To convert or not to convert?

Rolling a 401(k) into a Roth IRA  

Rolling your 401(k) into a Roth IRA can be a strategic move for certain clients to optimize their retirement savings, but it requires a consultation with your financial advisor and your tax advisor to ensure you understand the tax consequences, specific rules, and eligibility criteria. Here’s a brief overview: 

 

Pros and cons of rolling a 401(k) into a Roth IRA 

• Pay tax on converted amounts now, enjoy tax-free withdrawals later: One of the most significant advantages of a Roth IRA is that qualified withdrawals are tax-free. This is particularly beneficial if you expect to be in a higher tax bracket during retirement. Keep in mind, however, that when you convert amounts from your 401k to a Roth IRA, it is a taxable conversion, and you will owe taxes on the converted amount. In exchange, your future withdrawals, including investment earnings, should be tax-free so long as they are qualified withdrawals. If you expect to be in a lower income tax bracket in retirement, however, a conversion may not be as beneficial for you.  

• No required minimum distributions (RMDs): Unlike traditional IRAs and 401(k)s, Roth IRAs do not require you to take minimum distributions at age 73. This allows your savings to grow tax-free for longer, providing more flexibility in your retirement planning. 

• Estate planning benefits: Roth IRAs can be an excellent tool for estate planning. Since they do not have RMDs, you can leave the entire account to your heirs, and they will not be required to take RMDs after your death. Beneficiaries can also take advantage of tax-free withdrawals, provided the account has been open for at least five years. 

• Diverse investment options: Rolling your 401(k) into either a Traditional IRA (no conversion) or a Roth IRA (taxable conversion) may give you access to a broader range of investment options. Many 401(k) plans offer limited investment choices, whereas Traditional IRAs and Roth IRAs generally provide more flexibility in selecting mutual funds, stocks, bonds, and other securities. We recommend that every client consult with an accountant or tax advisor before implementing any taxable conversion strategy. 

 

Roth conversion rules 

• Taxes on conversion: When you convert a 401(k) to a Roth IRA, you will owe taxes on the amount converted. This is because 401(k) contributions are typically made with pre-tax dollars, and Roth IRA contributions are made with after-tax dollars. The amount converted is added to your taxable income for the year, potentially pushing you into a higher tax bracket. It is optimal to use after-tax funds to pay the taxes, allowing you to keep the 401(k) funds intact as you convert. 

• Five-year rule: There are two five-year rules to be aware of with Roth IRAs. First, to avoid paying taxes on earnings, your Roth IRA must be open for at least five years before you can take tax-free withdrawals. Second, each conversion starts a new five-year clock for penalty-free withdrawals of the converted principal. 

• Conversion limitations: There are no income limits or maximum dollar amounts for Roth conversions. However, you need to plan carefully to manage the tax impact, especially if converting a large 401(k) balance in a single year. 

 

Roth IRA eligibility criteria 

• Income limits for contributions: While there are no income limits for converting a 401(k) to a Roth IRA, there are income limits for contributing to a Roth IRA. For 2024, if your modified adjusted gross income (MAGI) is $153,000 or more (single filers) or $228,000 or more (married filing jointly), you cannot contribute directly to a Roth IRA. 

• Contribution limits: For 2024, the contribution limit for a Roth IRA is $6,500 or $7,500 if you are age 50 or older. These limits apply to the combined total of all your IRA contributions for the year. 

 

Retirement savings optimization 

• Tax diversification: By rolling a 401(k) into a Roth IRA, you can potentially diversify your tax exposure in retirement. Having both tax-deferred (401(k) or traditional IRA) and tax-free (Roth IRA) accounts gives you more flexibility in managing your tax liabilities. 

• Potential for growth: With no RMDs, funds in a Roth IRA can continue to grow tax-free throughout your retirement. This can significantly increase your retirement savings, especially if you live longer or do not need to withdraw the funds immediately. 

• Flexible withdrawal strategy: Roth IRAs provide more flexibility in your withdrawal strategy. Since withdrawals are tax-free, you can use them to manage your taxable income in retirement. For example, you might draw from your Roth IRA in years when other income pushes you into a higher tax bracket, minimizing your overall tax burden. 

 

Steps to roll a 401(k) into a Roth IRA 

• Check eligibility: Ensure that you are eligible to roll over your 401(k). Consult with your accountant or tax advisor to ensure that it makes financial sense, given your current tax situation and future plans. 

• Open a Roth IRA: If you don’t already have a Roth IRA, you will need to open one with a financial institution that offers the investment options you want. 

• Initiate the rollover: Contact your 401(k) plan administrator to initiate the rollover. You can choose a direct rollover, where the funds go directly from your 401(k) to your Roth IRA, or an indirect rollover, where you receive the funds and then deposit them into the Roth IRA within 60 days. 

• Pay taxes: Be prepared to pay taxes on the converted amount. Consult with a tax professional to understand the implications and plan for the tax payment. 

 

For more information, please reach out to Alpine Bank Wealth Management. Together, we can develop a personal financial strategy based on your lifestyle and financial needs. 

*Alpine Bank Wealth Management services are not FDIC insured, may lose value, and are not guaranteed by the bank. 

• August 13, 2024
• Financial
• Alpine Bank Staff

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