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Converting Your 401(k) to a Roth IRA

Converting your 401(k) to a Roth (IRA) can help lower your tax bill in retirement.

Written by Ashlyn Brooks / July 21, 2022

Quick Bites

  • Converting your 401(k) to a Roth IRA can help your tax bill during retirement.
  • A Roth IRA is a tax-advantaged account, but be mindful of the conversion tax when rolling over your 401(k).
  • The 5-Year rule will lock investment earning withdrawals.

401(k)s are great because they are funded silently in the background over the course of your career. This is a nice perk for people who aren’t too concerned with being in the driver's seat of their retirement accounts. One downside, however, is that once you are ready to make withdrawals come retirement, you’ll be hit with taxes. Not planning for these taxes could put you in a situation where you don’t have as much saved for retirement as you thought.

But, you can avoid those later taxes if you convert your 401(k) to a Roth IRA, which allows you to pay taxes when you put the money in the account. Of course, there are a lot more details to making the switch and areas of concern to look out for. We’ll dive into those below to give you a better understanding of if converting your 401(k) to a Roth IRA is in your best interest.

Inside this article

  1. Watch out for taxes
  2. What’s the five-year rule?
  3. How do we roll this puppy over?
  4. What are my alternatives?
  5. Pros and cons
  6. Should I convert?
  7. FAQ

Watch out for taxes

The old adage rings true: the only two guarantees in life are death and taxes. This means that regardless of your account type, 401(k) or Roth IRA, taxes will be paid. The difference between the two account types is when those taxes are handed over to Uncle Sam.

  • 401(k) - taxes are paid during retirement

  • Roth IRA - taxes paid upon making contributions

Conversion Tax

So how do taxes work as they pertain to converting your 401(k) to a Roth IRA? The biggest hit you will take is called a conversion tax for the tax year you conducted the rollover. Remember, the funds sitting in your 401(k) account are pre-tax and you’re transferring them to your Roth IRA, which is a post-tax account. This means that the amount you roll over will be subject to income tax at the tax rate of your earning bracket. For example:

  • 401(k) account = $100,000

  • Income tax rate = 24%

  • Amount taxed at rollover = $24,000

  • Roth IRA account = $76,000

This might seem unsettling to look at, but after that initial rollover tax, the withdrawals from your Roth IRA during retirement are tax-free.

What’s the five-year rule?

The five-year rule pertains to a waiting period you inherit before earnings can be withdrawn from your new Roth IRA account. Per the IRS, to withdraw earnings from your Roth IRA, without incurring any penalties, you have to be at least 59 ½ years old and the Roth IRA account must be held for 5 years.[2]

It is important to note that the 5-year rule only pertains to the withdrawal of your earnings. Earnings meaning capital gains, dividends and interest from your investments. The contributions you make from your own pocket into the account are not subject to the five-year rule. This is because your contributions came from your after-tax money and therefore, can be withdrawn at any age or time without penalty.[2]

How do we roll this puppy over?

Rolling over the funds between these two accounts isn’t as daunting as you might think. It can happen in these few simple steps.

Consult your 401(k) plan administrator

The first step in initiating a rollover is to contact the administrator of your company’s 401(k) plan. You’ll just explain that you are wanting to convert your 401(k) to a Roth IRA and they will advise you on the necessary steps to do so. The two most common forms you will fill out will be:[1]

  • Transfer Form

  • Application Form

Open a Roth IRA account

Obviously, you’ll need to have a Roth IRA account available to accept the transfer from your 401(k). You can open a Roth IRA account with a bank or a broker.

How to Open a Roth IRA

How to Open a Roth IRA

It takes just a few simple steps to open a Roth IRA and start saving for retirement.

Find out more

Rollover

The last step on your list is to initiate the rollover of your funds from your old 401(k) to your new Roth IRA. You’ll use the forms you filled out from your 401(k) plan administrator in order to request a direct deposit of those funds into your Roth IRA, also referred to as a trustee-to-trustee rollover.

What are my alternatives?

There are many different investment vehicles you can convert your 401(k) into. Some common alternatives to save or invest for retirement include:

Pros and cons

We reached out to some experts in the field to get their take on any potential pros and cons of ditching your 401(k) for a Roth IRA.

Pros

“If done with careful consideration–which means you take into account your current and projected future tax liability, a properly timed Roth conversion can lower your lifetime tax liability,” says Phillip Weiss, a financial advisor at Apprise Wealth Management. “A down market, such as the one we have now, can make Roth conversions even more attractive. It can allow for the recovery of your accounts to be realized tax-free. Since the Roth growth is tax-free, the funds can be withdrawn tax-free.”

Cons

“A big drawback to converting to a Roth IRA would be that any amount converted would also be subject to income taxes in the year it is rolled over,” says Matthew Stratman, a financial advisor at Western International Securities.

John McGee a financial advisor at High Point Financial Group adds to the list of disadvantages, stating that “people need to be careful before they reach that golden age of 59 ½. If they choose to make a withdrawal before this age they will be subject to an additional 10% penalty fee. Tack that onto the 401(k) conversion tax you paid and you could make an unsightly dent in your retirement savings.”

So, should I convert?

Converting your 401(k) to a Roth IRA will give you greater ownership over your retirement account. However, it is crucial to know the advantages and disadvantages of making the switch.

It is highly advised to do your own due diligence before deciding to convert your 401(k) to a Roth IRA. If you are confused or have questions about the tax implications or how to make the switch without incurring additional fees, it is best to contact a financial advisor. After all, this is your retirement nest egg you are dealing with. Making the conversion under the right guidance will ensure that you stay on track for retirement.

FAQ

Is it worth converting a 401(k) to a Roth IRA?

Converting a 401(k) to a Roth IRA may make sense if you believe that you'll be in a higher tax bracket in the future, as withdrawals are tax-free. But you'll owe taxes in the year when the conversion takes place. You'll need to crunch the numbers to make a prudent decision.

Is there an age limit to opening a Roth IRA?

Unlike a traditional IRA, where contributions aren't allowed after age 70½, you're never too old to open a Roth IRA. As long as you're still drawing an earned income, the IRS is cool with you opening and funding a Roth.

What age can I open a Roth IRA?

Technically speaking, you personally can’t open your own Roth until you turn 18. However, an adult can open a Roth IRA for someone younger than 18 and serve as the custodian or manager. The custodian maintains control over contributions, investments, and distribution until you inherit the account on your 18th birthday.

Article Sources
  1. “401(k) Rollover Forms” 401kRollover. https://www.401krollover.com/401k-rollover-forms/
  2. “Distributions from Individual Retirement Arrangements (IRAs)” IRS. May 2, 2022. https://www.irs.gov/publications/p590b#en_US_2019_publink1000231057

About the Author

Ashlyn Brooks

Ashlyn Brooks

Ashlyn is a personal finance writer with experience in budgeting, saving, loans, mortgages, credit cards, accounting, and financial services to name a few.

Full bio

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