Most of the time when you transfer or roll over money from one retirement plan to another, you don’t pay tax on the funds until you withdraw them from the new plan. However, rolling over money from a traditional retirement plan such as a 401(k) or IRA to a Roth IRA is treated differently.
That’s because the contributions to that traditional plan are typically made with pre-tax dollars, whereas Roth IRA contributions are made with after-tax dollars. Since you haven’t yet paid taxes on the contributions to a 401(k) or traditional IRA, this process is called a conversion and the amount you convert to a Roth IRA is taxable.
Rollovers and Roth IRA conversions can be complicated, and it’s important to follow the rules about timing and limits to avoid penalties and extra taxes. Learn more about rollovers to Roth IRAs and their tax implications.
- Rollovers from a traditional retirement plan such as a 401(k) or traditional IRA to a Roth IRA are known as conversions, and the amount rolled over is taxable.
- There is no limit on the amount you can roll over or convert into a Roth IRA.
- While the IRS imposes a one-per-year limit on IRA rollovers, it doesn’t apply to Roth IRA conversions.
Roth IRA Conversions Are Exempt From the One-Per-Year Limit
You may have heard of annual rollover limits on IRAs, which apply to indirect rollovers where a distribution from an IRA or a retirement plan is paid directly to you, and you deposit it in another IRA or retirement plan within 60 days. You can only make one of these rollovers every 12 months, no matter how many IRAs you have. You can avoid the limit by choosing a trustee-to-trustee transfer, in which funds are sent directly from one plan to another.
Rollovers from a traditional IRA to a Roth IRA are known as conversions and are exempt from the one-per-year limit.
IRA Rollovers Can Be Any Amount
Direct contributions to all IRAs are limited to a combined $6,000 per year or your taxable compensation for the year, whichever is lower. Your eligibility to make Roth IRA contributions depends on your income and tax filing status.
Roth IRA conversions are not considered to be plan contributions. Since tax laws changed in 2010, you’ve been able to convert as much as you’d like (up to the full amount in your qualified plan).
Tax Implications of a Roth IRA Rollover
Rollovers from a traditional plan to a Roth IRA are called conversions because the tax treatment is different. Traditional plan contributions are tax-deductible and distributions are taxable. In contrast, Roth IRA contributions are taxable and distributions are tax-free.
If you contribute to a traditional plan, you haven’t paid any taxes on those dollars yet—which is why conversions to a Roth IRA are 100% taxable. You’re converting the funds to post-tax dollars.
Because you need to include the rollover amount in your gross income, the tax hit can be significant. For example, converting a traditional 401(k) with an account value of $250,000 to a Roth IRA creates $250,000 of taxable income. Not only do you have to pay tax on the $250,000, but adding this amount to the rest of your income may push you into a higher tax bracket.
Before you initiate a Roth conversion, you may want to consult with a professional financial or tax advisor to fully understand the tax implications. They can help you develop a solid strategy for your circumstances.
One way to limit the effect of a Roth IRA conversion on your tax bracket is to convert smaller amounts over several years, instead of converting all at once.
Frequently Asked Questions (FAQs)
How do you roll over a 401(k) to a Roth IRA?
There are three steps to rolling your 401(k) to a Roth IRA.
- Open a Roth IRA: First, you’ll open a Roth IRA with a custodian, a bank, brokerage firm or other financial institution. You’ll complete a form to open the account and provide information about your 401(k) plan.
- Notify the 401(k) plan administrator: The plan administrator will verify that you’re eligible to roll over money from the 401(k). You’ll complete a form to authorize the transfer and provide details about the Roth IRA custodian.
- Report the rollover on form 1040: The plan administrator will send you a 1099-R to report the income on form 1040 when you file your tax return.
What is an in-plan Roth rollover?
You can roll money from your traditional employer-sponsored plan to a designated Roth account in the same plan if your plan allows. Plans that may offer this feature include 401(k), 403(b), and 457(b) governmental plans. As long as your plan allows for it, you can roll over any vested balances to the designated Roth account. However, in-plan Roth rollovers are taxable in the year they’re made, so you’ll need to include the taxable amount in your gross income.
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