan, if it’s allowed
- Roll it over to an individual retirement account (IRA)
- Cash it out, which may result in you paying taxes and a penalty fee on the amount you withdraw, unless an exception applies
Pretax and Roth options are available for both workplace retirement plans—such as 401(k)s—and those you establish yourself—such as IRAs. If your 401(k) account is already Roth, it must stay as Roth—you can’t make it pretax at this point. But if your 401(k) savings are pretax, you can choose between keeping it pretax (e.g., rolling it over to a traditional IRA) and converting it to Roth (e.g., converting it to a Roth IRA).
Pretax vs. Roth IRAs—what’s the difference?
There’s a handful of key differences between traditional and Roth IRAs, including the tax treatment.
|
Traditional IRA |
Roth IRA |
How are contributions taxed? |
Pretax—You may be able to deduct the money you deposit in a traditional IRA in the year you put it in |
After tax—Your money is taxed before being deposited in a Roth IRA |
How are withdrawals taxed? |
All your money—your contributions and any earnings—is taxed as ordinary income when you withdraw it |
You can take out your Roth IRA contributions tax free and the earnings on your investments are tax free, provided you’ve held the Roth IRA for a period of at least five years and withdrawals are made on or after age 59½, due to your disability or death, or on satisfaction of the requirements for the first home exception. |
The lesser of $6,500 or 100% of your compensation ($7,500 if you’re age 50 or older) |
The lesser of $6,500 or 100% of your compensation ($7,500 if you’re age 50 or older) |
|
Are there any criteria you must meet to save?
Note—These criteria only apply to new contributions you make, not rollovers |
Anyone can contribute to a traditional IRA. You must meet certain criteria to deduct your contributions from your taxable income. |
Yes. Your income must fall below certain thresholds in order to make contributions to a Roth IRA. |
Do required minimum distributions (RMDs) apply? |
Yes |
No |
What are the potential benefits of converting from pretax to Roth?
Converting from pretax to Roth will increase your tax bill for the year, so why do it? There are a few reasons it might make sense for you:
1 You expect your tax bracket to be higher in retirement than it is today. You likely want your money taxed when you’re in the lowest tax bracket possible. If that’s today, then Roth makes sense; if you expect your taxes to be lower in retirement, wait to have it taxed then by choosing a pretax (traditional) retirement account.
2 You want to have a mix of pretax and after-tax retirement savings. Having a balance of pretax and Roth savings may provide more flexibility to help you make the most of your savings with thoughtful tax planning, especially since you can’t be certain what your future tax rate will be.
3 Your income is abnormally low this year. If you find yourself in a particularly low tax bracket this year, it may be a good time to take advantage of a pretax-to-Roth conversion. For example, you’re in sales and having a down year, you took a year off to care for loved ones, or you’re a business owner operating at a net loss.
4 Stock prices are down. Your taxable income is based on your investments’ value when converted. So, if your investments are down, a Roth conversion may make sense—your tax expense will be lower than when investment values are higher.
5 You plan to pass on as much as possible to loved ones. Your IRA is intended to help pay for your retirement, but if you want to leave as much as possible for your beneficiaries, RMDs will force you to take money out. Roth IRAs aren’t subject to RMDs during the IRA owner’s lifetime, but traditional IRAs are.
6 You may not be eligible to make contributions to a Roth IRA. Due to the income limits for Roth IRAs, you may not be eligible to establish one; however, you may be able to enjoy the same tax benefits by converting pretax amounts to a Roth IRA. Additionally, even if you’re eligible to establish a Roth IRA, a conversion generally permits you to accumulate more money. That’s because Roth IRA conversions aren’t subject to the IRS annual contribution limits that apply to Roth IRA contributions.
Making the conversion from pretax to Roth
To convert from pretax to Roth, you’ll want to shop around and find the right IRA provider, and they’ll help you move your money. There are many financial institutions that offer both traditional and Roth IRAs.
The money you convert from pretax to Roth is taxable income in the year of the conversion, so be sure you understand how much you’ll owe in taxes. Although you may not enjoy paying taxes now, that cost can be worth it in the long run and may provide your retirement savings several benefits, including tax and estate planning flexibility. That said, Roth conversions can’t be undone, so it’s vital that you understand the potential consequences before proceeding. Consider talking to a tax expert and financial professional to help you understand how a Roth conversion will affect your taxable income and finances.
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Important disclosures
Distributions from Roth accounts must be “qualified” for both the contributions and earnings to be treated as tax free. Certain conditions would apply. See your plan document for more details. All references to tax-free treatment of qualified distributions are intended to refer to the treatment of such distributions at the federal level only. You may want to consult a professional tax advisor regarding any tax issues discussed.
This content is for general information only and is believed to be accurate and reliable as of the posting date, but may be subject to change. It is not intended to provide investment, tax, plan design, or legal advice (unless otherwise indicated). Please consult your own independent advisor as to any investment, tax, or legal statements made.
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