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ROLLING OVER YOUR 401K INTO A ROTH IRA

Updated on May 9, 2013

At one time or another, most of us have left jobs where we had a 401k retirement plan. It is pretty common knowledge that you need to do something with that old 401k plan... you can't let it just sit there. Now, the benefits coordinator for your new employer may try to convince you to roll the old 401k into the new company's plan, but unless it is a stellar plan, there are better options. While many people opt to roll the 401k into a traditional IRA, a much better option is a Roth IRA. In this hub, I hope to shed some light on the Roth IRA, and why you should pursue that option.

What's the difference?

The first question you may be asking is what is the difference between a traditional and Roth IRA. While both are great retirement vehicles, there is a huge difference between the two with regard to taxes. A tradition IRA is what is known as a tax deferred investment. This means that when you contribute to the retirement plan, the contributions are tax deductible. However, when you retire, your withdrawals are taxed. The theory behind this is that in retirement, you will be making less money (you are retired after all), so you will be in a lower tax bracket.

Whereas the traditional IRA is tax deferred, the Roth IRA is tax exempt. Contributions are not tax deductible; you must pay taxes on them at the time of contribution. But the great thing about the Roth is that when you retire, you withdrawals are tax free. That means that all of that interest accrued over the years was accumulated without paying a dime to the government (and you have no idea how happy that makes me). I personally like this system better, as paying no taxes in retirement is very appealing to me.

Steps to a Roth IRA Rollover

Before going any further, it is important to make sure you meet the Roth IRA income requirements. (These change year to year, so be sure to check with the IRS for current requirements.) For 2013, you may contribute up to the maximum contribution ($5,500/year) to a Roth IRA if you file taxes married filing jointly and have a joint income of under $178,000 per year. If your joint income is between $178,000 and $188,000, your contribution limit is on a sliding scale. Couples with an income over $188,000 may not contribute. In the case of an individual filer, the income cap is $127,000, with the sliding scale from $112,000 to $127,000. In any case, when performing the rollover, you can roll the entire amount of the 401k into the Roth; an exception to the maximum contribution is made in the case of a rollover.

Since a Roth is a tax exempt vehicle, you will need to pay taxes on the value of the 401k when you roll it over. For tax purposes, it is treated as ordinary income.

To avoid a 20% penalty from the IRS, you are going to want to do what is known as a direct rollover. Essentially what happens is the distribution check from the retirement plan at your old company must be made out in the name of the trustee or custodian of the IRA account that you want to receive the rolled-over funds. Here are the steps you must follow:

  1. Open a Roth IRA with any financial institution that offers Roth IRAs. There are a lot of institutions that offer Roth IRAs, so do your homework on them and see what is best for you.
  2. Inform your former employer that you want to do a 401K rollover to Roth IRA. They will have some forms for you to fill out.
  3. Once the transfer is completed, the hard work begins! Now it is time to allocate your assets to investments as you see fit. What to invest in is far beyond the scope of this article; I would suggest finding a good financial planner to help you out.

Many financial institutions have managed to find their way to the 21st century, and may allow you to do everything online. Also, be sure that you stay on top of the process. There is a bad habit among many financial institutions to make the process as painful and difficult as possible, in an attempt to hold onto your money. So if a week or two goes by and you have not received an update, get on the phone and find out what is going on. It is your money, and it should be up to you to invest it as you see fit.

Conclusion

For the majority of people, a 401k to Roth rollover makes more sense than rolling to a traditional IRA. For example, if it will be years before you begin drawing from the retirement funds, then a ROTH makes a lot of sense. But retirement planning takes a lot of careful reasoning, so your best bet would be to see a good financial planner. Together, you and the planner should be able to figure out what is your best interest.

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    • Efficient Admin profile image

      Efficient Admin 

      5 years ago from Charlotte, NC

      This hub is a reminder and also motivating me to do just that. I have to set one up first though. Will do some research. Thanks for sharing, voted up.

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