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By Stang Gappa
Updated on November 4, 2024
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When you switch jobs or retire, you need to decide what to do with your previous 401(k) plan. One option is transferring your money from your old employer’s plan by doing a 401(k) rollover to a Roth IRA (short for Individual Retirement Plan).
Many people decide to roll over, or transfer, their former employer’s retirement plan to a Roth IRA due to the flexibility these accounts provide. Often, as with a Traditional IRA, a Roth IRA gives you more investment choices and can have lower fees than a 401(k). A Roth IRA rollover also provides you with a convenient option to consolidate other retirement accounts in one place, helping keep track of your retirement savings as your career progresses.
However, a rollover from a 401(k) to a Roth IRA may not make sense for everyone. Your financial situation and personal goals play a large part in determining whether a rollover is the right move. Next, we’ll explore how the rollover process works and key financial considerations so you can decide whether this is right for you.
A Roth IRA is an after-tax Individual Retirement Account that lets you make post-tax contributions up to an annual limit set by the IRS. A Roth IRA allows you to pay taxes on contributions up front, in exchange for the future tax benefit of not paying income tax on investment gains when you withdraw later, as long as you follow the Roth 5-year rule.
Roth IRAs have different tax rules compared to another type of popular retirement account, the Traditional IRA.
The available 401(k) investment options and fees play a large role in determining whether a 401(k) rollover to a Roth IRA (or other rollover IRA) makes sense for you. Tax implications and consolidation options are important to consider as well.
Your old 401(k) plan likely allowed you to choose your retirement portfolio allocation from a pre-selected menu of mutual funds. Carefully look over the fund options available to ensure that they align with your desired investment strategy, diversification approach, and comfort with risk.
Rolling over your 401(k) to a Roth IRA could give your retirement portfolio more control by giving you the chance to choose your preferred provider, investment style (robo or self-managed), and diversification and investment options (traditional assets such as stocks, bonds, and ETFs, or alternatives like real estate, crypto, etc).
401(k) fees vary substantially depending on which institution your employer works with. There are some 401(k) plans with high custodial fees and funds that have higher-than-average expenses. Other 401(k) providers may offer minimal maintenance fees and low-cost investments.
Roth IRAs can be opened for free through many online providers, but some investment platforms charge a small recurring fee. Roth IRAs give the flexibility to choose low or no-cost investments, or more expensive versions if you desire.
Ultimately, a 401(k) to Roth IRA rollover can give you more options when it comes to minimizing your retirement portfolio’s investment fee.
As your career progresses, you’ll likely work for many companies over the years—or even yourself. With each career move, you’ll then need to decide what to do with your old retirement funds.
If you’re employed, your new employer’s plan may allow for other retirement accounts to be rolled into them, but that’s not true with all employers. A Roth IRA can be an attractive place for your retirement savings plan (other than a current 401(k)) so that all your retirement money is in one place while helping to ensure your investment strategy is aligned.
Keeping careful track of your rollover funds is one of the key ways to get the most out of them. An Individual Retirement Account helps you do just that.
If you feel you’ll be in a higher tax bracket at retirement than you are in today or are concerned about the uncertainty of your future income tax rate, moving your 401(k) to a Roth IRA is an option to consider since you won’t pay taxes when withdrawing at retirement.
Keep in mind that your personal financial situation greatly influences whether a 401(k) to Roth IRA rollover makes sense for you. There are additional tax considerations to evaluate as well when moving pre-tax dollars from a 401(k) to a post-tax account like a Roth IRA (more on this in a bit).
First, open a single Roth IRA account at an institution or brokerage of your choice. Next, provide your new account details to your old 401(k) plan provider. This may include the new Roth IRA’s provider’s name, account number, and address. Your old company’s 401(k) plan may require additional steps, such as getting a plan administrator to sign off on the transfer.
Once complete, you’ll choose between a direct 401(k) to Roth IRA rollover or an indirect rollover.
A direct rollover means the funds are sent directly to your new Roth IRA provider in the institution’s name, for your benefit. Your 401(k) plan may require that the disbursement is sent to you first before forwarding on to the new institution as an extra security precaution.
An indirect rollover from a 401(k) to a single Roth IRA, also known as a 60-day rollover, is when the 401(k) funds are sent directly to you for depositing in a non-retirement account. In these cases, the IRS requires your 401(k) plan to withhold 20% of your account balance for taxes that may be due. You’ll then have 60 days to re-deposit the funds to another retirement account or the distribution will be taxed at your income tax rate. Make sure you know how to check your 401(k) account balance before you move forward with an indirect rollover so you can anticipate how much will be withheld.
Indirect rollovers take a bit of extra work, so it’s often easier and smoother to do a direct rollover. If you do want to tackle an indirect rollover, consider hiring a tax advisor to help.
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A Traditional 401(k) can’t be directly transferred to a Roth IRA since these accounts receive different tax treatments. So, you’ll first need to move these funds to a Traditional IRA or Rollover IRA, which you’ll later be able to convert into a Roth IRA.
Once you open a Traditional IRA, you’ll follow a similar process as you would have when moving a Roth 401(k) to a Roth IRA. Once the funds are in a Traditional IRA, open a Roth IRA so you can then convert the account.
Traditional 401(k)s and Roth IRAs have different tax statuses and therefore come with different tax implications.
When you contribute to tax-deferred accounts like a Traditional 401(k), you receive a tax break in the form of a deduction. For example, if your income is $50,000 and you contribute $5,000 to a Traditional 401(k), you’re only taxed on $45,000 worth of income for the year.
A Traditional 401(k) then grows tax-free until you reach retirement, which is defined as reaching at least age 59 ½ according to the IRS. This is also called tax deferred. When you make withdrawals at that time, you pay the regular income tax rate to the federal, state, and local tax governments on the full withdrawal amount.
However, a Roth IRA doesn’t give you a deduction when you contribute. Instead, Roth accounts offer the benefit of tax-free withdrawals at retirement (among others).
Moving funds from a Traditional account to a Roth account changes the tax status and, as a result, there are tax implications by making this transaction. In other words, the IRS essentially requires you to give back the tax deduction made on the original Traditional 401(k) before you can put the funds in a Roth IRA. This allows you to receive the benefit of tax-free withdrawals at retirement age.
Moving your retirement fund from a Traditional 401(k) to a Roth IRA is called a Roth IRA conversion. The tax impact is determined by the total amount you decide to convert from a Traditional IRA into a Roth account. This amount is added to your taxable income in the year you make the conversion, and is taxable at the federal, state, and local levels. As with many taxes, there is more that goes into how Roth IRA conversions are taxed, so make sure to do your homework first. Consider contacting a tax advisor or personal financial advisor to help you understand your specific implications and potential income taxes.
One piece of good news: If you happen to have a Roth 401(k), you won’t have to go through the conversion, which can lead to an expensive tax bill in the short term.
Although making a Roth IRA conversion is a great first step, to get the most out of your new account, you’ll want to continue to fund it. Making the maximum Roth IRA contribution each year helps ensure your savings will grow steadily and support you with retirement income.
Like all IRAs, Roth IRA contributions are subject to annual contribution limits. In 2024, you can only contribute up to $7,000 across any and all IRAs your own, or $8,000 if you’re aged 50 and older. Keep in mind that the contribution limits can change each year.
Roth accounts are also subject to income-based restrictions. If you’re an earner in a higher tax bracket, you may not be eligible to make Roth IRA contributions directly, though anyone can perform Roth IRA conversions regardless of income. In 2024, single filers who earn $146,000 or more per year or joint filers who out-earn $230,000 are ineligible to make the full Roth IRA contribution. If you earn slightly more than this, you may still be able to make a limited contribution. A financial advisor can help ensure you’re making the best moves with your retirement fund.
In addition to a 401(k) to Roth IRA rollover, there are several other rollover options you have when deciding what to do with your former employer’s retirement account.
A Traditional IRA has the same tax status as a Traditional 401(k). They’re both tax-deferred accounts. As a result, you can move your retirement savings account to an IRA provider of your choice without triggering tax implications. IRA assets can be easily managed apart from your previous employer.
Your new employer may offer a 401(k) and allow for transfers from outside retirement accounts. Consider the investment options available in your new 401(k) plan (company stock may be one of them) and ask whether your new company will let you transfer to other accounts.
If you’re pleased with the investment diversification choices and fees in your previous employer’s 401(k) plan, keeping your retirement savings account in place is a viable option. Keep in mind, however, that you won’t be able to make new contributions or transfer to other accounts.
All 401(k) accounts give you the option to withdraw your funds and receive the proceeds as cash. But remember that if you aren’t 59.5 yet or if you’re not 55 and retired, withdrawals from your 401(k) won’t be considered qualified distributions eligible for penalty-free treatment.
Withdrawing pre-tax contributions from your 401(k) is typically best saved as a last resort, since you’ll have to pay federal taxes — as well as state and local taxes, plus early withdrawal penalties — if you haven’t yet reached retirement age. You’ll also potentially give up the benefit of additional tax-advantaged investment returns.
However, if you need access to the funds for non-retirement purposes or financial hardship, withdrawing from your 401(k) is something you can consider.
If you have a Roth IRA account that consists of post-tax contributions, the Roth five-year rule states that you cannot make a tax-free Roth IRA withdrawal of earnings until you have waited five years from the first tax year the account was funded.
Unless you have an immediate emergency that requires you to take an early 401(k) withdrawal, most financial advisors recommend that you try to avoid cashing out your 401(k). Doing so will subject you to an early withdrawal penalty and can significantly impact your future retirement income.
We’re glad you asked! Capitalize is a free, online service that helps you digitally find your old 401(k) before pairing you up with one of our rollover experts who will manage the entire process of rolling over your retirement funds into a Roth IRA for you. Our team has handled thousands of rollovers just like yours, so you can rest assured it gets done correctly. It doesn’t matter if you’re 401(k) has pre-tax contributions or post-tax contributions – we can handle them both.
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Capitalize is an online service that helps you digitally locate your old 401(k) and pairs you with an expert who manages the entire process of rolling over your 401(k) into a Roth IRA of your choice for you – for free. This can save you hours of your time and spare you the headache of going through the antiquated rollover process. Capitalize is a great option for you if you’re busy or unsure about how to approach the 401(k) rollover process yourself.
Regardless of which rollover option you choose, Capitalize is on a mission to make the rollover process easier for everyone. You can learn how a 401(k) rollover with Capitalize works – we’ll help manage your rollover from start to finish, giving you peace of mind and providing expert support along the way.
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