401k Rollover To A Roth IRA

Should you perform a 401k rollover to a Roth IRA?

This is a common question many people face when leaving a current employer.

Why?

Because most 401k plans provide you with the option of rolling over (moving) your current 401k plan to your new 401k plan or another retirement savings plan, such as a Traditional IRA or a Roth IRA, whenever you leave a job.

If you find yourself in this situation, you need to compare the benefits of a 401k vs. a Roth IRA to find out which plan is the best fit for your personal financial plan.

The right choice won't be the same for everyone.

But, if you decide that a 401k rollover to a Roth IRA is the best course of action, you need to know the rules for conversion.

Previous 401k Roth IRA Rollover Rules

Prior to 2008, you could only roll funds over from a Traditional IRA, a SEP IRA, or a SIMPLE IRA to your Roth IRA.

However, as of 2008, you can roll over to your Roth IRA all or part of a rollover distribution you receive from your (or your deceased spouse's):

• Employer's qualified pension, profit sharing, or stock bonus plan (including a 401k plan)
• Annuity plan
• Tax-sheltered annuity plan (403b plan), or
• Governmental deferred compensation plan (section 457 plan)

Because of the law change, your 401k is now eligible for a direct rollover distribution into your Roth IRA. So if you wanted to perform a 401k rollover to a Roth IRA prior to 2008, but couldn't... Now's your opportunity!

The rules for such a rollover are essentially the same as a Traditional IRA rollover to a Roth IRA...

Current 401k Roth IRA Rollover Rules

So what are the rules for a 401k rollover to a Roth IRA?

To perform a successful rollover, you need to do the following things...

• Have an open/established Roth IRA account
• Have adjustable gross income (AGI) under the IRS limits
• Move distributions from your 401k to your Roth within 60 days
• Pay taxes on rollover distributions, if necessary

Obviously, you need to have an open Roth IRA account to roll your 401k funds into. If you don't, make sure to open one prior to initiating the process.

You also need to have adjustable gross income (AGI) of $100,000 or less in order to qualify for a Roth IRA rollover, although that limit soon changes, which we'll address in just a moment.

Any rollover distribution you receive from your 401k must be moved into your Roth IRA within 60 days of the day it leaves your 401k. Otherwise, you owe taxes and penalties on the full amount of the distribution as though you had simply withdrawn it.

And, of course, you'll probably owe taxes on some, if not all, of your rollover distribution.

So let's take a closer look at some of these rules...

2010 Roth IRA Conversions

As of right now (2009), you can NOT perform a 401k rollover to a Roth IRA if your adjustable gross income (AGI) exceeds $100,000 for the taxable year.

But...

That all changes next year.

As of 2010, the AGI limit on Roth IRA conversions disappears.

Yep, you heard that right.

The limit disappears!

As of 2010, you'll be able to roll over funds from your 401k, your Traditional IRA, your 403b, or any other qualified account regardless of how much money you make.

So if you earn more than $100,000 today, don't get down about your inability to roll over funds.

In 2010, the door will open for you as well...

How To Rollover Your 401k To A Roth IRA

To perform a 401k rollover to a Roth IRA, all you need to do is contact your plan administrator and initiate the process. Details on how to do so should be available from your employer's accounting department.

Just remember, you need to...

• Move the rollover funds into your Roth within 60 days, and
• 20% might be withheld by your 401k plan to pay your tax bill

Pay special attention to the latter point. Depending on how you perform your rollover, things can get dicey if your 401k plan administrator withholds a portion of your funds for tax purposes. However, keep in mind that under the law, a written explanation of rollover treatment must be given to you by the plan making the rollover distribution. In this case, that's your 401k plan administrator.

If you want to avoid having 20% of your rollover distribution withheld for taxes, contact your 401k plan administrator and ask them if they will roll over those funds directly into your Roth IRA.

Not only does a direct rollover eliminate the potential 20% in tax withholding, but it simplies matters for you personally.

Why?

Because without a direct rollover, you'll probably get a check. And that check needs to be deposited into your Roth IRA no later than 60 days after you receive it. Otherwise, you loose your opportunity to complete the rollover!

Taxes Due From Your 401k Rollover

So what sort of tax consequences do you trigger with a 401k rollover to a Roth IRA?

You'll have to pay income taxes on any amount you roll over, unless of course, you made non-deductible contributions, such as with a Roth 401k (see below).

But assuming you have a typical 401k plan, you're going to owe income taxes on the full amount of the rollover distribution, with the applicable tax rate being the same as what you would pay on your regular income.

For tax purposes, you simply add the full amount of the rollover distribution to your adjustable gross income (AGI).

But don't worry about your rollover pushing you into a higher tax bracket. The tax rate you pay is based on your pre-rollover AGI, not your post-rollover AGI.

For instance, let's say you have a 401k with $200,000, an annual salary of $30,000, and you're in a 20% tax bracket.

Even though you file a tax return with $230,000 in adjustable gross income, you remain in the 20% tax bracket. So your total tax liability is $46,000.

Roth 401k Rollovers

If you were fortunate enough to have an employer who offered you a Roth 401k, and you were savvy enough to invest in one, then you can also choose to perform a Roth 401k rollover to a Roth IRA.

This process is also simple and easy. The same rules apply as outlined above, with one exception...

You won't owe any taxes.

Why?

Because the plan is essentially set up just like a Roth IRA. Your contributions are non-deductible, earnings grow tax free until retirement, and funds are withdrawn tax-free and penalty-free after age 59 ½.

Since you've already paid taxes on the non-deductible contributions, you're free and clear to roll those funds over into your Roth IRA without additional taxes or penalties.

Conclusion

There are many reasons you might want to perform a 401k rollover to a Roth IRA. But it's not always the best thing to do. Make sure you examine any potential rollover from every angle. Otherwise, you might trigger an unforeseen tax consequence or some other potential pitfall.

A successful 401k rollover isn't hard. Just remember the following checklist...

• Have an open/established Roth IRA account
• Have adjustable gross income (AGI) under the IRS limits
• Move distributions from your 401k to your Roth within 60 days
• Pay taxes on rollover distributions, if necessary

And, remember, if you're currently ineligible for a 401k rollover to a Roth IRA due to the AGI limit, just wait patiently for 2010. Once 2010 arrives, the limit expires, making Roth IRA conversions available for everyone!