The purpose of this post is to make sure a 401K rollover is the correct transfer for your situation and to lay out the steps necessary for a successful transfer.
First, who would want to rollover their 401K and who is eligible?
If you plan or have changed jobs recently, you have the option of rolling over your 401K. Options include rolling over your 401K to a Traditional or Roth IRA.
To be eligible for a Roth rollover in 2009, you must be qualified to open a Roth IRA. To qualify for a Roth IRA in 2009, you must have an AGI below $100,000. In 2010, there are no income limits for Roth IRA Rollovers.
How To Rollover your 401K to a Roth IRA
Before 2008, in order to accomplish a 401K to Roth IRA rollover, it was a two-step process.
- Rollover 401K to Traditional IRA
- Rollover Traditional IRA to Roth IRA (commonly referred to a conversion)
The IRS has made this process a little simpler after 2008. Individuals have the option of rolling over an old 401K directly to a Roth IRA.
In order to avoid any excess taxes and fees on this transfer, the first step is to establish a Roth IRA. You can use your existing Roth IRA or if you have never opened a Roth IRA, start a new one.
Do not wait to open a Roth IRA after your 401K funds have been withdrawn. You have 60 days from the day the funds are withdrawn to complete a rollover. If you do not complete the transfer within 60 days, the IRS will think that the money was used for purposes other than retirement savings. Making this transaction subject to income tax and an early withdrawal penalty.
After you have established the new account, let your plan administrator know you want to rollover your 401K to a Roth IRA. They should provide you with the necessary paperwork.
When filling out the paperwork, make sure to elect that you will be rolling over the funds into a Roth IRA.
What Happens When You Rollover a 401K to a Roth IRA?
Unlike rolling over your 401K to a Traditional IRA, rolling over to a Roth IRA is a taxable event. The entire amount rolled over is included in taxable income.
Therefore, you must have cash set aside to pay taxes.
So why would you want to pay taxes now rather than later?
Advantages to a 401K to Roth IRA Rollover
In deciding to convert over to a Roth IRA, you’re essentially saying that you expect your taxes to be higher in the future. Therefore, you would rather pay tax now, while your tax rates are low, then pay taxes in the future at a higher rate. This is the primary advantage of rolling over to a Roth IRA. I have previously discussed more advantages that a Roth IRA has for most members of Gen Y.
The next advantage to rolling over is that you have more control over your assets. Instead of just investing in mutual funds provided by your employer, you have greater flexibility in where you choose to invest.
Last, many employers still don’t include the option to contribute to a Roth 401K. Plus, there are low contribution limits for IRA’s. Rolling over your 401K to a Roth IRA allows you to move as much money as you can into an after-tax account.
A rollover to a Roth isn’t for everyone. The biggest disadvantage is that the money is included in taxable income for the year. Unfortunately, you must have cash set aside to pay this tax. As an estimate, rolling over $10,000 could cost you around $1,500 in taxes.
Next, this isn’t a concept I have discussed before, but worthy of discussion. Having your entire retirement savings into Roth accounts is a form of speculation. You’re betting that you will be paying taxes at a higher rate in the future. While, this is true for most members of Gen Y, who have not hit their prime earning years, it will not be true for everyone.
If you want to hedge your taxes in retirement, you might want to rollover your 401K into a Traditional IRA.
A 401K rollover to a Roth IRA isn’t for everyone. Make sure you weigh out the advantages and disadvantages before proceeding.