401(k) retirement savings plans offered by many employers provide an easy way to save for retirement. But what happens if you change jobs? You can always keep your current account, but you also have the option to transfer your account to an Individual Retirement Account (IRA) or convert it.
Tax Consequences of Converting a 401(k) to 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 will need to pay taxes on this money when you withdraw it. In contrast, contributions to a Roth IRA are made with money that has already been taxed. When you withdraw this money in retirement, it will not be taxed again.
How much tax will I pay when converting a 401(k) to a Roth IRA?
If you want to convert your traditional 401(k) to a Roth IRA, the taxes you will need to pay will be calculated based on your income. The IRS uses marginal tax brackets to determine your tax burden.
Let’s say you were working as an administrative assistant at your previous job. You are unmarried and your annual salary was $65,000 after deductions, placing you in the 22% tax bracket for 2023. Now that you have left your job, you are looking to convert your traditional 401(k) plan to a Roth IRA.
You did not work for your previous employer for a long time, so the total amount in the account is only $12,000. As noted above, this $12,000 was contributed pre-tax (and no investment gains were taxed yet), meaning you have not paid income tax on the entire amount. Since you will be transferring your pre-tax account to a post-tax account, you will need to pay taxes on that $12,000.
The money you are converting is considered ordinary income, so you will add this $12,000 to your salary of $65,000. This gives you a total taxable income of $77,000 for the year.
The 22% tax bracket for 2023 extends up to $95,375, so you will pay a 22% tax on that $12,000. If the amount is large enough to push you into the next tax bracket, calculating how much you owe in taxes will be more complex and costly.
To calculate how much you will pay in taxes, multiply the total amount of your account ($12,000) by your marginal tax rate (22%). In this case, you would owe $2,640 in taxes when converting your 401(k) to a Roth IRA.
Note: It is not necessary to pay these taxes upfront; they will be collected by the IRS when you file your tax return as usual. Although there is no mandatory withholding when converting your 401(k) to a Roth IRA, you can ask your retirement plan administrator to enter into a voluntary withholding agreement. This means that the administrator will withhold taxes during the conversion, eliminating the need to pay them during tax season.
Should I convert my old 401(k) to a Roth IRA?
It may sometimes make sense to convert your traditional 401(k) to a Roth IRA. This is true anytime you think your current income will be lower than your future income.
Let’s say you quit your job in April and do not expect to get another job for at least a year. Your total taxable income for this year is likely to be very low since you only worked for a few months. This extends to the income considered by converting your 401(k) to a Roth IRA.
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It is also appropriate to consider converting your plan when you have significant losses during the tax year. With sufficient losses, you can reduce your total taxable income and your tax burden.
In contrast, converting your 401(k) to a Roth IRA may not be suitable if you expect to have lower taxable income in the future. Suppose you fall into the 35% marginal tax bracket for 2022 due to a generous bonus from your employer. However, you would generally be in the 24% tax bracket and are likely to owe less tax when you retire.
Alternatives to Converting a 401(k) to a Roth IRA
Converting a traditional 401(k) to a Roth IRA is not the only option you have when leaving your job.
Converting to a Traditional IRA
Choosing to convert your traditional 401(k) to a traditional IRA keeps your money tax-free. In this case, your entire account balance would be transferred to the IRA, and there would be no taxes due until it’s time to withdraw. This solution can be better if you expect to have a lower tax rate in the future.
Keeping Your Current Account
While it is possible to convert your 401(k) to a different account, it is not necessary. You can leave the money where it is. This may be convenient if your current account has low fees and is already performing well.
Taking a Distribution
You are 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 that amount, leaving you with less money in your pocket. You will also miss out on a great opportunity to earn tax-deferred investment returns.
Converting to a New 401(k)
If your new employer also offers a 401(k) plan, you may be able to transfer your current account to the new one. To do this, you will need to contact the retirement plan administrator of your new employer to see if they accept transfers. There may be restrictions; for example, you may need to work at the company for a full year before they allow you to do this. Like converting to a traditional IRA, you won’t owe any taxes on this money until it’s time to withdraw from your new 401(k) plan.
Frequently Asked Questions (FAQs)
How can I convert my 401(k) to a Roth IRA?
There are two ways to convert your 401(k) to a Roth IRA. You can choose to do a direct transfer, where the funds are deposited directly into the Roth IRA. Or you can choose an indirect transfer. In this case, the cash is distributed to you, except for the 20% withheld by the retirement plan administrator for taxes if you choose not to fund the new account, and you are responsible for depositing the funds into the new account. Be careful – there are tax implications and other restrictions that come with this method.
How much can I contribute to my 401(k) and Roth IRA?
The amount of money you can contribute to your 401(k) and Roth IRA changes each year. The maximum contribution for your 401(k) for 2023 is $22,500 ($30,000 for those aged 50 and over). The maximum contribution for both your Roth and traditional IRA is $6,500 combined ($7,500 for those aged 50 and over).
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Sources:
- Internal Revenue Service. “401(k) Plans.”
- Internal Revenue Service. “Roth Comparison Chart.”
- IRS. “IRS Provides Tax Inflation Adjustments for Tax Year 2023.”
- FINRA.
“401(k) Rollovers.”
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