Best Time to Convert Your 401(k) to a Roth IRA

LouisHorkan

By

Louis Horkan

Reviewed by Nathan Kattner

Table Of Contents

    When’s the best time to convert your 401(k) to a Roth IRA? Learn the important details and considerations necessary that can help you make that decision.

    Introduction

    We all know it’s human nature to follow the pack. This is certainly the case when it comes to trends involving money and investing.

    Being honest, most of us (present company included) watch the business channels and scour our favorite sites, newsletters and podcasts in search of trends and opportunities that might help us line our pockets.

    Some of those trends are worth paying attention to, while many others are worthless at best, and downright dangerous if we allow ourselves to be duped into jumping on the bandwagon. The trick is sifting through all the chatter and garbage in search of the real nuggets.

    One interesting trend that made the headlines in 2024 came from a CNBC broadcast on October 16th regarding the news that Fidelity had released data indicating that there had been a 46-percent rise in investors converting their 401(k)s to Roth IRAs during the 2nd quarter.

    Given the potential benefits, combined with the uncertainty brought on by the potential sunsetting of the 2017 tax cuts (Tax Cuts and Jobs Act  – TCJA) in 2026, it makes sense that lots of investors were contemplating such a strategy when it comes to their retirement savings.

    Whether converting a 401(k) to a Roth IRA is a nugget or not for you really boils down to your own particular set of circumstances.

    To assist you in making that particular determination, we decided to focus today on a potential Roth conversion from a 401(k) plan.

    To that end, we are posing the question of when would be the best time to convert your 401(k) to a Roth IRA. We will look at what a Roth IRA is, plan differences, mechanics, pros & cons, some rules, and more.

    We feel doing so will probably make you more confident in your decision in terms of whether it makes sense to convert. And prepare you for what to expect if you decide to make the big move.

    What is a Roth IRA

    According to Investopedia, a Roth IRA is a type of retirement account that allows you to invest after-tax dollars and later withdraw your contributions and earnings tax-free and penalty-free once you meet certain conditions, which will be discussed shortly.

    According to Investopedia, a Roth IRA is a type of retirement account that allows you to i nvest after-tax dollars and later withdraw your contributions and earnings tax-free and penalty-free once you meet certain conditions.

    Big difference

    When it comes to Roth IRAs compared to qualified tax-deferred accounts, such as Traditional IRAs for individuals and employer-sponsored plans, such as 401(k)s and 403(b)s, the big differentiator is when you pay the tax.

    There are other differences to be sure, but the bottom line is the fact the government will get it’s pound of flesh at some point, be it collecting taxes now or later. The real issue is you and your personal circumstances, as well as your belief about your future situation. Chief among the considerations is whether you expect to be in a higher tax bracket and earn more income now or after you retire.

    The Roth conversion

    The first big hurdle in terms of converting your 401(k) is determining if you are eligible. If you still work at the company where your 401(k) resides you will have to check with your plan administrator to determine if the plan allows for conversion. Some do and some don’t. If they don’t you won’t be able to convert to a Roth IRA while you continue to work for them.

    If they happen to offer a Roth 401(k) plan, as long as the plan rules allow, you may be able to convert some (possible even all) of your current plan balance into their Roth 401(k). If allowed, you can contact the plan administrator to make this happen. (Note – if converting a Roth 401(k) plan at some point, you can only do so into a Roth IRA.)

    FYI, this is often interchangeably referred to as an “in-plan” or “in-service” conversion, although you need to be aware that “in-service” is terminology often used for other types of allowable plan distributions.

    If instead you no longer work at the employer where your 401(k) plan is held or if you plan to retire, you are eligible to perform a rollover. While the IRS does allow for direct conversion, most plans don’t allow for a direct conversion from their 401(k) to a Roth IRA (pre-tax vehicle versus after-tax vehicle), so you’ll probably have to perform a rollover to a Traditional IRA or Rollover IRA account, and then convert that to a Roth IRA.

    You definitely want to check with your plan administrator on this. And given this can get complicated and can cost you dearly if done incorrectly, you should work with your advisor to ensure everything is done properly.

    Regarding a Roth IRA account, you can set one up at a bank, brokerage, mutual fund house or insurance company.

    And you can invest the funds converted (as well as those you contribute separately) into a wide array of investments (determined by the account custodian), ranging from stocks, bonds, mutual funds, exchange-traded funds (ETFs), CDs, annuities and other approved instruments.

    The first big hurdle in terms of converting your 401(k) is determining if you are eligible.

    Transferring funds

    Assuming your plan doesn’t allow direct Roth conversion, there are two main procedures for transferring your 401(k) proceeds to a Traditional IRA or Rollover IRA account:

    Direct/trustee-to-trustee rollover – upon receiving the proper forms that include instructions for the transaction, the plan administrator for your 401(k) plan will sell the positions in your account, according to Oak Harvest Founder and CEO Troy Sharpe, CFP®, CPWA®, CTS®.

    Once they have done so, they will directly transfer the money from the account to the custodian of your IRA account. This is the desired approach, as it is straightforward and easy. They can even send you a check, as long as it is made out to the new custodian, according to Sharpe.

    Indirect rollover – If the event the plan administrator sends you a check in your name they will likely withhold 20-percent (mandatory federal tax withholding) for taxes. You will have to deposit the amount they sent to you, plus the 20-percent withheld for taxes, within 60 days. As long as you do so the rollover transaction will be considered complete. And you will receive the 20-percent withheld back when you file your taxes.

    The taxes

    Ah yes, paying your fair share.

    It’s fair to say that taxes are something we’d all prefer to avoid. Good financial planning is intended to minimize the amount of taxes you may pay each year, and certainly collectively throughout your retirement. Utilizing a Roth conversion is one strategy that can potentially help in that endeavor.

    Given that you are considering converting your 401(k) to a Roth IRA, you probably have an understanding of retirement accounts and some of their many benefits. And you’re now wondering if a conversion might help you retain even more of your hard-earned dollars in the future.

    Before starting down this road it’s important to remember that you can’t reverse a conversion or rollover, so you want to be certain in your decision.

    Whether such a move makes sense or not comes down to you and your circumstances. But there is a major consideration that must first be taken into account – taxes.

    If you decide to proceed you will have to pay the taxes due on the entire amount you seek to convert, including all pre-tax contributions and the associated earnings.

    That’s right, you will pay taxes now versus later in retirement when you begin taking distributions. According to the IRS, in addition to taking the tax hit now (and giving up the benefit of tax-deferral), keep in mind that Roth contributions you might wish to make into this account later will not reduce taxable income for the tax year (a benefit a 401(k) contribution does provide), as they must be made using after-tax dollars as well.

    That said, you’re probably aware of the fact that later when you take distributions in retirement from your Roth IRA you will generally be able to do so on a tax-free basis (contributions and earnings), which is probably chief among your reasons for considering a Roth conversion. Or it should be!

    Regarding that tax hit we just mentioned, it can be a doozy, as the funds converted are considered earned income and must be reported in your federal tax filing for the year in which the transaction occurred. You’ll need the funds available to make those tax payments.

    On that issue, you don’t want to pay those taxes out of the money being converted, or from any other qualified accounts, as it reduces your overall retirement balance. This can cost you thousands of dollars in growth when your main intention is that of eventually funding your retirement.

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    Does it make sense for me?

    Now that you understand the mechanics, it’s time to look at the pros and cons so you can begin to determine if such a move makes sense.

    Pros:

    • You’ll potentially pay fewer taxes now than in future. Moreover, your savings go from an account that is tax-deferred and tax-infested to one that is tax-free. When making your determination, be sure to take into account other sources that might increase your ordinary (taxable) income later, potentially placing you in a higher tax bracket and increasing your tax liability. These can include items such as investment income, Social Security benefits, pensions, annuities, inheritances, rents and royalties, et cetera
    • Contributions and earnings grow tax free
    • You can withdraw contributions at any time and for any reason tax-free
    • Withdrawal of earnings in the plan are tax-free and penalty-free, as long as the distribution from a Roth IRA is “qualified,” meaning it meets the following conditions:
      • The distribution is made after you reach age 59 1/2, or if you become disabled or it goes to your beneficiary after your death, and
      • The distribution is made after the five-year period beginning on January 1 of the first year that you made a Roth contribution into the plan
    • You don’t have to take required minimum distributions (RMDs), which is a big consideration versus 401(k) and Traditional IRAs, which can force you to take distributions starting at age 73 (whether you want or need to), resulting in an increase in income and the increased taxes you will pay at that time
    • Not having to make RMDs also makes a Roth IRA a valuable estate planning tool, enabling you to continue to grow your savings and to eventually pass them on to your heirs
    • Those normally ineligible for a Roth IRA contribution due to income limits can potentially utilize a backdoor Roth IRA strategy, which you can learn more about here
    • Diversify investments – you may be able to invest in an array of different assets depending on the rules of the Roth IRA account you utilize versus what are often relatively limited choices within a 401(k)
    • Greater control of assets – 401(k) plans generally come with many rules and restrictions. A Roth IRA (especially a self-directed plan) often offers greater flexibility to make decisions and move your money around in a manner of your choosing
    • Save on fees – you may save on fees in your Roth IRA versus a 401(k) plan, which often have higher fees

    Moreover, your savings go from an account that is tax-deferred and tax-infested to the one that is tax=free.

    Cons:

    • As previously detailed, you must pay potentially substantial tax on the conversion in the year that it occurs
    • You lose the tax reduction you now receive for making contribution to your 401(k), so you have higher payroll income and will probably owe more in taxes. That means less in your pocket now
    • Annual contribution limits into a Roth IRA are substantially lower than your 401(k), according to the IRS
    • You may no longer enjoy the benefits of employer match and company stock, which can represent the loss of substantial dollars over time. You may also lose other benefits offered by your 401(k) plan, such as the ability to take out loans
    • You must wait five years to take penalty-free withdrawals of your earnings if you’re under age 59 1/2
    • 401(k) funds are generally protected from creditors, while Roth IRAs are generally only protected from creditors through bankruptcy

    Does a Roth Conversion make sense for me?

    Five-year rules

    The IRS has a five-year Roth contribution rule. It requires that a Roth IRA account needs to have been funded for five years before you can make a qualified withdrawal, in which case the earnings can be withdrawn tax-free.

    If you fail to wait and prematurely withdraw earnings from the account before the five-year period is met, taxes will apply to those earnings. If this is done before you reach age 59 1/2, you’ll also be on the hook for the 10-percent early withdrawal penalty on the earnings withdrawn.

    Note that the five-year period for the account starts as of January 1 of the year of the first contribution, conversion or rollover.

    In addition, the IRS has a Roth conversion five-year rule that applies for a 401(k) to Roth IRA conversion scenario, according to Fidelity. Under this rule, if you withdraw converted funds before age 59 1/2, you’re generally going to be on the hook for the 10-percent early withdrawal penalty for the earnings withdrawn, but also for any pre-tax assets that were converted, as well as income taxes on the earnings. This is regardless of whether you’ve already met the five-year Roth contribution rule.

    You can withdraw earnings from the account tax-free and penalty-free if done after age 59 1/2, as long as the five-year contribution rule has been satisfied. Keep in mind that each Roth conversion has its own five-year holding period, which starts on January 1 of the year in which the conversion occurs.

    Future contributions

    If you’re planning  to contribute to your Roth IRA, your contributions (combined Traditional and Roth) are the same as your annual IRA contribution limits.

    According to the IRS, for 2024 the limit is $7,000 per individual, unless you are age 50 and over, in which case you can make a $1,000 additional “catch-up” contribution, for a total of $8,000. You can make a contribution for 2024 up to the unextended federal tax filing deadline, which is April 15, 2025.

    For tax year 2025, the limits and deadlines are the same – $7k or $8k age 50 and over, up to the unextended federal tax filing deadline.

    Remember that the actual amount that you are allowed to contribute to a Roth IRA is based on your income. For 2025, to contribute the maximum amount, your modified adjusted gross income (MAGI) must be less than $150,000 (up from $146,000 in 2024) if single, or less than $236,000 (versus $230,000 in 2024) if married and filing jointly, according to the IRS.

    Contributions begin phasing out above those amounts. You can’t make a contribution into a Roth IRA in 2025 once your income reaches $165,000 if single, and $246,000 if married and filing jointly.

    Keep in mind that both spouses are eligible to contribute to a Roth IRA plan as long as they both have earned income up to or greater than what they contribute – but they are still limited to the annual limits.

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    Important scenarios to consider

    If you’re younger and have a long-term horizon till retirement, a Roth conversion from a 401(k) might make sense now given that you will probably grow your income over time. In that scenario you’re likely to pay less tax now than down the line when your income might be substantially higher.

    Where you intend to retire is worth considering. If you plan to move from a lower-tax state in middle-America to a high-tax state such as California, it might make sense to convert to a Roth IRA and pay taxes before doing so, when you know your tax burden is going to increase.

    Another is income-related monthly adjustment amounts or IRMAAs. A tax-free withdrawal from your Roth IRA can be advantageous, as it won’t contribute to your taxable income, which is used to determine how much you pay for Medicare Part B and Part D premiums, according to the Centers for Medicare & Medicaid Services (CMS).

    If you’ve experienced a job loss or decline in income over a period it can also make sense to consider a Roth conversion. The decreased income and tax rate might enable you to pay less tax on the conversion now versus later in retirement.

    The same holds true if your 401(k) experienced a decline in value due to market-related losses. Although unfortunate, you may be able to take advantage of that issue to pay less taxes now, and hopefully regrow your money tax-free for use in your future retirement.

    One other key consideration is the timing of your Roth conversion. Because the IRS requires estimated quarterly tax payments (your employer normally collects those payments from your payroll), if you convert early in the year you will owe the taxes at that point. If you don’t pay them at that time and instead do so later in the year, you could end up owing penalties and interest as well.

    If you don’t intend to pay the tax till near year-end, you might be better served performing the conversion in the last quarter. But you want to be careful as the transaction must be settled by December 31st in order to count for the current tax year.

    Important scenarios to consider when converting

    Conclusion

    Wow!!!

    To say that was a mouthful is a major understatement. There is so much to cover and to consider. Believe me when I say that this article could have been two or three times longer had we gone into every avenue related to a Roth conversion of your 401(k) plan.

    There’s no getting around the fact that a Roth conversion strategy of this nature is very complicated and involves many moving parts. There a many serious considerations that must be undertaken, as well as pitfalls that can expose you to negative consequences if mistakes are made.

    All the said, the decision on whether it makes sense to convert your 401(k) to a Roth IRA still boils down to your personal circumstances.

    Unfortunately, there is no crystal ball that tells you whether your future income will be higher or lower than it is presently, what the tax situation will be, how long you’ll live and need income in retirement, or that can address countless other key factors.

    Before making that decision, it’s safe to say that you’d be best served consulting with an experienced financial advisor who can walk you through the myriad considerations.

    At Oak Harvest we’d be happy to consult with you as you make the decision regarding whether a Roth conversion for at least a portion of your 401(k) makes sense.

    Additionally, we can also look at your current retirement plan to determine if it’s capable of helping you achieve your retirement goals.

    Or we can assist you by creating a retirement plan capable of enabling you to meet your goals. We can build a holistic, comprehensive retirement plan addressing relevant issues, utilizing strategies that cover Social Security, taxes, income, spending, healthcare, legacy, and more, customized to your family’s specific needs.

    A plan created with the goal of ensuring you can successfully live out the retirement you and your spouse envision.

    If you are ready to take the next step and talk to a team of financial advisors and retirement planners who can advise on all your retirement needs, Schedule a call today!

     

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