401k Funds to Roth IRA?

How to Convert a 401k funds to a Roth IRA-The Process

The question comes to me occasionally.  It goes something like this….”How do I convert a 401k to a Roth IRA?” or “How Do I rollover my 401k to a Roth IRA?”

The answer really is this……you can’t.  At least not the way the question is asked.  Let me explain.

When you are enrolled in a traditional 401k plan, and have made contributions to that 401k, the contribution amounts (or withholdings) were not taxed.  Those funds went right into the 401k account and bypassed being included in your taxable income on your income tax return the following year.

Part I:  Rolling Over a 401k

Why does this matter?  Well, the IRS wants taxpayers to keep untaxed money with untaxed money.  So, to execute a 401k rollover, the amount must be rolled over to a Traditional IRA, where funds are yet to be taxed as well.  This joins “like accounts” as both account types (and the funds that they contain) are yet to be taxed.  In other words, we cannot directly convert a 401k to a Roth IRA.  We have to first roll the amount into a traditional IRA.

OK. We have now made our 401k to IRA rollover.  The first step of our two-step process is over.

Part II:  IRA Roth Conversion

The IRS has determined that you now may convert your Traditional IRA funds to a Roth IRA without penalty.  However, it is important to note that you will pay ordinary income tax on these assets.

You should now contact your financial advisor or custodian and make your request, telling them that you want to move funds from your traditional IRA to a Roth IRA.  Your advisor opens a Roth IRA for you and you’re off and running.  

Just a note, you will get a 1099 tax form at the beginning of the following year showing the amount converted and any corresponding withholding amounts as well.

What is the tax effect?  Well, it depends on your marginal tax rate.  If you converted $10,000 and your marginal Federal Tax rate is 25%, then you will have an additional $2,500 tax due on the following year’s return.  

If this process is done as it should be, there will not be a penalty on any part of the process.  Just make sure that all transfers (rollovers) are made from one account to the next.  Do not take control of the assets personally.  

So, here’s how it looks in bullet form:

• Request transfer of 401k assets to a Traditional IRA, then,
• Request a conversion of those assets in the Traditional IRA to a Roth IRA.

Roth Conversion Tax Tip

The following process helps to optimize what portion to convert from a Traditional IRA to a Roth IRA.  This process is especially helpful when next year’s income is comparable to this year’s income.  

Remember, you don’t have to convert the whole amount in one year.  Spread it out over three or four years if it makes financial sense.  Here’s the Roth conversion tax tip.

• Check your current year’s taxable income on your tax return and compare it against next year’s tax tables.
• Find the Marginal Income Tax Bracket in which you belong.
• Subtract the largest taxable income figure you can report and still belong in the current bracket in which you are taxed.
• Convert an amount UP TO the higher bracket and no more.

Following the numbers of this tax tip may allow you a Roth conversion amount that is less than you would like.  However, it will keep you from jumping up with a marginally higher tax bill on at least some of the Roth Conversion.

To summarize, the process to convert a 401k to Roth IRA is not for everyone.  Not everyone is eligible for 401k withdrawals and for those that are, not all should make them.

 

401kFundAdvice offers investment advice on any type of investment account, including Roth IRA's and 401k's.