Month: September 2024

Thinking of rolling over a 401(k) into an IRA? There are tax and flexibility advantages. But tread carefully.

By Adam Shell

Published July 16, 2024

Rolling over a 401(k) into an IRA is an effective way to keep retirement savings growing when you plan to switch jobs or retire from the 9-to-5 for good. This type of rollover can also confer tax benefits and give you more control over your investments. 

A 401(k), of course, is an employer-sponsored retirement savings plan. In contrast, an IRA, or individual retirement plan, is a personal account set up at a brokerage firm or mutual fund company that the saver manages.

Rolling over a 401(k) to an IRA allows you to move funds from your previous employer’s retirement plan into an IRA. The big benefits of a rollover is that you can preserve the tax-deferred status of your retirement account, avoid a distribution that results in a tax bill, and sidestep early withdrawal penalties if you haven’t yet reached the full retirement age of 59 ½ when you move the money to the IRA.

“A rollover from a 401(k) to an IRA is about the added flexibility, the greater range of investment options, and continuing to maintain the same tax advantages that you had in your 401(k),” said Rob Williams, managing director of financial planning at Charles Schwab.

Rolling over a 401(k) into an IRA

Of course, rolling over a 401(k) plan into an IRA isn’t your only option. “You have a choice,” said Williams. You can always leave your nest egg in your former employer’s 401(k) if they permit you to do so. You may also have the option of rolling your money into your new employer’s retirement plan. You could also opt for a cash distribution and take the money and run, but that option could result in taxes and paying a 10% penalty if you’re younger than 59 ½.

There are many reasons why rolling over a 401(k) plan to an IRA makes the most financial sense.

• Rollovers are tax-friendly. You’ll maintain the tax-deferred status of your retirement account and avoid taxes and potential penalties. If you move your account balance from a 401(k) to an IRA your money will continue to grow tax-free and allow more of your savings to benefit from compounding.
• IRAs offer a wider range of investment choices. 401(k) plans have a limited number of investment options to choose from, and typically include broadly diversified stock and bond funds, as well as target-date funds that adjust the fund’s risk profile as the investor gets older. In contrast, IRAs provide investors with a much wider array of investment choices, including the ability to invest in any mutual fund or ETF offered by a slew of different mutual fund companies, but also individual stocks, bonds, and CDs.
• Rollovers keep you from raiding your nest egg. Saving for retirement is a long game. Building wealth through automatic payroll deductions to a 401(k) takes decades. Your path to a secure retirement gets that much tougher if you raid your 401(k) or take a lump-sum payout if you leave a job or retire before age 59 ½. “Taking a lump sum can be tempting, but avoid the temptation,” said Williams. Rolling over a 401(k) to an IRA helps you avoid shrinking your account balance as well as paying taxes and penalties on early distributions.

It makes sense to roll over a 401(k) to an IRA if your ex-employer’s retirement plan doesn’t offer a wide breadth of investment options and charges high fund investment fees and administration expenses, notes Christine Benz, director of personal finance and retirement planning for fund-tracker Morningstar.

Knowing the difference between a direct IRA rollover and an indirect rollover is also important. A direct rollover — which personal finance experts recommend — is when the administrator of your 401(k) plan delivers your distribution check directly to the financial company where your IRA rollover is set up. The main benefit of a direct rollover is you never touch the money and, therefore, avoid the risk of being hit with a tax bill on the distribution from the IRS or paying the 10% early withdrawal penalty if you’re not yet at full retirement age.

In contrast, an indirect rollover is when your 401(k) administrator sends your assets directly to you, typically in the form of a check. It is then your responsibility to roll over all the assets into an eligible plan, such as a rollover IRA, within 60 days of receiving the distribution. The 60-day rule is important to understand. If you don’t roll over your 401(k) to an IRA within the 60-day grace period, the money will be treated as a distribution and will be taxed at your ordinary income rate. If you’re younger than 59 ½, you’ll also be subject to a 10% penalty. If your employer-sponsored plan sends a check directly, they might be required to withhold 20% in federal income taxes, although you can recover that money if you rollover your total 401(k) balance. (The IRS, however, may waive the 60-day rollover requirement in certain situations if you missed the deadline because of circumstances beyond your control. But it’s best to avoid this inconvenience if possible.)

Rolling a 401(k) into a Roth IRA

Savers in traditional 401(k)s — accounts funded with pre-tax dollars that are taxed as ordinary income at the time of withdrawal — can roll over their money into a Roth IRA. But there’s a catch. “The transaction is effectively a Roth conversion,” said Nilay Gandhi, senior wealth advisor at Vanguard. Since Roth accounts are funded with dollars that have already been taxed but come with tax-free withdrawals, you will have to pay taxes at your personal income tax rate on any traditional 401(k) assets you roll over to the Roth IRA at the time of the conversion, according to IRS rules.

The calculus — or bet you’re making — when rolling over a 401(k) into a Roth IRA is that you will be in a higher tax bracket in retirement than you are now, says Gandhi. Here are ways to reduce your tax burden now if you opt for a rollover from a traditional 401(k) to a Roth IRA. 

Do the rollover in years when your reported taxable income is lower. The timing of your rollover to a Roth IRA is also critical. Just as a contestant on The Price Is Right who wins a new car is responsible for the tax bill on that “extra” earned income the car’s value represents, so too is a retirement saver responsible for paying taxes on the 401(k) assets he or she rolls over into a Roth IRA. 

One way to reduce the hit is to do the conversions over a number of years rather than converting the whole thing at once. Say you have $500,000 in your 401(k). You could roll over the total balance over four or five years, which means you’ll only add $100,000 or $125,000 to your taxable income in a single tax year instead of the entire $500,000.

But remember, in order to take tax-free withdrawals from a Roth, you must be at least 59½ and have held the account for at least five years. Otherwise, you could owe taxes on your earnings and a 10 percent early-withdrawal penalty, too. So, rolling over a 401(k) to a Roth IRA makes less sense if you need access to the money now.

There are reasons, though, to keep your money in your existing 401(k) plan. Such factors include things like finding value in the tools and advice that your employe-sponsored plan offers. And for those under the age of 59 ½ who think they might need to tap their retirement account at some point, a 401(k) allows you to take loans against your balance, whereas an IRA does not. “Where there are needs for liquidity or access to the funds, it may still make sense to leave the money in the 401(k),” said Gandhi.

Source: https://www.kiplinger.com/retirement/401ks/rolling-over-a-401k-into-an-ira

by Miranda Marquit

updated: September 1, 2024

One way to increase your retirement savings is to use a tax-advantaged retirement account. These are accounts for which the government offers special provisions in an effort to encourage people to build a nest egg.

A Roth IRA makes sense for someone who doesn’t mind paying taxes now in order to avoid paying them on withdrawals later. Conversely, a traditional 401(k) makes sense for those who look for a tax deduction today and are prepared to pay taxes on distributions. It’s also an important choice if your employer offers matching contributions.

It’s possible to have both types of accounts to manage your tax situation in retirement. Let’s take a look at how each operates, so you have a better idea of what might work for you.

Examining the differences between a Roth IRA and a 401(k)

First, it’s important to understand the differences between these two categories of tax-advantaged accounts. Here are the issues you need to consider.

Tax treatment

A traditional 401(k) offers a tax benefit today. You make contributions, and those contributions are then deducted from your taxable income in the year you make them, lowering your tax bill. In your account, your investments grow tax deferred, meaning that you’ll eventually have to pay taxes on the money you withdraw from your account.

With a Roth IRA you make contributions using after-tax dollars, so you don’t see a lower tax bill today. As with a 401(k), your investments grow tax free. But when you take distributions later on, you won’t pay taxes on your Roth IRA money. That means, unlike with a 401(k), all the earnings on your Roth come to you tax-free at retirement.

You may have a third choice. Some employers offer a designated Roth 401(k) option. This combines elements of both categories: As with an IRA, you contribute after-tax dollars and get no tax deduction in the year when you contribute. However, the amount you can contribute is the same as for a traditional 401(k). And that makes a big difference.

Contribution limits

Contribution limits for a 401(k) are much higher than Roth IRA contributions. In 2023 you can contribute up to $22,500 to a 401(k). Compare that with only $6,500 to a Roth IRA. For those 50 and older, it’s possible to make extra contributions of up to $7,500 to a 401(k) and $1,000 to a Roth IRA. In 2024, contribution limits go up to $23,000 for a 401(k) and $7,000 for a traditional or Roth IRA. The catch-up contributions for 50+ workers remain the same.

Additionally, there are income limitations on a Roth IRA. Once you reach a certain income threshold based on your filing status, you can no longer contribute directly to one. Instead, if you want to make contributions, you need to use a “backdoor” Roth, which involves contributing to a traditional IRA and rolling over the money. Be aware of tax consequences—and complicated tax rules, such as the pro rata rule—entailed in using this method.

Early withdrawal rules

It’s possible to withdraw money early from a traditional 401(k) for limited purposes or by using various rules (such as the rule of 55, which lets you take penalty-free distributions if you leave your job at age 55 or older). However, for the most part you’re likely to see a penalty if you take distributions prior to age 59½. You’ll also pay taxes on the amount you withdraw.

With a Roth IRA it’s possible to withdraw your contributions to it penalty free and tax free at any time. There is a penalty for withdrawing any investment earnings on those contributions prior to age 59½, though. Some exceptions exist for early withdrawals, even for earnings, but it’s important to check with a financial professional or tax professional to understand the consequences.

Required minimum distributions (RMDs)

Your 401(k) comes with required minimum distributions (RMDs) once you reach 72—73 if you reached 73 after Dec. 31, 2022. You’re required to take a certain amount from your account at that point based on the account size and your age. If you don’t take RMDs, you’re subject to penalties. With a traditional IRA, you owe taxes on your RMDs; with a designated Roth, you don’t (but you lose the tax-free growth you get within the account).

The Roth IRA has no RMD requirement in the owner’s lifetime, though heirs are subject to one.

401(k) vs. Roth IRA: Pros and Cons

Depending on your goals, one account might work better for you. A Roth IRA offers tax-free investment growth and no RMDs, but there are bigger limits on contributions, and you don’t get a tax benefit today. A traditional 401(k) offers the opportunity to put away more and get a tax benefit today, but you will owe taxes later when you withdraw and must take RMDs. A designated Roth 401(k) doesn’t provide tax benefits today, but all your withdrawals will be tax-free, including RMDs.

This chart can help you compare the features of traditional and designated Roth 401(k)s vs. a Roth IRA.

Feature	Traditional 401(k)	Designated Roth 401(k)	Roth IRA
Contribution limits	$22,500 in 2023, with a catch-up contribution of $7,500; $23,000 in 2024, with a catchup contribution of $7,500	$22,500 in 2023, with a catch-up contribution of $7,500; $23,000 in 2024, with a catchup contribution of $7,500	$6,500 in 2023, with a catch-up contribution of $1,000; $7,000 in 2023, with a catch-up contribution of $1,000
Income limits	None	None	In 2023 the phase-out starts at $138,000 for a single filer, $153,000 for a head of household, and $218,000 for joint filers; in 2024, the phase out starts at $146,000 for a single filer, $161,000 for a head of household,and $230,000 for joint filers.
Withdrawals	Early withdrawals come with penalties and taxes	No penalty for early withdrawals of contributions	No penalty for early withdrawals of contributions
Taxes	Tax deduction on contribution, pay taxes when taking distributions	Contributions with after-tax dollars, but there are no taxes on distributions	Contributions with after-tax dollars, but there are no taxes on distributions
RMDs	Yes	Yes, but tax-free	No (in account owner’s lifetime)

When is a 401(k) a better retirement savings option?

A traditional 401(k) works well if you want a tax benefit today and plan to set aside more for the future. The higher contribution limit, plus the potential for an employer match, can help you build a nest egg faster. There are also no income limits on contributing to a 401(k) the way there are for a Roth IRA.

However, you also need to engage in tax planning for later. The hope is that you’ll have lower taxes during retirement, so your withdrawals won’t cost you more. And unlike with a Roth IRA, you will pay taxes both on your original contributions and on all the earnings they accrued while in your account.

A designated Roth 401(k) offers the higher contributions of a traditional 401(k) with the tax-free withdrawals of a Roth IRA and has no income limits. However, you don’t get a tax deduction when you make your contributions.

When is a Roth IRA a better retirement savings option?

If you want to diversify your tax situation in retirement, a Roth IRA can make sense. For those who are just starting out and don’t expect to pay much in taxes today, it can be a good vehicle. It’s possible to pay taxes on the money at a lower rate and then take advantage of tax-free growth.

And because you can withdraw your contributions (not earnings) at any time without penalty, a Roth may be a less daunting way to put aside money. It’s not the best choice because you lose future savings,, but in an emergency you have easy access to Roth contributions.

What’s more, without RMDs it’s possible to let the Roth IRA grow for as long as you wish. You can even leave it to someone in your will.

Other retirement investment options

You don’t have to rely on either type of 401(k) or a Roth IRA. There are other ways to invest for your future.

Traditional IRA

You can contribute to a traditional IRA if you don’t qualify for the Roth IRA. You receive a tax deduction for your contributions and they grow tax free while in the account. However, you have to pay taxes when you withdraw at retirement. Additionally, you’ll be subject to early withdrawal penalties on contributions.

Another version of the traditional IRA is the SEP IRA, which is aimed at business owners. If you’re self-employed, you can take advantage of a higher contribution limit with a SEP IRA. For example, you can contribute up to $66,000 in 2023 and up to $69,000 in 2024.

Health Savings Account (HSA)

If you qualify for a health savings account (HSA), you will be able to set aside money for current and future medical expenses. You can invest a portion of your account, which rolls over year to year. Contributions to an HSA are tax deductible, and the money is tax free when you withdraw it for qualified expenses. You might be able to use the HSA as a healthcare account in retirement. However, to be eligible to open this account, you must have a high-deductible health plan (HDHP), which may not meet your health insurance needs.

Taxable investment account

Don’t forget about a “regular” taxable investment account. You don’t have to worry about contribution limits or early withdrawals with one of these accounts. This can be a way to supplement your plans for early retirement. Just be aware of the capital gains taxes that come with investment earnings.

TIME Stamp: Consider a plan with a combination of accounts

There are several different accounts you can use to increase your wealth for retirement. There’s no one right answer, and it’s possible to use a combination of accounts to better manage your taxes later. Create a plan that includes different accounts designed to help you meet your goals. You can invest with confidence online while managing your accounts with tools such as Empower.

Frequently asked questions (FAQs}

At what age does a Roth IRA make sense?

While a Roth IRA can make sense at any age, some experts suggest it might be best for younger workers early in their careers. At this point taxes are generally lower, so it might make sense to contribute to a Roth IRA and take advantage of tax-free withdrawals later on. What’s more, younger workers are more likely to have lower earnings and qualify to contribute to a Roth IRA.

Can I take a loan from my Roth IRA?

Generally you can’t take loans from a Roth IRA. However, there are certain circumstances under which you can take early withdrawals without penalty, including that you can withdraw your contributions (not earnings) at any time. You can also temporarily remove money from your Roth IRA—then roll it over back into your account within 60 days—to avoid having it considered an early or a hardship withdrawal.

What is a typical company match for a 401(k)?

It’s not uncommon to see companies match 50 cents on the dollar, up to 6% of income. However, according to a Fidelity analysis from 2019, the average 401(k) match is around 4.7% of income.

TIME Stamped is paid a flat fee for each successful referral to Herring RIA Sub, LLC (“Playbook”) made through our links. TIME Stamped is not a Playbook client. There is no guarantee that clients will have similar experiences or success.

Source: https://time.com/personal-finance/article/roth-ira-vs-401k/