How To Transfer A 401(k) To A Roth IRA

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Contributor, Benzinga
June 13, 2019

If you’ve held onto an employer-sponsored 401(k) plan for a long time, chances are you’ve accumulated a fair-sized nest egg for your retirement savings. If you leave your job or retire, do you know what you do with your 401(k) balance? Luckily, you do have options, which include transferring (or rolling over) your balance to a Roth IRA. That decision could play a pivotal role in saving you money in the long term, too. It’s equally essential to understand how to execute a rollover and where to transfer your 401(k) balance.   

Overview: 401(k) Rollover to a Roth IRA

Rollovers happen when you move savings from your employer-sponsored 401(k) plan into a Roth IRA. They will occur as a result of employer-sponsored plan rules barring ex-employees from participation, or as a result of your own need to exert more control over your retirement savings.

  • Typically, Roth IRAs have greater investment options than employer-sponsored 401(k) plans.
  • Most 401(k) plans have strict rules regarding when and how and what to buy, sell or hold. Roth IRAs, especially self-directed ones, free you from such restrictions.
  • Unlike a 401(k) in retirement, contribution and earning (interest, dividends, distributions) withdrawals from Roth IRAs are tax-free.

Most importantly, some employer plans may charge higher fees for ex-employees to continue participating while some 401(k) plans may only offer restricted (high-fee) investments. A well-planned 401(k) rollover to a Roth IRA could end up saving you lots of money in the long-run.

Know the Differences Between 401(k) and Roth IRA

Both 401(k) and Roth IRA plans are similar in that they are defined contribution retirement plans. What that means is that both allow plan holders to contribute a predefined amount toward retirement savings. The amount allowed depends on several factors, including the type of plans and your income. In both instances, investments grow tax-sheltered within these accounts. However, there are a few differences between these two retirement planning tools. In the 401(k) vs. Roth IRA table below, we’ve included a summary of the most significant differences:

401(k) vs Roth IRA

401(k)Roth IRA
Employer-sponsored, and may allow employers to make matching contributionsIndividually initiated and solely based on individual contributions
IRS usually allows employees to make larger contributions compared to Roth IRAsIRS-allowed contribution limits are typically lower than 401(k)s
Anyone with access to an employer-sponsored plan can contributeContributions are income-tested
Contributions are made from pre-tax earningsContributions are made from after-tax dollars
Contributions are deductibleContributions are not deductible
No contributions allowed past age 70 ½Contributions allowed by income earners even past age 70 ½
Mandated to take minimum distributions at age 70 ½IRS does not require distributions until after the owner of the plan passes  
Withdrawals are taxableQualified retirement withdrawals are tax-free

  The difference in how these plans are structured offers great flexibility in creating innovative retirement income solutions. For instance, both plans have different tax treatments on contributions into, and withdrawals from, the plan.

If You’re Currently in a High Tax Bracket

Then it might make sense to contribute (at least part of your savings) to a 401(k) plan. You’ll likely benefit from a higher tax deduction each year that you make contributions.

401(k)s May Offer Employer Matching Contributions

Your 401(k) vs. Roth IRA analysis should also consider the fact that 401(k)s may offer employer matching contributions, also known as free money, which might not be available in a Roth IRA. Due to this difference, you should consider 401(k) contributions to maximize employer contributions. Only then would it make sense to consider contributing to your IRA.

What if There’s No “Free Money” on the Offer?

A Roth IRA might be the better choice If you expect to earn substantially more during retirement. Why? Because your 401(k) withdrawal is taxable, you might end up paying higher taxes on those withdrawals in retirement compared to the tax deduction you potentially would have received at the time of making your contributions      If you are in an enviable position of being able to contribute to both plans, then it’s always advisable to maximize your contributions in both accounts.

How to Rollover 401(k) to Roth IRA

Rolling your 401(k) into a Roth IRA is a very important decision to make, but one that many might feel slightly overwhelmed making. This four-step process takes away the stress of decision-making and will help you through a seamless rollover.

Step 1. Assess Your Options

The first step is to do an assessment of your options.

  • Do nothing: When you quit or retire, if your plan allows for it, you could just let your savings be. However, you will likely lose access to internal 401(k) monitoring tools, which makes it harder to keep track of your savings. Some employers might charge higher fees to let ex-employees stay in their plans.
  • Cash out: Before doing that, consider the impact this may have. You may have to pay a 10% early withdrawal charge, plus tax on the withdrawal. That could deplete your savings by nearly 40% right off the bat!
  • Rollover: You could roll it over to your new employer’s 401(k) plan, or move it into an IRA. Because of the potential cost-effectiveness, better investment selection, and greater control they offer over investments, it might be advisable for most people to rollover 401(k) plans into Roth IRAs.  

Step 2. Choose a Rollover IRA

You have two options to choose from:

  • Traditional IRA: Choosing to rollover into a traditional IRA means you don’t have to stress about the tax consequences. The money transfers tax-free.
  • Roth IRA rollover: You may need to pay tax immediately upon the rollover (unless you’re transferring a Roth 401(k). However, if your income will be higher in retirement, a Roth IRA rollover might be the way to go. Lower Roth IRA investment fees and access to better-performing investments could also cushion the blow from paying those taxes now.

You’ll find more information here about the best Roth IRA account to consider.

The actual rollover process offers you two options:

A Direct Rollover

Also called a trustee-to-trustee rollover, is the best way to do this. Your existing plan’s administrators will work with the trustees of the new plan to complete the transaction. Once the money rolls over, you get to work with the custodians of your Roth IRA account to make investment decisions.

An Indirect Rollover

This involves you withdrawing the money yourself, and having your employer withhold 20% of your balance. You’ll have 60 days to figure out the process.  

Step 3. Make an Investment Decision

The Financial Industry Regulatory Authority (FINRA) offers some great tips on what to look out for when making sound rollover decisions. Before you start making investment decisions, it’s important to choose the right firm. Consider:

  • Fees: Check out what each prospective brokerage charges in fees, including annual fees, trading commissions, market data access fees, inactivity fees, account transfer fees, and account closing fees. Also, make sure that you’re taking taxes into consideration. You’ll need to pay taxes on your rollover.
  • A diversity of investments: Does the brokerage offer a wide range of investments, such as stocks, bonds, ETFs, low-cost mutual funds, options, foreign-exchange trading?
  • User-friendly platform: If this is your first foray into online investing, you need a brokerage that offers a super-easy platform to navigate and use. Also, look for plenty of videos and investor-education tools.
  • Reporting and account management: Check out the type of reporting and account monitoring tools offered. It’s always a good idea to open a practice account first before committing your Roth IRA savings to a specific brokerage account.
  • Online/telephone help: Check out the brokerages’ helpline and customer support policies. You don’t want to choose a broker that only provides support on weekdays from 9 a.m. to 5 p.m. and is off on weekends!

You have many choices to invest funds in your Roth IRA account, ranging from professionally-managed options to self-directed investments. Some of the Roth IRA brokerage account providers that meet (and even exceed) all these tests include TD Ameritrade, Ally Invest and E-Trade. You can find more information here on the best way to invest.

Final Thoughts

If you believe you could be in a lower tax bracket in retirement, it might make sense to roll over into a Traditional IRA. However, for individuals that expect to be in a higher tax bracket later, a 401(k) rollover into a Roth IRA is the best solution. The one option that you might want to stay away from, however, is a 401(k) cash-out.

Not only will that deprive you of a great tax-deferred retirement savings tool, but, if you are under age 59 ½, you will also receive an enormous tax bill to boot.   

Want to learn more? Check out Benzinga's picks for the best places to rollover a 401k, the best individual retirement accounts and the best roth IRAs.