About Converting 401K to Roth

About Converting 401K to Roth

Must-Know Rules For Converting A 401(k) To A Roth

by Cathy Pareto,CFP®, AIF® (Contact Author | Biography)

The benefits of owning a Roth IRA are quite clear; among them are the tax-free growth of assets and the ability to stretch distributions over one's lifetime. But did you know that you may qualify for a Roth conversion directly from your corporate retirement plan? Previously prohibited, the Pension Protection Act of 2006 initiated provisions that enable plan participants to convert employer-plan balances to Roth IRAs. However, specific guidelines had not been revealed by the IRS, and so the process garnered very little attention from investors. Let's shed some light on how these conversions work, and why you might want to consider making the switch.

How the Change Came About
The Pension Protection Act of 2006, commonly known as PPA, amended many rules relating to IRAs and qualified plans, including the rule that allows retirement plan participants to roll over corporate retirement-plan funds directly into a Roth IRA.  Prior to the amendment by the PPA, a Roth IRA could only accept rollover contributions distributed from another Roth IRA (referred to as "60-day rollover contributions"), a non-Roth IRA referred to as a conversion, or a rollover from another designated Roth account  also known as a Roth 401(k) or Roth 403(b). This rule essentially created a two-step process for qualified plan participants that wished to convert the funds into a Roth IRA and stretch out the distributions over their lifetimes. First, participants had to roll the funds over into a Traditional IRA, and then convert these assets into a Roth IRA. Section 824 of the PPA amended the definition of qualified rollover contributions to include other eligible retirement plans, thus making the two-step process obsolete. (If you want to learn more on the PPA, check out Pension Protection Act Of 2006 Becomes Law.)

IRS Notices And Clarifications
On March 5, 2008, the IRS released Notice 2008-30, spelling out the details for converting employer-plan funds directly into Roth IRAs, including the restrictions. Here's the simplified version of the rule:

i) Company retirement plan assets, including those from 401(k), 403(b) and 457(b) governmental plans, can now be converted directly to a Roth IRA.

ii) The normal Roth conversion rules still apply, including:

• Modified adjusted gross income (MAGI) cannot exceed $100,000, whether you file a joint or single return.
• You cannot be married filing separate returns for the 2008-2009 tax filing year.  
  
  (It's worth noting that in 2010, these rules will be permanently repealed.)

iii) Any funds converted into a Roth IRA that would otherwise be taxable must be included as income for the year of the conversion.

iv) If the plan participant has after-tax funds in his qualified plan account, the conversion of plan assets to a Roth IRA will NOT be subject to the pro-rata rule, which states that participants have to pay personal income taxes on any deductible pretax contributions. It does not apply to after-tax funds converted to a Roth IRA because the participant has already paid taxes on those contributions.

v) Direct rollovers of plan funds into a Roth IRA will not be subject to a 20% withholding, but 60-day rollovers are, so it is best to do a trustee-to-trustee transfer. (For more insight, read Did Your Roth IRA Conversion Pass Or Fail?, The Simple Tax Math Of Roth Conversions and Recharacterizing Your IRA Contribution Or Roth Conversion.)

When Do Conversions Make Sense?
The right candidates for retirement plan rollovers into Roth IRAs are usually individuals who will not need to take distributions from the account for many years or who won't take any distributions at all. This is important to remember if you convert the retirement plan funds into a Roth IRA, because you will have to pay a 10% penalty on the funds withdrawn if the following applies:

• You withdraw funds from the Roth IRAwithin five years of the conversion, and 
• You are younger than 59.5 and don't qualify for an exception to the 10% penalty.

Another important consideration in making your decision to convert the funds is having the ability to pay the taxes up front for the conversion from a source other than the Roth IRA. (Read Avoiding IRS Penalties On Your IRA Assets to learn which transactions can have expensive consequences.)

Impact on Non-Spouse Beneficiaries
One of the most significant changes the PPA made is that non-spouse participants now have the ability to roll over the inherited retirement-plan assets into inherited Roth IRAs, which they were previously unable to do. This is significant because beneficiaries cannot convert inherited IRA funds into Roth IRAs, but they can now convert inherited retirement-plan assets into an inherited Roth IRA - go figure. However, in order for the non-spouse beneficiary to take advantage of the Roth IRA, they must do a direct transfer. If the beneficiary receives the distribution (a 60-day rollover), he or she will not be able to roll those assets into any inherited IRA, Traditional IRA or Roth. Not only that, but the beneficiary will owe taxes on the distribution and will miss out on the ability to stretch out the account.  Again, this is why it is so critical for the plan participant or beneficiary to request a direct rollover or trustee-to-trustee transfer.

But before you attempt to rollover the funds into a Roth IRA, you should make sure that the employer plan allows non-spouse beneficiary rollovers into an inherited IRA. A lot of plans do not, but if yours does, then you should be able to roll over the funds into a Roth IRA. (Check out  Inherited Retirement Plan Assets - Part 1 and Part 2 for further reading.)

Beneficiaries are Subject to Required Minimum Distributions (RMDs)
Once the beneficiary successfully rolls over the retirement-plan assets directly into an inherited Roth IRA, that person will have to start taking RMDs from the inherited Roth IRA. These distributions must begin the year after the death of the person from whom the account was inherited, and the amounts will be based on the beneficiary's age. These minimum distributions are not taxable (because the tax has already been paid in the conversion), they are not assessed with penalties (regardless of age) and they are based on the beneficiary's life expectancy.

This is important to understand, especially if the beneficiary of the account is older.  It may not make sense to convert the account and have to take large distributions, even if these are tax free. There simply may not be enough time to make up for what you lost in taxes on the conversion. (Head over to our article Avoiding RMD Pitfalls to learn more.)

Restrictions for Beneficiaries
There are several restrictions and obstacles that beneficiaries have to overcome to be able to roll over a retirement plan into an inherited Roth IRA. Here are some of the major ones:

• The beneficiary is subject to the same AGI and marital restrictions as any other owner converting IRA funds into a Roth, but only for 2008-2009.
• If the beneficiary does the conversion from the employer plan, he or she will have to pay the taxes up front.

Conclusion
While these rules on Roth conversions from corporate retirement plans are great for some, they won't benefit everyone.  What the PPA 2006 has done is to provide more options to both retirement-plan participants and the beneficiaries of these plans. You don't have to roll over the assets into a Roth IRA, but you still have the option to roll over your retirement plan into a traditional IRA or traditional inherited IRA if you are the beneficiary, which is frequently the best option. IRAs not only provide you with more investment options, but also with greater flexibility for estate planning. If the reason for not taking advantage of the Roth IRA happens to be the MAGI limits, and the corporate retirement plan is a good one, you may even consider leaving the assets behind until 2010, when the MAGI limits are repealed.

For further reading, be sure to check out our Roth IRAs Tutorial.

Conversion Eligibility
Find out if you're allowed to convert to a Roth IRA
By Kaye A. Thomas
Updated January 23, 2009

Details on eligibility to convert a traditional IRA to a Roth IRA.

Are you eligible to convert your traditional IRA to a Roth IRA? Here are the main points:

■For years before 2010, if your filing status is married filing separately, you don't qualify unless you lived apart from your spouse for the entire year.
■For years before 2010, if your modified adjusted gross income is greater than $100,000, you can't convert a traditional IRA to a Roth IRA.
■For years before 2008, direct conversions from an employer plan to a Roth IRA were not permitted. You can do that now, but in some situations it may be preferable to roll to a traditional IRA and then convert to a Roth IRA.
■If you inherited a traditional IRA from a person other than your spouse, you can't convert it to a Roth IRA.
■You can convert a traditional IRA to a Roth IRA even if you made a rollover within the previous 12 months.
■If you're otherwise eligible, you can convert part of a traditional IRA to a Roth IRA. But you can't convert only the nontaxable part.
Details concerning each of these points are provided below.

Filing Status
For years before 2010, you generally can't convert a traditional IRA to a Roth IRA if your filing status is married filing separately. There is an exception, though: if you live apart from your spouse for the entire year, you can file a separate return and still be eligible for a conversion if you meet the other requirements.

Change in the law: Beginning in 2010 the rule against conversions by people who are married filing separately no longer applies.

Modified Adjusted Gross Income
For years before 2010, you can't convert a traditional IRA to a Roth IRA in a year when your modified adjusted gross income is greater than $100,000. The term modified adjusted gross income refers to your income after certain deductions (but not all) are allowed, modified to add back certain items that are excluded from income. See IRAs and Modified AGI.

Q: How does this limit work for married couples?

A: The limit is the same for married couples as for single individuals. If you are married filing jointly, your joint modified adjusted gross income must not exceed $100,000 in the year you roll to a Roth IRA.

Q: What if I make a conversion early in the year but end up exceeding the limit because of unexpectedly large income?

A: You should be able to avoid a penalty if you take corrective action by your return due date (including extensions).

Q: What if I exceed the $100,000 limit during some later year?

A: No problem. The limit only applies to the year of the conversion.

Change in the law: Beginning in 2010 the $100,000 limit no longer applies. See Conversion Rule Changes.

Accounts eligible for conversion
For years before 2008, the only thing you could convert to a Roth IRA was a traditional IRA (including a SEP IRA). You couldn't convert directly from a 401k or other employer plan to a Roth IRA. If you were eligible to roll a distribution from an employer plan to a traditional IRA, and also eligible for a conversion from a traditional IRA to a Roth IRA, you could accomplish your goal in two steps: first roll to a traditional IRA, then convert to the Roth IRA. But a direct rollover from an employer plan to a Roth IRA wasn't permitted.

A direct conversion from an employer plan to a Roth IRA is permitted beginning in 2008, but only in circumstances where you would be eligible for both steps in the two-step conversion just described (a rollover to a traditional IRA followed by a conversion of that IRA to a Roth).

Q: What about a SIMPLE IRA?

A: A SIMPLE IRA can be converted to a Roth IRA, but only after you've participated in a SIMPLE IRA Plan for the employer maintaining that plan for at least two years. Before that, the only rollover permitted for your SIMPLE IRA is to another SIMPLE IRA.

Roll what you received
If the rollover distribution from your traditional IRA was entirely in cash, then your rollover contribution to your Roth IRA must also be in cash. You don't have to show that it's the same cash, but you're not allowed to use the cash to buy property and then roll the property into the Roth IRA.

If you received a property distribution from your traditional IRA, then you must roll exactly the same property to your Roth IRA — or cash proceeds from the sale of that property. A rollover or conversion is the only time you're allowed to contribute property to a Roth IRA.

Inherited IRAs
Conversions are not permitted for an IRA you inherit from a person other than your spouse. Guidance issued by the IRS in March 2008 seemed to indicate these conversions would be permitted, but a technical corrections law passed in December 2008 clarified they are not permitted.

When you inherit a traditional IRA from your spouse you're permitted to elect to treat this IRA as your own. If you make this election, you can convert the IRA to a Roth IRA if you meet the other requirements described on this page.

Rollover within 12 months
Normally you aren't allowed to do more than one rollover from or to the same IRA within a 12-month period. This rule applies to Roth IRAs, too, but with a special exception. For purposes of this rule you're permitted to disregard a conversion from a traditional IRA to a Roth IRA, even if the conversion takes the form of a rollover.

Example: In November, 2007, you took a distribution from your traditional IRA and rolled it to a different traditional IRA within 60 days. In March, 2008 you want to roll this traditional IRA to a Roth IRA. This rollover is permitted if you meet the other requirements for a rollover.

Rolling part of your IRA
There's no rule that says you have to convert your entire IRA at once. You can convert part of an IRA if you choose. Unfortunately though, you can't choose to roll only the nontaxable part of a traditional IRA that contains taxable and nontaxable money.

Example: You have a traditional IRA with a balance of $10,000, which includes $6,000 of nondeductible contributions. If you roll $6,000 of this IRA to a Roth IRA, you're required to treat that rollover as coming 60% from nondeductible contributions and 40% from other money — the part that's taxable.

How to Convert a 401k to a Roth IRA

By Kent Ninomiya
eHow Contributing Writer

There are several rules you must follow when you convert a 401k to a Roth IRA. The Internal Revenue Service has very strict regulations regarding who can perform a 401k-to-Roth IRA rollover and how it is to be done. It is important to follow all of these regulations so that all the money in your employer-sponsored 401k plan gets to the Roth IRA account.

Difficulty: Moderate

Instructions

1. Step 1

   Determine if you are eligible to convert a 401k to a Roth IRA. The IRS only lets taxpayers who meet certain income requirements do so. A taxpayer's modified adjusted gross income must be $100,000 or less. Your MAGI is the figure on your tax return that is actually subject to tax. It is what is left over after all of the deductions and credits are subtracted from your gross income. If your MAGI is more than $100,000, you cannot perform the rollover during that tax year. It is possible to perform the conversion in a later tax year if your MAGI drops below $100,000.

2. Step 2

   Perform the 401k-to-Roth IRA conversion at an appropriate time. Most taxpayers do it when they stop working for the employer that is hosting their 401k plan. This makes sense if you want to have more control over your retirement investments. However, most 401k plans allow you to keep your money in them indefinitely. Investors always have the option to roll over their 401k to an IRA anytime after leaving a workplace. There is no time limit. This makes sense if the taxpayer is waiting for a tax year when she is eligible for a Roth IRA rollover. The only time it does not make sense to convert 401k money to a Roth IRA is if you are still participating in the 401k plan.

3. Step 3

   Set up a Roth IRA account. If you already have a Roth IRA, you can use that. If you don't, you must establish one. Most major financial institutions sponsor Roth IRA accounts--including banks, stockbrokers and mutual-fund companies. Most investors choose mutual-fund companies like Fidelity, Vanguard or T. Rowe Price, because they have "no-load" funds with low fees and offer a wide range of investment options. Tell the financial institution that you want to convert a 401k to a Roth IRA. They will send you papers to fill out and sign.

4. Step 4

   Contact the holder of your 401k and tell them you want to "roll over" your account to a Roth IRA. Most will make you read a document, then fill out authorization papers. Sign the papers and send them back. Be sure to clearly state where you want the 401k money sent, and that you want a "rollover" and not a redemption.

5. Step 5

   Ask the holder of your 401k to send the money directly to the Roth IRA account. Some financial institutions will do this so you never have to touch the money. However, many financial institutions won't; instead, they send you a check. Make sure this check is made out to the Roth IRA account and not you. As soon as you get the check, forward it to the financial institution holding your Roth IRA. Your 401k-to-Roth IRA conversion is complete.