Roll a Traditional 401k Directly to a Roth IRA
By Randall | December 21st, 2007 | Category: Retirement | 4 comments 2,688 views | 4 Comments » |
Starting in Jan of ‘08, thanks to the Pension Protection Act of 2006 (PPA’o6), the working man has a new option for his retirement funds.
The ‘Old’ Way
Previously, if you left your job or had a ‘qualifying event’ (an event that allowed you to withdraw your 401k money, depending on the funds’ rules), the only place you could put the money from your old 401k would be either; Another 401k, or a Traditional IRA. That or take a cash disbursement + early withdrawal penalties + paying taxes due.
Assuming you wanted the money to end up in a Roth IRA, the jump path would be
Original 401k -> Traditional IRA -> Roth IRA.
And in addition, you couldn’t roll the Traditional IRA to a Roth, if you had a Modified Adjusted Gross Income of over $100k for the year. Another stumbling block.
Not much flexibility there. But now with the PPA’06, the money can be moved directly into a Roth IRA.
The ‘New’ Way
Here’s the steps
- Open a Roth IRA at your bank or financial institution.
- Contact the institution where your 401k is currently held and ask what their procedures/paperwork is for making a Direct-to-Roth IRA Rollover. (Understand, that this might be new to them, so a little patience may be involved.)
- Receive the paperwork, fill it out, and return it.
- Wait for a few weeks, and
- See the money arrive in your Roth IRA account.
Pretty straightforward and easy.
Now the catch.
You will have to pay taxes on the amount that you roll over into the Roth, since going from a pre-tax source to a post-tax source will cause the government to come get their due.
Strategies
If you’ve got a significant amount of money to move, the tax-hit might be pretty high, so to alleviate the hit you can move the money into a Traditional IRA, then ’stage’ the move over a few years, to spread out the tax hit.
By spreading the taxation out over a few years, pay a slight amount more (because hopefully the pre-tax money will accrue a little more interest) but it will be broken up over a space of years, and be less of an individual hit.
I’m going to start looking for a new job soon, and if I start somewhere new, I will have to decide if it will be better to roll my 401(k) into my new fund, or roll it into an IRA. Depending on what the options are for the new fund, I may roll it into an IRA. I always prefer Roth over Traditional, so I may be in for a BIG tax hit if I go that route.
I will have to do a lot of research if I get a new job. Very informative article.
@Patrick,
It’s ALMOST always a better idea to roll it to an outside IRA. You almost always have more choices and control over it. I personally can’t really think of a situation where you would WANT to move it to your new employer’s 401k, even though many offer it.
The only thing I could think of would be if you were planning to use the 401k as a basis for a loan (from the plan) for a house purchase or something, and even then, it’s a bad idea.
If you don’t have to use the money, wouldn’t it be better to leave your money in a 401(k) since with a 401(K) you are not required to make money out until you are 70 1/2 vs. a Traditional IRA 59 1/2? Even though you are not paying taxes when just rolling over the money to a TIRA, you still would be required to take money out and pay taxes on that money if you are 59 1/2 or older (even if you don’t need the money). Why not just leave the money in a 401(k) until you are 70 1/2. At that point, roll it over to a Traditional IRA at that point. When you take money out of the TIRA because you have to and you pay taxes on it, you then can deposit it in a ROTH IRA if you don’t need the money. It can continue to grow tax free and you can take it out whenever you want in the future w/out paying taxes. Better yet, if you are young and havea 401(k), maximize it and then if you can contribute to a ROTH IRA as well every year. When you are older and you need money, if you are under 70 1/2 you can hit your ROTH IRA FIRST before touching your 401(k).
If you are an older person and you roll all of your 401k money to a TIRA
@Christina, it’s true that for a TRADITIONAL IRA you have to start taking distributions at 70 1/2 (not 59 1/2). But for a ROTH IRA, you don’t have to take any distributions EVER if you don’t want to.
Also, Roth distributions are tax-free, since you paid taxes ‘going in’. Traditional IRAs require tax payments, as do 401(k) distributions, since both are pre-tax deductions.
When you take money out of your Traditional IRA, realize that there are penalties involved if you’re not taking it out for a ‘qualified distribution’ (new house, repairs to an existing house, etc. etc). That, and you have to pay taxes on it. You can then turn around and contribute what you don’t need into a Roth IRA, but only up to the maximum contribution for the year (2008=$5000). It’d be better to do a Traditional->Roth rollover and save on the penalties. You still have to pay the taxes, but that’s just part of the deal.
Otherwise, you’re last couple of sentences are spot on. Start early and max both the 401(k) and Roth IRAs and you can use the Roth as an extra emergency fund.
Some more sources:
http://www.irs.gov/publications/p590/ch01.html#d0e5766
http://www.irs.gov/publications/p590/ch02.html#d0e11001
And another article on using the Roth as an emergency fund.
http://www.creditwithdrawal.com/2008/05/27/the-roth-ira-as-emergency-fund/