A rollover 401k to Roth IRA can potentially boost your net after-tax return, but you need to be clever about it. Remember, moving money from a pre-tax account like a 401(k), 403(b), or traditional IRA to a Roth IRA triggers tax in the year of the conversion.
To rollover 401k to Roth IRA funds, be sure and first check your company’s plan details for any restrictions.
Unless your employer allows “in-service withdrawals,” where money can be withdrawn from employee retirement accounts once you reach age 59 ½ while you’re still under their employ, doing a rollover 401k to Roth IRA from a company-sponsored retirement plan is contingent upon you separating from service from that employer.
A traditional IRA conversion to Roth IRA is the easiest type of conversion to make. Both are private accounts. That means no employer rules get in the way, like minimum balances or limits on the number of conversions you can make.
This is especially true if you plan to convert smaller sums over a period of years, which is a great strategy to minimize the amount of tax you pay. Converting traditional IRA to Roth IRA sums in this way is especially easy if you open up both accounts at the same financial institution.
Crucial to your converting decisions will be the rate at which the converted funds will be taxed. That’s why it’s smart to plan your conversion around tax time, especially if your income varies from year to year.
Another variable affecting your decision – what ordinary
income tax rates you would pay down the road if you didn’t convert –
unfortunately is impossible to predict with certainty. This is up to our
elected officials. If I had to guess, I'd say tax rates will be higher.
The pro-rata rule states you must convert a proportional amount of both deductible and non-deductible contributions from your traditional, SEP, and SIMPLE IRAs when doing a Roth IRA conversion. It doesn’t matter if the money is in separate IRA accounts.
This could put a damper on a popular strategy that I’ve heard referred to as a backdoor Roth, a stealth Roth IRA, or, as I like to call it, the Roth IRA switcheroo. For those whose income exceeds the income limits for Roth IRA, a popular strategy is to first make a non-deductible traditional IRA contribution, for which there are no income limits, then at a later date convert it to a Roth IRA.
This strategy is perfectly legit, but if you have both kinds (taxable and non-taxable contributions), the pro-rata rule states that a pro-rata share of each must be converted – you can’t choose to convert one type over the other.
So, if you’ve made deductible traditional contributions in the past or rolled over a 401(k) or other company plan to a traditional , SEP, or SIMPLE IRA, you may have to rethink your switcheroo strategy.
By the way, funds left in old 401(k), 403b, or 457 accounts from a past employer do not count when computing the ratio. For higher wage earners, this could be a good reason not to rollover that old employer plan if you want to perform the Roth IRA switcheroo every year.
Example: Max is 44 and a high wage earner. Ten years ago he rolled over a 401(k) from an old job to a traditional IRA, and the account is now worth $94,500. This year, because he was over the income limits for a Roth IRA, he made the maximum allowable $5,500 contribution to his traditional IRA as a non-deductible contribution and then later converted it to his Roth IRA.
The pro-rata rule states he actually converted a pro-rata share of his taxable and non-taxable funds, meaning $5,198 of the $5,500 conversion (94,500/100,000 or 95%) was included in his income for the year and taxed at his marginal income tax rate. Ouch!
Don’t confuse a rollover 401k to Roth IRA with moving a pre-tax account to another pre-tax account (like Max did in the above example) or rolling an existing Roth IRA to another Roth IRA with a conversion. Those like to like events are non-taxable because you’re simply moving money from one like pre-tax or post-tax investment to another.
To convert or not convert? Hopefully, you’re now better able
to determine if a rollover 401lk to Roth IRA
is right for you. Maximizing your net after-tax return should be your
ultimate goal. Check out the IRS's IRA FAQ Page on this subject for more information.