Retirement: How to Roll a 401(k) to Roth IRA

I would like to know the best way to roll a 401(k) over to a Roth IRA and the tax consequences–Reuters Prism Money blog post

This reader brought up a good point in response to another Prism Money story posted February 2, “Don’t lose retirement money with a rollover mistake.” Successfully rolling over a Roth IRA does have some other considerations since the tax laws governing a traditional IRA are different than those for a Roth IRA.

As you probably know, a Roth IRA grows income tax free and you’re not required to begin to take minimum distributions at age 70-and-a-half. So as long as you or your beneficiaries own it, the account can grow tax-free. You don’t get a tax deduction when you make a contribution but your withdrawals are tax-free. In contrast, with a regular IRA, your contributions and the growth are not taxed until the money is withdrawn.

So what is the best way to roll over a 401(k) to a Roth IRA? First things first, you must have left your job to rollover a 401(k). “From a tax standpoint, you can go directly into a Roth,” says Jonathan Davis, a managing director at Lenox Advisors. “They [account holder] would pay ordinary income tax,” he says.

The tax treatment aside, there are other considerations. For the right person, this can be a very good trade. “A rule of thumb revolves around age — a younger person, who has a minimum 20-year-horizon, can pay the tax up front,” says Davis. For an estate, this strategy can create significant wealth because there aren’t any required distributions. “That’s a huge difference,” he says.

In general, depending on the person, it makes a huge amount of sense for people who have the cash outside the IRA to pay the taxes. Say you have $100,000 and your tax bill is $30,000. “If you have to take the $30,000 out of the Roth and you are under 50-and-a-half 59-and-a-half, then you will be penalized,” says Peter Lang, managing director of Strata Wealth Management. “You have to have the money outside the account to pay the taxes for the rollover to work,” he says. At a younger age, it clearly makes sense because the account grows tax-free and the withdrawals are tax free assuming it has been in the account for more than five years.

But be aware, that it doesn’t have to be an all or nothing solution. “You can do parts as a Roth, or leave parts in a plan or put parts in a traditional IRA,” says Greg Rosica, a tax partner and contributor author to the Ernst & Young Tax Guide 2011. In deciding what strategy you’ll use, consider what your future tax rate may be, what kind of growth may occur in the account and whether or not there will be a need to withdraw the funds. “If an individual is relying on these funds it is different than someone who will never touch it and pass it into an estate,” says Rosica.Realize, however, that you may want to rollover your 401(k) into a Roth IRA but, in some cases, your company may not have that option. In this scenario, you’ll need to go through an IRA first, says Mitchell Kaufmann, a financial advisor and financial planning instructor at University of California at Santa Barbara. Then you’ll need to have the Roth IRA already established before other steps are taken.

As with any rollover, it is always best to do a direct distribution where the funds are send from the employer 401(k) to the Roth IRA without touching the money. “This avoids any implication of receipt and simplifies paperwork and record keeping, says Kaufmann.

Another issue to understand is the five-year holding rule. For the Roth IRA to retain it characteristics once you hit 59-and-a-half, you have to have invested five years prior to time you withdraw the funds, “ says Rosica.

To be sure, “there are a lot of nuances and it is complicated,” says Lang. That is why you need to really to think through your entire situation — look at the pros and cons — before you make a decision. The situation will be different for everyone.