Suppose you have a 401k plan in your old employer’s company, you wonder what you ought to do next. Should you cash it out, leave it behind, or roll it over to a new tax-deferred retirement account? What are your options?
Let’s recap what a 401k plan is,
You contribute money to your 401(k) plan through pre-tax payroll deductions. In other words, the money comes straight from your paycheck before it can be taxed. Once the money is in the 401(k) plan, you can then allocate it to different investments, depending on your plan. Usually, you can choose from a number of different mutual funds, including money market funds, bond funds, and stock funds.
Here’s the best part. While your money is in the 401(k) plan, any interest, dividends and capital gains on your investments aren’t taxed. In fact, the money grows, untaxed, until you withdraw it in retirement. At that point, you pay taxes on your withdrawals at the regular income tax rate.
But when you leave a job, become disabled or reach age 59 ½, a 401(k) rollover is certainly worth considering; but before you can make a decision, let’s relook at what your rollover options are.
- Leave your money in your former employer’s plan
- Roll over your money to your new employer’s plan
- Roll it over to an IRA
- Cash out the account and pay the associated taxes and penalties
- Do a 401k rollover to Roth IRA
Can you rollover your 401k to Roth IRA?
For many, the idea of rolling over their 401k to Roth IRA is attractive. Besides allowing tax and penalty free withdrawals of contributions, the Roth IRA enables you to maximize your retirement nest egg with tax-free money.
The beauty of the Roth IRA is that while this money goes in post-tax (i.e. it’s money you’ve already paid taxes on) it will not be taxed at withdrawal. As long as you are over 59 ½, withdrawals from earnings are completely tax-free. However, your account must be open for at least five years to qualify for tax-free status.
But first you have to complete a 3-step process
- Open a Traditional IRA
- Roll your 401(k) funds into a traditional IRA
- Convert the Traditional IRA to a Roth IRA
Unlike IRA, Roth IRAs are funded with after-tax dollars, therefore any amount you convert from IRA to Roth will be taxed in full upon conversion at the prevailing margin rate. In this scenario, Roth rollover works best if you are in a lower bracket at conversion and most importantly, you have enough cash to pay the due taxes without dipping into your account balance.
Now that you’re aware of the taxes that will be due upon conversion, do the math to see if converting makes sense.
Steps to do a 401k rollover to Roth IRA
- Ensure you are eligible. Workers whose income is less than $116,000 (single filer) and $169,000 (married and joint filer) are qualified.
- Choose a custodian for your new Roth IRA. This custodian can be a bank or mutual fund company.
- Contact the company that holds your 401k money. You need sign and complete the authorization form to roll your old 401(k) into your new traditional IRA.
- Pay the associated taxes on the 401k money as funds in your new Roth IRA is post-tax.
- Fill out the Roth Conversion paperwork to turn your new IRA into a Roth IRA.
Update: In 2010, you will be able to direct rollover your 401k into a Roth IRA and bypassing the unnecessary middle step. Thus less paperwork involved.
Moving money from an IRA or employer’s 401k plan to a Roth IRA is now known as “converting.” So, anyone willing to pay the income taxes due upon making such conversion will be able to funnel retirement savings into a Roth, where it can grow tax-free.
Should you consider converting your 401k into IRA or the Roth IRA? The question remains..
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- Is a Roth Conversion Right for You? Kim Lankford from Kiplinger explains why 2010 is the year of the Roth for the...
- 401(k) Rollover Options Understanding your 401(k) rollover options help you make a smarter choice for your retirement dollars...
2010 Contribution Limits
The 401(k) contribution limit for is $16,500 for those under 50 years old. For anyone between the ages of 50 and 59 ½ years old you also have the option of contributing an additional $5,500 as a catch-up contribution.The IRA contribution limit for is $5,000 for those under 50 years old, with a $1,000 catch-up contribution option for those between 50 and 59 ½ years old.