[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 Earnings in a Roth IRA, unlike the 401(k), can be withdrawn after age 59Â½, tax-free.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 59Â½. 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 59Â½. 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 59Â½). 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."]
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