Your Guide: How And Why To Roll Over A 401(k) To A Roth IRA

You can roll over your 401(k) to a Roth IRA (individual retirement account), since the money you have in your employer-sponsored account is technically yours. Of course, there are some steps you need to take, including making sure you’re eligible to initiate the rollover. There’s also the matter of understanding your responsibilities as far as taxes go.

Before deciding on your investment choices, it’s important to learn about what a Roth IRA is, whether this type of investment is right for you and how to conduct a 401(k) rollover.

What Is A Roth IRA?

A Roth IRA is a type of individual retirement account that you can contribute post-tax dollars to, up to a limit set by the Internal Revenue Service (IRS) each year. A traditional IRA, on the other hand, allows you to contribute pretax dollars. The main benefit of a Roth IRA is that your contributions also grow tax-free, and when you make qualifying distributions or withdrawals, you won’t have to pay taxes on the amount you've earned. 

When it comes to Roth IRA conversions, it’s important to first understand whether you’re eligible and what investment options are available to you compared to your existing 401(k). It’s also crucial to understand what the tax implications are when you do a Roth IRA conversion.

Eligibility Requirements

The eligibility requirements for a Roth IRA account are based on your income level. They will also depend on your tax filing status. Keep in mind that the IRS will look at your modified adjusted gross income (MAGI). You can calculate your MAGI by looking at your adjusted gross income (AGI) and adding back in certain deductions and excluded income. You may be able to find your AGI on your most recent tax return. If you’re unsure what it is, you can seek the help of a tax or investment professional.

Aside from income and tax filing status, you can only contribute up to a certain amount of after-tax dollars each year. For 2023, you can contribute up to $6,500; if you’re 50 and older, up to $7,500.

Roth IRA Income Limits

Here are the MAGI limits if you want to contribute to a Roth IRA for the 2023 tax year:

• Single person: under $153,000
• Married filing jointly: under $228,000
• Married filing separately: $10,000

If you’re under the above amounts, you can still contribute to a Roth IRA, but IRS limits apply. There is a point that your contribution may be lower if your MAGI reaches a certain amount, or is completely phased out. For instance, if you’re single and your MAGI is $142,000, you can contribute up to $5,200, whereas you won’t be able to if you make more than $153,000. Since it can change each tax year, it’s best to check with your tax advisor or the IRS for the most up-to-date information.

If you’re conducting a rollover, however, the contribution limits typically don’t apply.

Considerations When Rolling Your 401(k) To A Roth IRA

When you’re considering whether to roll over your 401(k) into a Roth IRA, it’s important to look at the potential benefits and drawbacks of your decision.

For one, you may find that depending on your 401(k) or Roth IRA provider, you may have more investment choices than what you currently have. If there are more, you may be able to further customize your portfolio, such as adding more mutual funds or finding ones that have lower expense ratios. Saving money on fees can save you tens of thousands of dollars over the long term, which can make a huge difference in your retirement savings.

Conducting a rollover IRA also means that your earnings and contributions from your 401(k) can generally grow tax-free (though it depends on your 401(k) type). Any additional contributions you make will be after-tax earnings, but your contributions will grow tax-free.

Even if your 401(k) may have similar features and investment choices as your Roth IRA brokerage, it makes sense to roll it over because it can help simplify your finances. Having one or two retirement accounts instead of multiple ones can make it easier to manage.

Understanding Taxes

If you’re rolling over a Roth 401(k) to a Roth IRA, you most likely won’t need to pay any taxes, since these are similar types of accounts. Your Roth IRA contributions are made with after-tax dollars, so you've already fulfilled your tax obligations. However, if you want to roll over a traditional 401(k) to a Roth IRA, there may be some tax consequences. That’s because contributions to a traditional 401(k) are pretax dollars. If you rollover your traditional 401(k), you will most likely be hit with a tax bill, though it’s best to speak with your tax advisor to see what your tax situation may be.

For those who think their taxable income will go up over the years, a Roth IRA may make sense since you’ve already paid taxes at a lower tax bracket for your retirement contributions. That way, when it comes time to withdraw your earnings, you won’t have to worry about taxes.

Applying The 5-Year Rule

The Roth IRA 5-year rule indicates you can’t withdraw your earnings tax free until the contributions you've made have been in your account for at least 5 years. So once you’ve made your first contribution, you’ll need to wait at least 5 years before you can make tax-free withdrawals. Even rollover contributions will need to remain in the account for at least 5 years in order to avoid paying taxes and penalties on qualified distributions.

How Distributions Work

You have access to withdraw the funds you’ve contributed to a Roth IRA at any time without paying a penalty. It’s when you want to take withdrawals on your earnings that you’ll need to be mindful of whether you’ll pay taxes. In general, you can withdraw your earnings after 5 years and after age 59.5 and not have to pay taxes and penalties. If you make a withdrawal after age 59.5 but before your contributions have been in the account for at least 5 years, you may be subject to tax penalties.

Unlike other retirement plans, you’re not required to make required minimum distributions (RMD), so you can hold onto the funds in your account well past retirement age without worrying about having to make distributions.

How To Convert A 401(k) To A Roth IRA

In general, here’s how you can convert your 401(k) account to a Roth IRA:

• Determine your 401(k) type: Understanding whether your 401(k) is a traditional or Roth 401(k) will help, as each type will need to follow different steps.
• Open an IRA account: If you have a traditional 401(k), open a Traditional IRA, and open a Roth IRA for a Roth 401(k).
• Initiate the rollover: Gather any information your new brokerage may require, such as your plan administrator information and any documentation they may need to sign off so you can conduct a direct rollover (you don’t have to touch the money).
• Convert IRA: If you rolled over your 401(k) to a traditional IRA, then you’ll need to follow the instructions from your new brokerage to convert it to a Roth IRA.

Other 401(k) Rollover Options

The following are other retirement planning options that involve a 401(k) rollover.

401(k) To Roth 401(k)

Some employers offer both types of 401(k) accounts — check your employer’s plan to see if it’s possible. If so, you can consider rolling over your account, but be prepared for a tax bill.

401(k) To 401(k)

Some employers allow you to roll over your 401(k) account from your former employer to your new employer. If this is the case, you can contact your new employer’s plan administrator to learn the steps to do so.

401(k) Rollover FAQs

The following are some of the most common questions asked about a 401(k) rollover.

Is it a good idea to roll over a 401(k) to a Roth IRA?

It may make sense to roll over your 401(k) to a Roth IRA if you believe you’ll have better investment options and can save money on fees.

How do I transfer my 401(k) to a Roth IRA without paying taxes?

You may be able to avoid paying taxes if you roll over a Roth 401(K) to a Roth IRA through a direct rollover (where the brokerages transfer money from one institution to another). However, if you’re rolling over a traditional 401(k), you will most likely have to pay taxes depending on your overall income for the year, among other factors.

How much money can I roll over from a 401(k) to a Roth IRA?

Since this type of transaction is considered a conversion, there is technically no limit as to how much you can roll over from a 401(k) to a Roth IRA. However, depending on the type of 401(k) you have, you may have to pay taxes on the rollover.

The Bottom Line: Converting A 401(k) To A Roth IRA Can Help High-Income Earners

A Roth IRA may make sense for high-income earners if they believe they’ll pay more taxes later on. That way, you can pay taxes now and have the benefit of withdrawing your earnings tax free.

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