The first consideration in rolling over an account balance in a 401(k) plan to an individual retirement account is often whether to fund a traditional IRA or a Roth IRA. Workers leaving an employer do not necessarily have to exclusively choose just one IRA type. Individuals planning a 401(k) rollover can fund both a traditional IRA and a Roth IRA.
Each 401(k) plan has its own administrative rules concerning the distribution options that are available. Understanding the specific distribution rules of your 401(k) is essential to developing the most effective rollover strategy. The tax rule restricting an individual to one IRA rollover per year is not applicable to a 401(k) plan rollover.
Traditional IRA
Your primary goal is likely to be maintaining the tax-deferred status of funds coming out of your 401(k). Rolling the funds over to a traditional IRA usually accomplishes that goal. Distributions from the traditional IRA are not taxed until they are eventually withdrawn. When funds are finally distributed from the traditional IRA, they are taxed along with the accumulated earnings.
Roth IRA
The drawback of moving a 401(k) balance to a Roth IRA is that the amount transferred is taxed in the year of the rollover. The long-term advantage of a Roth IRA is enticing, since earnings accumulated after the rollover are received tax-free when eventually withdrawn. A Roth IRA might be the best option if you still have several years left before you reach retirement.
If you are close to retirement age, you might prefer to roll over your 401(k) balance to a traditional IRA and continue to defer income tax for a few more years. However, if you have reduced earnings in the year of the rollover, you might be able to roll over some or all of the funds to a Roth IRA without incurring additional current taxes.
Allocation between IRA types to minimize tax
A 401(k) rollover to a traditional IRA is reported on Form 1040 but is not currently taxable. A rollover to a Roth IRA is also reported, but the amount is usually taxable in the current year. After subtracting all your allowable deductions from your total income, the result may be that the figure labeled as taxable income on your Form 1040 is zero. If so, you can increase the portion rolled over to a Roth IRA to the point at which it results in taxable income.
For many tax filers, a 401(k) rollover to a Roth IRA is likely to result in additional taxable income in the current year. You may have other factors to consider when allocating a 401(k) rollover between a traditional IRA and a Roth IRA. Contact a retirement-planning professional such as Family Financial Partners for more information about 401(k) rollovers.
