Frank recently contacted me to ask this question…
“Could you tell me the consequences of rolling over a 401k to a Roth IRA?”
What a great question! Thanks so much for the e-mail, Frank. I appreciate it. There are several tax consequences to think about when you take money that has not been taxed out of your 401k retirement plan and deposit it into a new Roth IRA that is funded with after-tax dollars. The company you work for will send you a check for the full vested balance of your account if you are not careful. To avoid paying taxes, you should ask for a direct rollover into a traditional IRA account instead of a Roth IRA or roll the old 401k into a new 401k.
Time Is Not On Your Side. If the company makes the check out to you, it is required to withhold 20% for taxes. If you are keeping your money in a new traditional IRA, you will have to come up with the missing 20% or you will get hit with an income tax bill on the distribution plus a 10% penalty on the withdrawal if you are under age 59 ½. To avoid the 20% tax, you must arrange for a “direct” rollover which is also known as a “trustee to trustee” rollover. The distribution check from your old 401k retirement plan must be made out in the name of the trustee or custodian of the new IRA account that you want to receive the funds. You can ask your bank or brokerage house that handles your new IRA for specific instructions on how the check should be made out. You only have 60 days to deposit the check into your new traditional IRA. The clock starts the day you receive the check and doesn’t stop until the money is in the IRA.
You Owe Taxes If Converting To a Roth. If you are converting your old 401k retirement plan into a Roth IRA, you will owe taxes on that money. You are going from a before tax dollars plan to an after tax dollars retirement plan. The good news is that it will only be a one time tax payment since future disbursements in retirement will be tax free, but the bad news is that a large distribution can push you into a new higher tax bracket. When you convert your 401k to a Roth IRA, you will have to pay tax on any earnings and pretax contributions. This is in lieu of paying taxes upon later withdrawals from the Roth IRA account. You should not tap your IRA to pay the conversion tax, however. Another bummer is that if you pay for the tax bill out of the proceeds from your 401k plan, you can also be charged with the 10% penalty for early withdraw if you are not 59 ½.
Another drawback is that you will permanently give up the opportunity for tax-free Roth IRA compounding for that amount you paid in taxes from your investment. It is always better to have the cash on hand to pay for your taxes before you convert and not to pay the taxes out of your investment proceeds. And, don’t forget that the higher tax bracket may also disqualify you from other tax benefits such as the dependent child, retirement contribution, and college tuition tax credits. There is a lot to consider in a conversion, and you may want to seek the advice of a certified financial planner.
This article in the news & mainstream media:
– Chicago Sun Times: The Consequences Of Rolling Over A 401k Into A Roth IRA