Pros and Cons of Converting a 401k to a Roth IRA

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smart_savingIf you’ve been thinking about converting a 401k to a Roth IRA, you should read this article. You’ll learn about the pros and cons of making the move, and how to go about it the right way if you decide to proceed.

Now, in separate articles I went into detail about all the advantages and disadvantages of 401ks and Roth IRAs. You can read all about them by visiting these links.


What Is a 401k and How Does It Work?

What Is a Roth IRA and Who Qualifies?

One of the biggest differences between these two investment vehicles has to do with taxes on contributions. For the traditional 401k, the annual contributions you make into your account are tax deferred. This means that the IRS won’t get their grubby hands on any of your money until you withdraw it.

On the other hand, the contributions you make into a Roth IRA are taxed in the same year as the contributions, but the IRS will never come calling again unless you take early withdrawals of investment profits. You will often hear these contributions referred to a after-tax dollars.

So it shouldn’t surprise you that the decision to convert or roll over a traditional 401k to a Roth IRA comes down to a question of taxes. If and when you do it, the IRS will demand their cut.

I love the Roth IRA and have one in my investment portfolio. But a conversion from one to the other takes a bit more thought and planning.

Steps for Converting a 401k to a Roth IRA

First, you have to consider how many years you have to go before you retire. If it’s more than 15 or 20 years, then doing the conversion would make more sense than if you only had a handful of years to go.

Second, you have to think about what income tax bracket you’ll fall into when you retire. The logic is this. If you’re currently in a much lower income tax bracket than you foresee yourself being in later in life, then it would make sense to go ahead and get the taxes out of the way now.

Makes sense right? The higher your tax bracket in the future, the more taxes you’re going to pay.

So as I alluded to earlier, the main reason for even contemplating a conversion is to avoid ever having to deal with taxes again for all the money that will be in your Roth IRA account.

Here are some additional key rules and provisions you must consider:

– You can only convert your 401k to a Roth IRA if you’ve left your employer.

– The money used to pay the income taxes resulting from the conversion cannot come from the 401k. You must use other sources.

– Initiating a conversion can be as simple as talking to the financial institution that manages your Roth IRA and filling out a form. They’ll walk you through the process.

– When you contact the 401k plan administrator, don’t have them send you a check directly. If you do it this way, they’ll withhold 20% of your money for tax purposes. Then you’ll have 60 days to deposit the check into the Roth IRA account, along with the 20% they withheld.

If you don’t deposit the money within 60 days, that will trigger an additional 10% tax penalty. So do yourself a huge favor and just request that the money be sent directly to your Roth IRA administrator.

– You are allowed to convert a portion of your 401k each year to reduce the tax burden. Spread it over as many years as you like.

So as you can see, there’s plenty to think about when converting a 401k to a Roth IRA. In general, it is a great way to enjoy many years of no-stress, tax-free growth for your investments. But talk to your tax adviser if there are any issues of concern.