4 Reasons to Convert Your 401(k) Into a Roth IRA and Gain More Control Over Your Money

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A 401(k) is great—until you want to take your money out. 

If you’re younger than 59 ½, you’ll be hit with a 10% penalty for withdrawing money out of a 401(k) account, and that’s on top of income taxes you’ll owe on the amount withdrawn. 

This is one of the reasons you might choose to convert your 401(k) into a Roth IRA. Like a 401(k), a Roth IRA is a tax-advantaged investment account. But unlike a 401(k), it offers the potential for tax- and penalty-free withdrawals. If you’re planning to be financially independent before traditional retirement age, or if you want to reduce the taxes you’ll owe later in life, converting a 401(k) into a Roth IRA might be a smart strategy. 

You’ve got to plan ahead, though, because this type of conversion often comes with an immediate tax bill plus a five-year waiting period before you can withdraw the funds without penalty. Here’s what to know about converting a 401(k) into a Roth IRA, according to experts.

How Does a 401(k) to Roth IRA Conversion Work?

Converting a 401(k) into a Roth IRA gives you greater ownership and direction over your money. A 401(k) is a tax-advantaged retirement account that is managed by an employer, while a Roth IRA is a tax-advantaged retirement account that is managed by you

In practice, this means you’ll open a Roth IRA account at an online brokerage firm (here are the 5 best places recommended by NextAdvisor) and then roll any money in your 401(k) into your new account.

Beware: this will likely be a taxable event. Most, but not all, 401(k) accounts are tax-deferred. This means that you’ve never paid any taxes on the money within. Roth IRAs, on the other hand, are post-tax, meaning that they must contain only money that has already been taxed. If you have a tax-deferred 401(k), also known as a traditional 401(k), you will owe ordinary income taxes on the amount of money you convert into a Roth IRA.

Pro Tip

Experts recommend diversifying your investments into different buckets: some in a tax-deferred account like a 401(k), and others in a post-tax account like a Roth IRA.

For example, if you convert $50,000 from a traditional 401(k) into a Roth IRA, “the IRS is essentially saying, ‘Hey, that’s an additional $50,000 of income that you earned this year,’” says Jose Hernandez, a financial educator, founder of Financial University, and author of the forthcoming book “Invest Like You Mean It.”

Once you pay that tax bill, the converted funds grow until you’re ready to take them out tax-free. The only exception is the five-year rule, which states that you must wait five years before you can withdraw the converted funds without penalty. 

Why Would You Want to Convert a 401(k) Into a Roth IRA?

When you’re employed by a company that offers a 401(k) plan, it’s an indispensable investing tool. Many companies match some of your contributions, which is essentially free money. 

However, when you leave that job, “this is a great time to look at the 401(k) you’ve been given and evaluate what is working for you,” says Nicole Stanley, a financial coach and founder of Arise Financial Coaching

Here are some of the most common reasons you might want to convert your 401(k) into a Roth IRA:

You Want to ‘Relax Early’

Proponents of the FIRE movement (a.k.a. Financial Independence, Relax Early) invest aggressively so they can become work-optional in their 50s or even earlier. 

If that’s your plan, you’ll want at least a portion of your investments to be in an account that’s more accessible than a 401(k), which you cannot tap without penalty before the age of 59 ½. A strategy known as a Roth conversion ladder involves converting 401(k) funds into a Roth IRA over a period of years.

“It’s a bit complex,” says Hernandez. “There’s a small number of people that it could make sense for. It’s important to understand the tax impact.”

You Think Your Tax Rate Is Going to Go Up

If you believe your current tax rate is lower than it might be in the future, you may want to convert your investments into a Roth IRA, pay your fair share of taxes now, and then let that money grow tax-free until you need it.  

Converting a pre-tax 401(k) into a post-tax Roth IRA will trigger a tax bill, but a financial professional might recommend it anyway. “It’s a way to hedge against the risk of taxes going up in the future,” says Hernandez. “In a general sense, if you’re still in the early stages of your earning career, it makes sense to go ahead and pay the taxes upfront and do the Roth contributions.”

Of course, no one knows for sure what their tax rate will look like in the future. That’s why many experts recommend diversifying your long-term investments into different buckets: some in a tax-deferred account like a 401(k), and others in a post-tax account like a Roth IRA. If all your money is one bucket, a conversion could make sense. 

You Want Lower Fees and More Investment Options

Because a 401(k) account is tied to an employer, it likely has a limited number of investment options, especially if the plan is administered by a small company. 

For example, you might have access to only a small group of mutual funds with relatively high expense ratios, or fees. Many discount brokerages, on the other hand, offer index funds with expense ratios close to zero within self-directed IRA accounts.

In a 401(k), “a lot of people feel like they’re handcuffed in terms of what they can own,” says Hernandez. “In most cases, in an IRA you have a lot more flexibility in what you can own.” 

You Want to Avoid Required Minimum Distributions

Here’s another rule that applies to a 401(k) but not a Roth IRA: required minimum distributions, or RMDs.

The IRS requires all 401(k) owners to withdraw a minimum amount from their accounts each year beginning in the year they turn 72. The exact amount depends on your balance, your age, and a life-expectancy variable determined by the IRS. 

With a Roth IRA, that money has already been taxed, so RMDs are not required.

Tax Implications of 401(k) to Roth IRA Conversion

To understand the tax implications, the most important thing  to know is whether your 401(k) is a traditional (pre-tax) or a Roth (post-tax). About 75% of 401(k) plan participants choose to make pre-tax contributions, according to a 2018 survey by the Plan Sponsor Council of America, a non-profit trade association.

That means the majority of conversions from 401(k) to Roth IRA will trigger a tax bill during the year in which the conversion takes place. Depending on how much money you’re converting, this could mean a significant and immediate increase in your tax bill. For that reason, a conversion is not to be taken lightly. 

“You have to be prepared for that tax bill,” says Stanley. “It’s a good idea to do it in stages and talk to your tax professional.”

Steps for Rolling Over a 401(k) Into a Roth IRA

Once you’ve done the research, consulted a professional, and decided that a 401(k) conversion to a Roth IRA is right for you, there’s a few things you’ll have to do. 

First, you’ll need to open a Roth IRA account. NextAdvisor recommends these 5 online brokerages, which generally have low fees and good customer service.

Next, call that brokerage and tell them you’d like to roll over a 401(k). This will likely be more effective than calling the institution that holds your 401(k) money — after all, that company is not incentivized to help you move it out. “As a general rule, it’s usually a lot easier to get money into a financial institution than it is to get money out of one,” says Hernandez. 

Depending on the institutions involved, the next steps may involve a paper check being mailed to your home, so you’ll need to make sure that both institutions have your most updated personal information on file. Make sure you’re keeping track of the transactions for tax purposes. The 401(k) institution should provide you with a 1099-R form, which you can provide to your tax preparer.

Try not to get overwhelmed by the paperwork, says Stanley. Break the task into steps and give yourself time to get it done. “You don’t even need to do it all at once,” she says. Whether you get it done in days or weeks, you’ll have taken a great step toward your financial goals.