If you have a 401(k) and want to roll it over into an IRA, you may or may not have to pay taxes on the rollover. Generally, 401(k) rollover tax implications only come into play when you're rolling the pretax funds over into a Roth IRA, which is funded with post-tax earnings.
A 401(k) Account Is Pretax
The reason rollovers may create tax liability is because a 401(k) is funded by pretax dollars, while some IRAs are funded by post-tax dollars. When your employer takes money out of your paycheck to put into your 401(k) account, it does so before it takes out the taxes. This reduces your taxable income for the year and defers taxation of those amounts until you withdraw them from the account. Ostensibly, you won't pay taxes on any of the funds in your 401(k) until you receive distributions at retirement.
Some IRAs Are Pretax and Some Are Post-Tax
Traditional IRAs are similar to 401(k) accounts in that they are funded from your pretax earnings. Roth IRAs are different, however. If you have a Roth IRA, you fund the account with post-tax dollars. That is, you earn your money, you pay taxes on those earnings, and then from the remainder, you contribute to the Roth.
Your 401(k) Plan Is Tied to Your Employer
You cannot have a 401(k) on your own; they're only available through your employer. Most 401(k) plans have a vesting period of a certain number of years of employment. If you work for your employer for the entire vesting period, all the money in the 401(k) is yours if you leave. If you leave before you're fully vested, you can take any contributions you made and the interest applicable to those contributions with you, but you'll only get a percentage of the employer matching contributions in the account.
Options for 401(k) Funds After Leaving Your Job
If you do leave your job and are fully or partially vested in your 401(k), you'll have to look at your plan to see your options. Some plans allow you to leave your money there, even if you don't work for your employer anymore. If you do that, however, you won't be able to contribute any further. If you simply withdraw the money and put it into a new retirement account within 60 days, you'll have to pay tax on the entire withdrawal. If you're under 59 1/2, and you're also under 55 and aren't turning 55 that year, and you aren't permanently and totally disabled, you'll also have to pay a penalty of 10 percent. Your third option is usually the best one, and that's a rollover.
What Is an IRA Rollover?
A rollover is simply the act of taking the money from one tax-exempt retirement account and moving it to a different one. You can roll over funds from a 401(k) to an IRA, or from an IRA to another IRA. You can either do a direct rollover, where your 401(k) plan sends the money directly to your IRA, or you can do it indirectly, where you make the withdrawal yourself and deposit the funds into the IRA yourself. If you choose an indirect rollover, you have to move the money into the IRA within 60 days.
Rules for Rollovers From a 401(k) Plan
Any amount you take from your 401(k) can generally be rolled over, with a few exceptions. For example, if you take a hardship distribution from your 401(k), you can't change your mind and then roll it over instead. If you take money out and only roll over some of the funds, you'll be taxed on the funds not rolled over, plus the 10 percent penalty, if applicable.
IRA Rollover Rules
The rules for rollovers to an IRA are the same as the 401(k) rollover rules. You can either withdraw the money yourself and deposit it into the new IRA within 60 days, or you can have the institution that holds the 401(k) to transfer directly to the new IRA. There is a limit on how many times you can roll over between IRAs; if you roll funds over from one IRA to another IRA, you cannot do another IRA-to-IRA rollover for the next 12 months with either of those accounts. That limitation is not applicable to a rollover from a 401(k) to an IRA.
IRA Contribution Limits
If you have an established IRA, regardless of the type of IRA, you're limited as to how much you can contribute to it. In 2018, you cannot contribute more than $5,500 to any IRA account; that figure is increasing to $6,000 for 2019. If you have more than one IRA, your contribution limits are stretched across all your IRAs. This means if you have three IRAs, you can only contribute $5,500 total to all three of them (you can't contribute $5,500 each).
401(k) to IRA Rollover Limit
Fortunately, the IRA contribution limits don't apply to rollover contributions. If you have $10,000 in your 401(k) or $100,000, you can roll over the entire balance to an IRA. Once you've completed the rollover, you're subject to the annual contribution limits going forward.
401(k) Rollover Tax Implications
If you roll over funds from a 401(k) to a traditional IRA, and you roll over the entire amount, you won't have to pay taxes on the rollover. Your money will remain tax-deferred, and you won't be taxed on it until you withdraw money from it permanently.
Rolling Over Into a Roth IRA
The rules are a little different when you roll a 401(k) distribution into a Roth IRA versus a traditional IRA. Because Roth IRAs are funded by post-tax money, and 401(k) plans are pretax, you'll have to pay taxes on the money from the 401(k) before you can move it into a Roth IRA.
Contributing to a Roth IRA
You can only contribute your post-tax dollars to a Roth IRA if you make less than $135,000 in modified adjusted gross income for 2018 ($199,000 for married couples filing jointly). If you make between $120,000 and $135,000 ($189,000 to $199,000 for married filing jointly), your contribution limit is gradually lowered from the traditional IRA limit of $5,500 until it reaches zero at $135,000. In 2019, those figures are increasing. Single taxpayers will have their limits reduced between $122,000 and $137,000, and must stop contributions at $137,000; married taxpayers will see limits reduced between $193,000 and $203,000, and cannot contribute if they make more than $203,000.
Roth IRA Conversion
If you have a 401(k) and want to roll it over into a Roth IRA, you must first roll it over into a traditional IRA, and then convert that IRA into a Roth IRA. Once the first rollover is complete, contact your financial institution that holds the IRA and take whatever steps are necessary to convert the IRA to a Roth IRA. Because the funds are pretax and are going into a post-tax account, you'll have to pay taxes on the rollover (but you won't have to pay any early withdrawal penalty). To report the conversion, you'll complete a Form 8606 and submit it with your tax return for the year of the conversion to report the income. You'll be taxed on the rollover at the ordinary income tax rate.
- IRS: Rollovers of Retirement Plan and IRA Distributions
- IRS: Rollovers of After-Tax Contributions in Retirement Plans
- IRS: Publication 575 (2017), Pension and Annuity Income
- IRS: Topic Number 451 - Individual Retirement Arrangements (IRAs)
- IRS: 401(k) Resource Guide - Plan Participants - General Distribution Rules
- Wells Fargo: 401(k) and Other Qualified Employer Sponsored Retirement Plan Distribution Option FAQs and Answers
- CNN Money: How Does Vesting Work Exactly?
- IRS: Retirement Topics - IRA Contribution Limits
- IRS: Amount of Roth IRA Contributions That You Can Make for 2018
- IRS: Amount of Roth IRA Contributions That You Can Make For 2019
- IRS: Publication 590-A (2017), Contributions to Individual Retirement Arrangements (IRAs)
Rebecca K. McDowell is an attorney focusing on creditor and debtor law. She has a B.A. in English and a J.D. She has written finance and tax articles for Pocketsense and eHow.