Make Sure To Know The Differences Between A Roth 401 And A Roth Ira Beforehand
In this clip from “Financial Planning Q& A 60” on Motley Fool Live, recorded on Jan. 26, Motley Fool contributor Dan Caplinger analyzes the advantages of a Roth IRA versus a Roth 401 and discusses the questions to ask your employer when considering a conversion.
Dan Caplinger: In general, if you have a 401 from a previous employer, you can convert it to a Roth IRA directly. It’ll be treated just like a conversion. Pretty much the same way as an IRA to Roth IRA conversion. If you are still in service with that 401 at a present employer, you’re going to have to talk to your present employer about whether the plan allows in-service distributions. Many don’t. You may not be able to get access to that money to do a conversion to an individual Roth IRA. As far as the advantages of a Roth IRA versus a Roth 401, the two big ones are that Roth IRAs do not have required minimum distributions at age 72. Roth 401s, like any other 401 account, do have those requirements. The other thing is that a Roth 401, you’re going to have a menu of investment choices that your employer picks. The Roth IRA gives you a wider selection of just about any investment that you can make. If you don’t like the investment options in the Roth 401, a lot of folks prefer the Roth IRA just the same way as with the traditional 401 and a traditional IRA. A lot of folks prefer that level of flexibility.
What Should I Do With An Old 401
You might have an old 401or severallying around from previous employers. Transferring the money from a 401 to your new employers Roth 401 might seem like an appealing option. But just remember, youll get smacked with a tax bill if you go that route.
Rolling your old 401 into a traditional IRA is another way to go. Youll have more control over your investments and will be able to choose from thousands of funds with the help of your financial advisor. Plus, you wont face any tax consequences since youre moving from one pretax account to another.
If you arent able to transfer your money into your new employers plan but think a Roth is for you, you could go with a Roth IRA. But just like with a 401 conversion, youll pay taxes on the amount youre putting in. If you have the cash available to cover it, then the Roth IRA might be a good option because of the tax-free growth and retirement withdrawals.
Roth Conversion: Things To Be Aware Of
Roth IRAs have a 5-year aging rule which requires you to wait 5 years after your first Roth IRA contribution before you can withdraw earnings tax-free in retirement or qualify for an exception to the 10% penalty.
There’s also a 5-year waiting period for conversions money). In this case, if you are under the age of 59½, you’ll need to wait 5 years before you can withdraw that money without incurring a 10% penalty. Note that this only applies to taxable money that was converted it does not apply to any balances that were not taxable when converted.
Another important fact to understandthere’s no way to undo a Roth conversion.
Before the Tax Cuts and Jobs Act was enacted in December 2017, you could undo a Roth conversion. That option is no longer available.
Finally, investors should be aware that taxes are not the only factor when it comes to rolling funds from a 401 plan to an IRA, of any type. There may be considerations related to fees, investment choices, creditor protection, RMDs, and other factors that need to be weighed in deciding whether a rollover is appropriate for you. Consider consulting a financial advisor before making any decisions.
Recommended Reading: How To Take Out 401k Early
Know The Rules For Roth 401 Rollovers
Eric is currently a duly licensed Independent Insurance Broker licensed in Life, Health, Property, and Casualty insurance. He has worked more than 13 years in both public and private accounting jobs and more than four years licensed as an insurance producer. His background in tax accounting has served as a solid base supporting his current book of business.
If you have moved jobs while holding a traditional 401, you are probably familiar with the rollover options for these ubiquitous retirement accounts. You may be less sure, though, of your options when you leave an employer with whom you hold a Roth 401, the newer and less prevalent cousin of the traditional 401.
The main difference between the traditional 401 and the Roth 401 is that the former is funded with pretax dollars while Roth contributions are in post-tax dollars so there is no tax hit from a qualified withdrawal made in the future.
If your job is at stake, or you are considering a career move, here are your options regarding your Roth 401 account when changing employers.
What Does Roth Mean Where Did The Term Come From Why Is It Called Roth Is Roth An Acronym
Lets start with the word Roth. The word Roth originates from Senator William Roth of Delaware. In 1989 Senator Roth teamed up with Senator Bob Packwood of Oregon. They proposed the IRA Plus Plan which allowed individuals to invest up to $2,000 with no tax deductions. The earnings could be later withdrawn tax-free at retirement.
The Roth IRA was eventually established by the Taxpayer Relief Act of 1997 and named after Senator Roth. In 2000, 46.3 million taxpayers held IRA accounts amounting to $2.6 trillion. Only about $77 billion was held in Roth IRAs. Seven years later the number of IRA owners jumped to 50 million with $3.3 trillion invested.
Don’t Miss: How To Roll Ira Into 401k
Is A Rollover To A Roth Ira Taxable
This rollover transaction isn’t taxable, unless the rollover is to a Roth IRA or a designated Roth account from another type of plan or account, but it is reportable on your federal tax return. You must include the taxable amount of a distribution that you don’t roll over in income in the year of the distribution.
Talk To A Pro Before Converting Your 401
An experienced investing professional can help you figure out the best way to handle your investment accounts in order to keep you on track toward your retirement goals. If you dont understand something, ask questions. We dont ever want you to make a financial move you dont understand.
If youre looking for an investing pro in your area, use our SmartVestor program! Its a free way to connect with top-notch investing professionals who are ready to help you make the most of your retirement dollars.
About the author
Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners.
Read Also: When Do You Need A 401k Audit
Roth 401 And Roth Ira Early Withdrawal
Although a Roth 401 account is funded with after-tax dollars, it is not immune to taxes and penalties. Understanding the rules regarding withdrawals is important if you want to avoid losing part of your retirement savings. Contributions and earnings in a Roth 401 can be withdrawn without paying taxes and penalties if youre at least 59 and a half years old and you meet the five year rule. Other exceptions include being permanently and totally disabled. You can also use up to $10,000 for a first-time home purchase without penalty or taxation.
Early Withdrawal of Roth Account Contributions
All withdrawals are not the same. Your Roth IRA contribution can be used in an emergency. If you need to take an early withdrawal from a Roth account contributions come out first. This is a nice move by the IRS to make things easier for you. When youre just tapping into your contributions, you dont have to worry about taxes, unless you pull out more than youve contributed.
Early Withdrawal of Roth Account Earnings
Things get more complicated when you start tapping into earnings. You can be taxed and have to pay a 10% penalty for early withdrawals on your Roth account earnings. However, there are some circumstances where you will not have to pay the 10% penalty, but still need to pay taxes. These special circumstances include:
Converting A Nondeductible Ira Contribution To A Roth Ira
You may know that if you or your spouse have a retirement plan available at work, it limits the deductible contributions you can make to a traditional IRA.3 If you’re in that boat and want to make the most of your tax-advantaged saving options, you can still make nondeductible IRA contributions. Earnings on these contributions will be tax-deferred but you do have the option of converting to a Roth IRA. In that case, your nondeductible contributions wont be taxed again, although any earnings would be treated as pre-tax balances, which means they would be taxable when converted. This type of conversion is sometimes called a backdoor Roth IRA.
If you do decide to convert either pre-tax or non-deductible contributions, the timing can be a little bit tricky. Some time should pass between the date of the contribution and the date of the conversion, but it’s not completely clear how much is enough. If you do decide to convert, consult your tax advisor first to ensure that you understand the full scope of potential tax consequences.
Don’t Miss: Should I Roll 401k To Ira
A Roth 401 Rolled Into Another Roth 401
If you roll your old Roth 401 to a new Roth 401, the specific distribution rules from the new account will vary by the plan itself your new employer’s human resources department should be able to assist with this.
However, some basic conditions apply. If you decide to roll over the funds from your old Roth 401 to your new Roth 401 through a trustee-to-trustee transfer , the number of years the funds were in the old plan should count toward the five-year period for qualified distributions. However, the previous employer must contact the new employer concerning the amount of employee contributions that are being rolled over and must confirm the first year they were made.
Note, too, that the rollover generally must be complete in order for the new funds to enjoy the carryover of the time period from the old Roth 401. If an employee did only a partial rollover to the new Roth 401, the five-year period would start again. That is, you do not get credit for the period the funds were in your old Roth 401.
Before making a decision, speak to your tax or financial advisor about what may be best for you. One option could even be leaving the Roth 401 in your previous employer’s plan, depending on the circumstances and that plan’s rules.
What Is The Difference Between A Roth 401 And A Roth Ira
As we discovered above the Roth IRA came into existence in 1997. The Roth 401 was first available in 2001. A Roth 401 has higher contribution limits, and lets employers match contributions. A Roth IRA offers more investment options, and allows for easier early withdrawals.
What is a Roth 401?
A Roth 401 account is set up by your employer for your retirement. There are no AGI limits to contribute like there are with Roth IRAs. However, there are contribution limits. The maximum you can contribute is $19,500. If youre older than 50 the limit is $26,500. The contribution limit counts towards both your Traditional and Roth 401. This means the combined total cant be more than $19,500.
What is a Roth IRA?
Roth IRAs are set up by individuals for their retirement. Employers have nothing to do with Roth IRAs, unlike Roth 401s. Individuals can only contribute to a Roth IRA if their Adjusted Gross Income is under $196,000 – $206,000. The IRS offers a phase-out table for more information. If youre eligible for a Roth IRA, your maximum contribution is $6,000. Its $7,000 if you are over 50.
Roth 401 plans are subject to required minimum distributions. Roth IRAs are exempt. The IRS requires Roth 401 holders to take mandatory distributions from their account starting at age 72. The withdrawals are based on your remaining life expectancy. Roth IRAs allow you to leave your money in the account and let it continue to grow until death.
What is a Back-Door Roth IRA?
Also Check: Should I Invest In 401k Or Roth Ira
Roth Ira Conversion Rules 202: Heres What It Means For You
Recently, the U.S. House of Representatives has passed the Build Back Better bill that would limit some of the ways to accrue tax-free savings in the future. Do Roth IRA conversion rules impact your financial freedom plan? Lets jump in.
The rich are currently prohibited from contributing directly to a Roth IRA if their modified adjusted gross income reaches at least $144,000 for individuals and $214,000 for the married. So a Roth IRA Conversion is used as a backdoor Roth IRA.
However, the draft bill approved by the House last November makes many people, especially high-income savers confused as it focuses on limiting tax-avoidance strategies favored by the rich.
One thing savers usually look out for is the ever-changing max 401 contribution limits, which are due to shift again in 2022, Roth IRA is not an exception. Keeping track of the latest rules and knowing what to do about them are the key parts of good personal financial management. If you do not know the meaning of Roth conversion rules 2022, read our article and get the answer.
Can You Transfer Roth Ira To Another Roth Ira
You can only upgrade Roth Funds, they will only go to another Roth IRA. Even Roth 401 plans are struggling to accept recommendations from the Roth IRA. If you take money from your new Roth IRA and use it for another type of annuity factor, it counts as a standing request to your IRA and an item for another Golden Years account.
Don’t Miss: How To Do 401k Rollover
How Do I Prove Ira Rollover To Irs
Reporting your rollover is relatively quick and easy all you need is your 1099-R and 1040 forms.
Confusion Of The Roths
Unlike the similarly named Roth IRA, the Roth 401 is different. A Roth IRA is an individual retirement account whereas a Roth 401 is part of and offered through an employer sponsored retirement plan.
This minor confusion might be an invisible obstacle for some employees, especially high-income earners who have been told they cannot contribute to a Roth.
High-income earners may be pleasantly surprised to hear they can contribute because a Roth 401 does not have income limits like a Roth IRA does. This means they now have access to a savings vehicle that can grow tax-free.
Additionally, since Roth 401 accounts follow traditional 401 contribution guidelines, the amount that can be saved per year is subject to 401 maximums. For example, in 2020, employees can contribute up to $19,500 in a Roth 401 and if the employee is 50 years old or older, they may make a catch-up contribution of up to $6,500, for a potential total annual contribution of $26,000.5
You May Like: Should You Always Rollover Your 401k
If You Have More Than One Ira: Ira Aggregation Rule And Pro Rata Rule
When it comes to conversions and distributions, the IRS views all of your traditional IRAs as one account. If you have 3 traditional IRAs and a rollover IRA spread across different financial institutions, the IRS would lump all of them together. It’s called the IRA aggregation rule and it can complicate your conversion to a Rothor make it more costly than you may have anticipated.
If you have existing IRAs, like a rollover, and also want to make nondeductible contributions and later convert them to a Roth, you won’t be able to convert only the after-tax balance. The conversion must be done pro rataor proportionally split between your after-tax and pre-tax balances, including contributions and earnings.
For instance, let’s say you have an existing traditional IRA worth $10,000. You’ve just made a nondeductible contribution to a new IRA in the amount of $5,000 and plan to convert it to a Roth IRA. You can convert $5,000 of your IRA dollars but you would have to pay taxes on about $3,333 of the money being converted.
Total IRA balance: $15,000 After-tax IRA balance: $5,000
$5,000 is one-third of your total IRA balance. That means that one-third of your conversion will be after-tax dollars and two-thirds will be pre-tax dollars.
Consider Converting Over A Period Of Years
Experts such as Victor advise careful planning to minimize the tax hit that comes with a conversion. Individuals could space the conversion out over many years rather than convert the full amount in one year. By doing so, they may be able to avoid jumping up to a higher tax bracket and paying more on each incremental dollar of converted money.
You May Like: What Will My 401k Be Worth At Retirement
Should I Convert My Current 401 Into A Roth 401
If you already have a traditional 401 at your current job and the company just introduced a Roth 401 option, converting that 401 into a Roth might sound like a good idea. But is a conversion your best option? It depends on your situation.
The main drawback of converting a traditional 401 into a Roth 401 is the tax bill that comes with making the switch. Youre going to have to pay taxes on that money because it hasnt been taxed yet.
Lets say you have $100,000 in your traditional, pretax 401 and you want to convert the account into a Roth, after-tax 401. If youre in the 22% tax bracket, that means youd be paying $22,000 in taxes. Thats a lot of cash!
If you convert your 401 into a Roth 401, you need to have the cash on hand to cover the tax billno exceptions. Do not use money from the investment itself to pay the taxes. If you do, youll lose a lot more than $22,000. Youll also miss out on years of compound interest, which is typically about 10%. So after 30 years, a $100,000 account could grow to be $436,000 more than an account with a $78,000 starting point because of compound interest.
There are also alternatives to a 401 conversion to consider. For example, you can leave your traditional 401alone and start putting money from your paycheck into a new Roth 401 instead. That way, you dont have to worry about taking a hit paying taxes now and still take advantage of the Roths tax-free growth later.