Do I Have to Pay Taxes If I Rollover My 401(k) to a Roth IRA?

By: Stephanie Faris | Reviewed by: Alicia Bodine, Certified Ramsey Solutions Master Financial Coach | Updated May 10, 2019

When you leave an employer or retire and you have a 401(k) in place, you can benefit from lower fees and tax-free retirement distributions by rolling your 401(k) to a Roth IRA. It’s a popular option, especially if you plan to have multiple employers throughout your career. However, to move the money in your 401(k) to a Roth IRA, you’ll have to do a Roth conversion, which will force you to pay taxes.

Tip

If you convert your 401(k) to a Roth IRA, you’ll have to pay taxes on the amount you converted. The good news is, you won’t have to pay taxes on the money when you take distributions post-retirement.

Taxes on Roth IRA Conversions

One of the biggest reasons investors gravitate toward Roth IRAs is the tax benefit. The money is put into the account after tax, so when it’s time to retire, you’ll be able to take the money out tax-free. That makes the Roth IRA a natural contender for rolling over 401(k)s since it allows you to enjoy tax-free distributions during your golden years.

However, it’s important to understand the rollover 401(k) to Roth IRA tax consequences. You didn’t pay taxes when you put money into your 401(k), with the understanding that you’d pay when you took it out. A Roth IRA is funded with money you’ve already paid taxes on, which is why you don’t pay taxes when you take it out. This means that the IRS has to get its money now, when you’re putting the money into the Roth IRA account.

Annuitization Calculator to Determine Taxes

But paying taxes now isn’t always a bad thing. In fact, some would argue that you can better afford the taxes now, while you’re still working. Claiming the rollover on your taxes when you have a decent salary coming in will likely be easier than paying taxes on the money you’re taking out when you’re in your 60s or 70s and no longer have a steady paycheck coming.

Another argument for paying the taxes now is that you’ll probably pay less than you will down the road, assuming tax rates increase over time. This, of course, may be a bigger difference if you’re younger rather than just a few years away from retirement. You can find annuitization calculators online that can help you determine just how much you’ll get each month from your various investments to determine what you’ll need to live on.

How a Rollover Works

You can’t roll a 401(k) directly into a Roth IRA. First, you’ll have to make something called a traditional IRA stop. That means you’ll roll the 401(k) to the traditional IRA, tax-free, then do a Roth IRA conversion. A brokerage firm can handle the conversion, usually through a trustee-to-trustee transfer.

It's essential that the money is transferred directly from one financial institution to the other. In other words, don’t have your former employer issue you a check for the amount, which you then put into a Roth IRA. If you do it that way, the employer will be required to withhold 20 percent for taxes, plus you’ll be responsible for penalties unless you meet the minimum age requirement of 59½.

Rollover Fees

The good news is, you probably won’t face any fees to roll your 401(k) over to a Roth IRA or any other type of investment account. A brokerage or financial institution should be more than happy to help you invest your money with them. There’s a reason for that: they can charge fees on managing that account, which is how they make money.

In addition to the amount you’ll spend on rollover 401(k) to Roth IRA tax consequences, you should also consider the fees you’ll pay. Fees will be nothing new, though. Your 401(k) had per-fund costs, administration fees and more. You may be able to save money with your Roth IRA since you aren’t limited to the investment options an employer offers.

Limits on Contributions

Before you move your money over, you should pay close attention to the 401(k) and IRA contribution limits. 2018 tax laws allowed you to contribute up to $5,500, or $6,500 for those aged 50 and over. In 2019, that limit increased to $6,000 and $7,000, respectively. If you’re used to 401(k) limits, this will be quite an adjustment. The limit on 401(k) contributions for tax purposes was $18,500 in 2018, increasing to $19,000 in 2019.

If you’ve had a 401(k) for a while, you probably have quite a bit of money in it. The good news is, you can roll over the entire amount, even if it exceeds the limit for that year. The contribution limits apply to any money you contribute to the new Roth IRA once it’s in place.

Taxes on Roth IRAs

Now that you are aware of the rollover 401(k) to Roth IRA tax consequences, it can help to know exactly what you can expect to pay in taxes the year you do the conversion. The converted amount will be taxed as ordinary income, which means you’ll need to look at the tax brackets to determine exactly how much you can expect to pay. It’s also important to note that this additional income for the year can push you into a higher tax bracket, which will increase your overall tax burden.

Experts recommend not using the money from your 401(k) to pay the taxes on the funds you’re converting. That means you’ll need to pull that money from other accounts – something that is important to plan for before you initiate the conversion. You may also need to pay estimated taxes throughout the year to avoid an underpayment penalty when you file in April.

401(k) to Traditional IRA

Rolling your 401(k) over to a traditional IRA will be an easier process. While you’ll still need to pay attention to the 401(k) and IRA contribution limits for 2018 and 2019, you won’t face any tax repercussions for doing so. However, at retirement time, when you take the money out of your traditional IRA, that money will be taxed as ordinary income.

In addition to being limited by 401(k) and IRA contribution limits for 2018, your rollover will also trigger taxes unless you do a direct shift. It will need to be moved from the existing 401(k) account to the traditional IRA account to avoid those tax consequences. But some people do choose to do something called an indirect rollover to set a little extra cash aside, which will require your employer to withhold 20 percent for federal taxes, plus a 10 percent early-withdrawal penalty if you’re under the age of 59½.

401(k) to Roth 401(k)

Like a Roth IRA, a Roth 401(k) gives you a tax break at retirement time. However, that means you’re supposed to put after-tax money in, which is not the typical setup when your 401(k) is with an employer. You may be given the option to convert your 401(k) to a Roth 401(k) at an existing employer, or a new employer may have that option, giving you an incentive to move over the money you have with a previous employer’s 401(k).

As with moving a 401(k) to a Roth IRA, you will be required to pay taxes on the amount you’re converting. You can look at your tax bracket to determine how much that will cost you since the amount will be taxed as ordinary income. Whether the move is worth it depends on whether you’d rather pay taxes now or when you retire. An annuitization calculator could help you determine how much your monthly payout will be at retirement so that you can make an informed decision about paying taxes now versus later.

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About the Author

Stephanie Faris has written about finance for entrepreneurs and marketing firms since 2013. She spent nearly a year as a ghostwriter for a credit card processing service and has ghostwritten about finance for numerous marketing firms and entrepreneurs. Her work has appeared on The Motley Fool, MoneyGeek, Ecommerce Insiders, GoBankingRates, and ThriveBy30.

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