There are many benefits to holding retirement money in a Roth IRA, but if you're thinking about rolling over the assets from a workplace retirement plan or a lump-sum pension payment directly into a Roth, first consider the tax ramifications. Rolling over your 401k or 403b to a Roth IRA -- even to a Roth 401k in your employer's plan -- will be treated as an infusion of ordinary income on your tax return.
Because workplace retirement accounts rarely include after-tax contributions, your entire rollover likely would be considered and taxed as ordinary income. However, you would not be assessed an early withdrawal penalty, even if you are younger than 59 1/2.
The tax will be assessed as part of your return in the year you roll over the assets. However, depending on the size of the rollover, you may need to make estimated quarterly payments to avoid a tax penalty.
Paying The Tax
If you need to hold out some money from the rollover to pay the tax, it will not be protected from the early withdrawal penalty. For example, if you're age 48 and rolling over a 401k account valued at $50,000, your tax liability at the 25 percent marginal tax rate will be $12,500. But if you hold out that amount for the tax bill, you're likely to incur an additional 10 percent, or $1,250 in taxes.
Partial Roth Rollover
You can defer some of your tax hit by rolling over part of the 401k into a Roth and part into a traditional IRA. The rollover into a traditional IRA carries no immediate tax implications. One option: Make your rollover a two-step process. First, roll over your workplace plan into a traditional IRA. Second, make a partial conversion from the IRA to a Roth account.
If you already have an IRA and a sizeable portion of it comprises nondeductible IRA contributions, there is a downside to mixing in a rollover from your 401k. Nondeductible contributions are not taxed in a Roth conversion. But if you decide after your rollover to convert IRA assets to a Roth, you can't pick only the nontaxable part. The conversion must be in proportion to the IRA's taxable and nontaxable assets, and the rollover will dilute the nontaxable assets. One option is to convert some or all of the traditional IRA assets before mixing in the rollover 401k.
Rolling over a workplace retirement plan into a Roth can increase your modified adjusted gross income (MAGI) enough to push you into a higher marginal tax bracket. The MAGI boost might also push your income past the threshold for income-triggered tax benefits, including eligibility for regular Roth contributions.