The federal government provides several vehicles through which people can save and invest for the future while incurring less tax liability. If you’ve ever been through a benefits package review with your company’s HR representative, then you’re probably well aware of your opportunity to stick some money into a 401(K) account or an individual retirement account (IRA). If you’re just sticking money away and not touching these accounts for years on end, your situation will be easy. In some cases, though, you may want to roll over your 401(K) into an IRA. Your financial adviser may let you in on a secret called the Roth IRA. How do you roll your 401(K) into a Roth IRA and why should you do it? Follow along to learn more.
Why do a rollover?
A 401(K) account is specific to your job. You can technically leave your money in that account, but this will not allow you to make further contributions to that particular 401(K). You’ll need to eventually do something with that money if you choose to leave your job. With this in mind, you have choices when you decide to make moves with the money.
Why roll over into a Roth IRA?
A Roth IRA is a vehicle for the investment of post-tax dollars. It still allows your money to grow tax-free over time, allowing investors to capitalize on any gains that may be experienced, as they can be re-invested without the burden of ongoing taxes. With a Roth IRA, you will be contributing post-tax money, but you won’t have to pay any taxes when you withdraw. This distinguishes the Roth from a traditional IRA, which allows for the investment of pre-tax dollars while requiring tax payments when you take the money out. People choose a Roth IRA when they think they’ll be in a higher tax bracket later in life than they are at the current time.
Rolling over a 401(K) into a Roth IRA
In order to roll over your 401(K) into a Roth IRA, you will first need to roll the 401(K) over into a traditional IRA. This can be done either directly or indirectly. With a direct rollover, the money is transferred from one type of account to another. With an indirect rollover, you will withdraw the money from your 401(K) and deposit it in a qualifying traditional IRA within 60 days. In most cases, you can avoid tax liability by sticking to these deadlines.
From there, you will have to do what is called a Roth IRA conversion. This is a process through which you can create a “back door” Roth IRA. In doing so, you will owe income tax on the contributions you make into your Roth IRA. For instance, if you’re converting $20,000 in savings to your Roth IRA, and you owe a 20% total tax rate, then you’ll pay $4,000 in income tax to make that contribution. This, however, will allow you take money out of the Roth IRA down the line without incurring any tax liability.