Are There Tax Consequences of Rolling a 401(k) Into a Roth IRA?

Saving for retirement is an important consideration, and 401(k) retirement savings plans, offered by many employers, can make it easy. But what happens if you change jobs? You can always keep your existing account, but you also have the option to transfer—or rollover—your account into an individual retirement account (IRA). 

There are two main types of IRAs from which to choose. Traditional IRAs let you set aside some of your income before it’s taxed, just like your typical 401(k). You’ll pay taxes later, during retirement, when you make withdrawals. By contrast, Roth IRA contributions are made from funds that have already been taxed. When you withdraw those funds during retirement, you won’t be taxed again.

Depending on the type of 401(k) you have, rolling over to a Roth IRA may have some tax consequences. Let’s take a look.

Tax Consequences When Rolling a 401(k) Into a Roth IRA

There are two main types of 401(k) plans available. Traditional 401(k) plans allow you to deposit pre-tax money into your retirement account. You’ll need to pay taxes on these funds when you withdraw them. 

Roth 401(k) plans, meanwhile, consist of after-tax money you contribute to your account. As a result, you won’t owe any additional money when it comes time to withdraw. The same is true for a Roth IRA.

This means that there are tax consequences if you roll over a 401(k) to Roth IRA. Because a standard 401(k) is funded with before-tax dollars, you will need to pay taxes on those funds in order to move that money into an after-tax funded Roth IRA account. 

How Much Will I Pay in Taxes for Rolling a 401(k) Into a Roth IRA?

If you’re looking to roll your traditional 401(k) into a Roth IRA, the taxes you’ll need to pay will be calculated based on your income. The IRS uses marginal tax brackets to decide your tax burden.

Let’s say that you worked as an administrative assistant at your previous employer. You’re unmarried and your annual salary was $65,000 after deductions, putting you squarely into the 22% tax bracket for tax year 2023. Now you’ve left your job and you’re looking to roll your standard 401(k) plan into a Roth IRA. 

You didn’t work for your employer for very long, so the total amount in the account is just $12,000.  As we noted above, this $12,000 was contributed pre-tax (and any investment earnings have not yet been taxed, either), which means you’ve never paid Uncle Sam his due for the entire amount. Since you’ll be moving your current pre-tax account to a post-tax account, you’ll need to pay taxes on that $12,000.

The money you’re rolling over is considered ordinary income, so you’ll add that $12,000 to your $65,000 salary. This gives you a total taxable income of $77,000 for the year. 

The 22% tax bracket for 2023 extends all the way up to $95,375, so you’ll pay 22% tax on that $12,000. If the amount were large enough to push you into the next bracket, calculating how much tax you owe on the transferred amount would be trickier—and costlier. 

To calculate how much you’ll pay in taxes, multiply the total value of your account ($12,000) by your marginal tax bracket (22%). In this case, you’ll owe $2,640 in taxes when rolling your 401(k) to a Roth IRA. 

Should I Roll Over My Old 401(k) Into a Roth IRA?

It can sometimes make sense to roll your standard 401(k) into a Roth IRA. This is true at any time when you think your current income will be lower than your future income. 

Let’s say you quit your job in April and don’t anticipate getting another one for at least a year. Your total taxable income for the year will likely be very low since you were only working for a few months. This extends to the income calculated by rolling your 401(k) into a Roth IRA.

In contrast, rolling over your 401(k) may not make sense if you anticipate having less taxable income in the future. Let’s say you fall into the 35% marginal tax bracket for 2022 thanks to a generous bonus from your employer. However, you’d generally fall into the 24% tax bracket and will likely owe even less tax when you’re retired. 

In this situation it wouldn’t be a good idea to roll your account into a Roth IRA as you’d pay more tax on it now than you would in the future. 

Alternatives To Rolling a 401(k) Into a Roth IRA

Rolling a traditional 401(k) to a Roth IRA isn’t your only option when leaving your job.

Rolling Into a Traditional IRA

Choosing to roll your traditional 401(k) to a traditional IRA preserves your tax-free money. In this case, your total account would be transferred over to an IRA and no taxes would be due until it’s time to withdraw. This can be a better solution if you anticipate having a lower tax rate in the future.  

Maintaining Your Current Account

While it’s possible to roll your 401(k) into a different account, it’s not necessary. It’s possible to leave the money where it is. This can make sense if your current account has low fees and is already highly successful.

Taking a Distribution

You’re allowed to take your 401(k) as a distribution when you leave your job, but be careful when doing so. You may owe a penalty and/or taxes on this money, leaving you with less in your pocket. You’ll also miss out on substantial potential for tax-deferred investment earnings. 

Rolling Into a New 401(k)

If your new employer also offers a 401(k) plan, you may be able to roll your existing account into the new one. In order to do so, you’ll want to contact the plan administrator of your new employers to see if they accept transfers. There may be restrictions for doing so; for example, you may have needed to work at your company for a full year before being permitted to do so. 

Like rolling into a traditional IRA, you won’t owe taxes on this money until it comes time to withdraw from your new 401(k) plan. 

Frequently Asked Questions (FAQs)