Typically, most people automatically assume they should roll over their old 401(k) into a traditional IRA. However, a lot of people have been asking about another option lately – and that’s whether you can roll your 401(k) over into a Roth IRA instead.
Fortunately, the definitive answer is “yes.” You can roll your existing 401(k) into a Roth IRA instead of a traditional IRA. Choosing to do so just adds a few additional steps to the process.
Whenever you leave your job, you have a decision to make with your 401k plan. Most people don’t want to let an old 401(k) sit idle with an old employer, and could benefit immensely by moving those funds somewhere that could benefit them more in the long run. Let’s see if I can help you make “cents” of the situation.
But first, let’s look at the rules behind the strategy of rolling over your 401k into a Roth IRA.
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Need to open a Roth IRA?
My favorite online broker is Ally Invest but you can check out our recap on the best places to open a Roth IRA and the best online stock broker sign-up bonuses. There are many good options out there, but I have had the best overall experience with Ally Invest. No matter which option you choose the most important thing with any investment is to get started.
Roth IRA Rollover Rules From 401k
As a reminder, you must generally be separated from your employer to roll your 401k into a Roth IRA. However, some employers do permit an in-service rollover, where you can do the rollover while still employed. It’s permitted by the IRS, but not all employers participate.
Before January 1, 2008, you weren’t able to roll your 401(k) into a Roth IRA directly at all. If you wanted to do so you had to complete a two-step process. (Keep in mind that this would also apply to old Simple IRA’s, SEP IRA’s and 403b’s, 457, and qualified pensions, too)
- Open a Traditional IRA.
- Convert the Traditional IRA to a Roth IRA.
However, the law changed shortly after and this option became available. Still, just because the law has made this option available doesn’t mean you can definitely roll your old 401(k) into a Roth IRA no matter what. Unfortunately, it all depends on your plan administrator.
For example, recently I had two clients who intended to roll their old retirement plans into a Roth IRA.
One client had an old military retirement plan- Thrift Savings Plan (TSP) – and the other had an old state retirement plan. After helping each of them complete the required paperwork, I came across an interesting discovery.
The TSP rollover paperwork had a box you could mark if you wanted to roll over the plan into a Roth IRA (the instructions had been added to make sure you had a Roth IRA already established). However, the state retirement plan did not give that option.
The only option was to open a traditional IRA to accept the rollover and then immediately convert it to a Roth IRA. That certainly seemed like a hassle at the time, and it definitely was.
However, this man’s state retirement plan is not the only one I’ve encountered with these extra “rules.” Many 401(k)’s and 403(b)’s come with the same “No-Roth IRA Rollover” option. This option was supposed to be mandatory in 2010, but some still do it on a voluntary basis.
At the end of the day, this means you should explore this option thoroughly before automatically assuming it would work in your case. Ask questions, consult your financial advisor, and read through all of your rollover paperwork carefully before you begin moving in this direction.
Recap on Roth IRA Conversion Rule
These days, nearly anyone can take all of their traditional IRAs and old retirement plans and convert them to a Roth IRA. The amount you convert will be taxed, but it still can be an attractive move for those that feel that taxes are going nowhere but up.
How Do I Rollover if I Receive the Check?
If you receive a distribution check from your 401(k) rollover to a Roth IRA, then chances are good they will hold around 20% for taxes. If you want a direct 401(k) rollover to a Roth IRA, you may want to send that check back to your employer 401(k) provider and ask to be sent all of your eligible retirement distribution directly to your new Rollover IRA account (not as a check, or they will just give you 80% again).
You have 60 days upon receiving the check to get the money into the Roth IRA- no exceptions! So don’t procrastinate on this one.
What About the Roth 401k?
If your employer offers a Roth 401k and you were savvy enough to take part, the path to a rollover will be much easier. When you’re converting one Roth product to another, there is simply no need for conversion. You would simply roll the Roth 401(k) directly into the Roth IRA with the help of your plan provider.
Roll Your 401(k) by Following These Steps
- You have to have a Roth IRA open/established before you can do any of this.
- Ask your plan provider about the paperwork required to roll your plan over, then complete the paperwork in a timely manner.
- Enjoy the tax-free growth of your Roth IRA!
4 Signs It Makes Sense to Roll Your 401(k) into a Roth IRA
If you’re thinking of rolling your 401(k) into a Roth IRA instead of a traditional IRA, you have plenty of reasons to do so. Not only do Roth IRAs let you invest your dollars in the same investments as traditional IRAs, but they offer additional perks that can help you save money down the line. Here are four signs that a Roth IRA might actually be your best bet.
1. You expect to pay higher taxes in the future.
Since Roth IRAs use after-tax dollars, you’ll have to pay taxes upfront on any funds you roll over. However, you won’t have to pay taxes on your distributions, which could be extremely beneficial if you’re taxed at a higher rate when you reach retirement. You’ll pay taxes either way – now or later. But with a Roth IRA, you can rest assured your withdrawals will be tax-free.
2. You want to take withdrawals when you’re ready, and not a minute before.
While traditional IRAs force you to begin taking withdrawals at age 70 ½, Roth IRAs do not have this stipulation. Because of this, you can squirrel your Roth IRA funds away until you’re ready to use them.
3. You expect to earn more money in the future.
If you plan to earn lots of money in the future – or earn a high income now – you should consider rolling your funds into a Roth IRA instead of a traditional IRA. For single filers in 2016, the maximum income allowable for contributions to a Roth IRA starts at $117,000 and ends at $133,000. Learn more about Roth IRA rules and contribution limits here. For married filers, on the other hand, the ability to contribute to a Roth IRA begins phasing out at $184,000 and halts completely at $194,000 for 2016. The more you earn in the future, the harder it will become to contribute to a Roth IRA and secure the benefits that come with it.
4. You want to increase your tax diversification.
Contributions to traditional IRAs are tax-advantaged, meaning you won’t pay taxes on your invested funds until you begin taking withdrawals at retirement. Roth IRAs, on the other hand, are taxed up front but offer tax-free withdrawals after age 59 ½. If you’re unsure how your tax and income situation might pan out in the future, having both types of accounts – a traditional IRA and a Roth IRA – is a smart move in terms of diversifying your future tax exposure.
The Bottom Line
Rolling your 401(k) into a Roth IRA is a smart decision for many investors, but it may not be right for everyone. Before you pull the trigger, make sure to investigate all of your options and consider speaking with a tax professional. When it comes to complex investment vehicles and taxes, what you don’t know can hurt you