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Converting Your 401(k) to a Roth IRA

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[The article below is from Dollar Guides. Dollar Guides is a paid directory of financial resources. I haven't looked at or used many of those resources and can not recommend them one way or the other.]

As most of us know, your 401(k) is a retirement plan that many employers offer. Simply, part of your earnings is deferred into your 401(k) account. In other words, money that is put into your 401(k) is tax-deferred until withdrawal. Likewise, some of us are also familiar with an individual retirement account, or IRA. However many are not familiar with a Roth IRA. Earnings in a Roth IRA, unlike the 401(k), can be withdrawn after age 59½, tax-free. With this said, many people decide to convert their 401(k) into a Roth IRA. This can be very beneficial, however it is not a simple one-step process.

In short, your 401(k) can be "rolled over" or converted into an IRA, both traditional or Roth. However, in order to convert your 401(k) into a Roth IRA you must first roll it over to a traditional IRA and then to the Roth IRA. It's basically a two-step process with many different factors involved.

So, what's the catch? Well, rolling your 401(k) into the traditional IRA is straight-forward. However, once your funds are in the traditional IRA and you wish to roll it into a Roth IRA you must pay taxes on them. This means that if you are in the 15% tax-bracket, and you were rolling $40,000 from the traditional to the Roth IRA, you must pay roughly $6,000 in taxes. So, why do you have to pay taxes at this stage of the roll-over? The answer is simple. When you contribute to a traditional IRA, your contributions are tax-deductible resulting in taxed earnings. On the other hand, when you contribute to a Roth IRA, you are doing so with after-tax dollars resulting in tax-free earnings after age 59½. So the funds contributed, or in our case rolled-over, must be taxed before entering the Roth IRA.

So, why would you consider rolling over the balance of your 401(k) into a Roth IRA when it requires paying taxes on the entire balance? Well, you might expect to be in a higher tax-bracket after the age of 59½. Let's consider an example:
John Doe is 35 years old and in the 15% tax-bracket. He expects to be in the 25% income tax-bracket at age 60. He is considering converting his balance of $40,000 that is in his 401(k) to a Roth IRA. If he chooses to convert the balance on his 401(k) into a Roth IRA at age 35, then he must pay 15% income tax on the current balance. However, he will not have to pay any taxes at the time of retirement (after age 59½). Let's remind ourselves that he is only 35 years old, the interest will be compounding for the next 25 years, and most importantly, he can continue to contribute the maximum amount to his Roth IRA each year. If he chooses to keep the funds in the 401(k) account until retirement, then he will be forced to pay 25% income tax on the final balance.

Many people that choose to convert their 401(k) into a Roth IRA use outside funds to pay the taxes on the converted balance. Many often decide to use funds from their savings account. Others simply allow the taxes to be taken out of the converted balance. Either way, converting your 401(k) can be considered for anyone with a 401(k) account. It is important to remember that the income restrictions for a Roth IRA still apply when converting from a 401(k).

In deciding on whether or not to convert your 401(k) into a Roth IRA, it is important to speak with someone you trust concerning your finances. Try to consider all of your options when planning for retirement.

[Editor's note: I'm not convinced that "most of us" know 401Ks and "many are not familiar with a Roth IRA."]

Posted on December 18, 2007.

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12 Responses to “Converting Your 401(k) to a Roth IRA”

  1. Mark says:

    This is a very good piece of info to have.
    I am considering rolling over a 403b into an IRA and was not aware of this factor.

    Good find!

  2. Most advisers I have talked to say to always pay the taxes out of your pocket instead of reducing the balance in your investment. The time it takes to make up the difference is too much time wasted.

  3. Ernesto says:

    Another consideration: Fast forward to 2030 and the US is in a financial what-are-we-gonna-do position because the retiring baby boomers are killing the social security “trust fund”. So looking for a way to get some extra $$ what looks good? How about all those trillions in Roth IRAs that have been compounding nicely for a quarter century? One signature on a federal spending bill wipes out your tax defered planning.

    I say take the tax write off today because YOU CAN. Better a tax write off today than hope for the best when you retire.

  4. Zook says:

    Ernesto, I have heard that many a time before. IF we elect a dirt bag that would sign off on a bill that would take away the tax advantaged savings in the future AND retroactively remove the tax deferred savings from the past, than shame on you, me and every other goober who elected officials who would fathom such an idea.

    You take the doomsday approach, which is fine, but what if Roth IRA’s are still going strong and have been adjusted for inflation in 2030 with BETTER benefits?

    I think you MUST have your foot in BOTH types of IRA’s. One where you will be taxed and and have required distribution at 70 and another that will not get taxed that can be used after you have spent down your first IRA.

  5. Lazy Man says:

    They’d sooner raise income tax another 10% (yes, even that high if necessary) before they’d start to tax Roth IRAs. They realize that people have entered into a contract not to spend that money or penalties will be extracted. In return for that restriction, they’ve promised a benefit. If that benefit disappears, expect to see the world’s largest class action lawsuit.

  6. goldi says:

    There is a great book dedicated to this topic called “It’s Your IRA”. It is an excellent resource for those wanting to learn more about investing in Roth and Traditional IRAs. It is available through Amazon or you can go to ItsYourIRA.com for more details. It is definitely worth a look.

  7. ct says:

    “Most advisers I have talked to say to always pay the taxes out of your pocket instead of reducing the balance in your investment. The time it takes to make up the difference is too much time wasted.”

    wrong! all things being equal, $60k in a 401k is the -exact- same amount of money as $40k in a Roth IRA (i’m simplifying some things a bit).

    So let’s say you have $60k in a 401k and you’re going to roll it over into a roth IRA. If you just have the taxes taken out from your 401k balance, in the 33% tax bracket, you’ll have $40k in a Roth IRA. If you choose to pay out of pocket, u’d have to front that $20,000 of AFTER TAX dollars, which is the same as $30,000 of before tax dollars.

    Of course, u’d then be able to write off this tax payment in your tax return and at the end of the year recoup $10k and end up paying (net) the same $20k in taxes as u would a 401k.

    the time to make up the difference is exactly 0 years. The rules are in place to prevent and discourage abuse of 401k/IRA programs. They’re designed to make the net gain as close as possible to 0 (zero) when converting.

    The only major difference is that if u pay out of pocket, you’ll have to wait until the end of the year to get 33% of your money back.

  8. Lazy Man says:

    That’s why it’s a guest post. I believe it’s the same as well.

  9. Channon says:

    Ct, that is not correct.

    At the instant of the conversion, that is correct, but consider a few years down the road. Say you start with a $60k 401k and $120k in savings.

    Good Advice – Pay the $20k of tax out of regular savings:

    Roth balance: $60k
    Savings, remaining: $100k
    Total of 2 accounts after conversion: $160k

    Poor Advice – Pay the $20k out of the Roth:

    Roth balance: $40k
    Savings, remaining: $120k
    Total of 2 accounts after conversion: $160k

    Ct, that’s where you stop thinking about this. But, you need to put the thinking cap on and stay focused, because you are only correct at that moment, assuming no more money is going to be earned on either account.

    Each year you would hopefully (present year excluded) have positive returns on your accounts. WIth the Roth, all these returns, cap gains and dividends, are TAX FREE. Not so with you savings account. The following year, you earn interest on the “tax wedge”, too. So suppose you earn 10% on each account and you’re still in the 33% tax bracket.

    After 1 year:

    Good Advice:

    Roth balance: $66k ($60k+10%)
    Savings balance: $106.7k ($100k + $10k [10%] less 33% taxes on the $10k)
    Total of 2 accounts after tax: $172.7k

    Poor Advice:

    Roth balance: $44k ($40k +10%)
    Savings, remaining: $128k ($120k + $12k {10%] less 33% tax on $12k)
    Total of 2 accounts after conversion: $172k

    After 1 year, the Good Advice has netted you and extra $700, just for not being lazy about the analysis. In Year 2, you’re going to get ANOTHER $700 extra PLUS, you’ll earn 10%, $70, on Year 1’s extra $700, so you be better off by $770 in Year 2, for a cumulative $1470. This continues to snowball.

    Now, what about a year like this when there are losses? You may be better off with Ct’s advice, if you realize those losses and offset ordinary income with them. BUT, if you expect to regularly lose money in the market, then you shouldn’t invest at all, of course, so stick with the good advice, and get your retirement and tax advice from intelligent professionals.

  10. jb says:

    Hmmmm, I would LOVE to see a savings account that earns 10%!!!!! I believe those are a thing of the way distant past. I think I would much rather take a chance with my Roth earning way more than my savings these days. Just my opinion.

  11. DC says:

    With the current recession, one has to wonder if all those people who were making $125000/yr and are now unemployed and made $25000 this year (clearly random numbers) should take this time to convert their 401K to a Roth IRA. They’d be in a much lower tax bracket, so the hit from taxes at conversion wouldn’t be as hard.

  12. SS says:

    Okay, you guys are brilliant. I need your help desperately. Now don’t faint. Desperation causes desperate measures.

    72K in 401K. My job is in dire straights (I’m looking, but at 45 it may be a while).
    I don’t want to lose my home. I have 1 credit card, but it’s substantial. I do NOT want to file bankruptcy. My plan may be to sell my car to pay the debt off, however, I don’t want to do that since I need it.

    I need to:
    A: resolve the CC debt in case I lose my job.
    B: See if I can reduce my house payments.
    C: Pay off what I owe on my car so I don’t have that payment (Owe $5,000.)

    My thought was. Pay off the credit card embarrassed to say, but $18,000 at 8% – the interest rate isn’t bad… but my balance is HORRIFIC! The card saved me after I was unemployed for nearly a year…a couple of years ago after my company of 12 years let me go to hire a 22 yo. (It’s been rough.)
    Pay off the car at $5,000.

    Pay the taxes on the 72… which would be over $20,000? Leaving me with $50… sadly, which is what I owe. $49,000

    How can I just REDUCE the CC, pay off the car. Pay the taxes… and SALVAGE SOME to roll into an IRA?

    The new job finding is up to me. I don’t make that much…and especially won’t starting a new job. (33K)

    Please don’t think I’m a fool for even touching the 401K….I’m not going to lose my house or go bankrupt when I have funds…but need to use them smartly.

    My house is 6% fixed. Would it help if I used it to reduce my Principal.

    I’ve exposed myself so please do not be harsh with me… I just need help right now… not criticism. Thank you.

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