Taxes When Rolling 401(k) to Roth IRA

by Leslie McClintock

A Roth individual retirement account (IRA) has some advantages over a 401k plan. While no income tax is due on 401k contributions, and both accounts provide an exemption from capital gains and income taxes, the Roth allows for tax-free withdrawals. Roth IRAs are also not subject to required minimum distributions. With Roth accounts, no estate tax will be due on that portion of the account used to pay income tax. Because of these benefits, it might make sense to roll a 401k over into a Roth IRA and take the tax hit.

Eligibility

To roll assets over into a Roth IRA, you must have earned income below the Internal Revenue Service limit. As of publication, that limit for single taxpayers is $122,000, and for married taxpayers who file a joint income tax return that limit is $179,000 per year. You cannot make a direct contribution to a Roth IRA if your income is over the limit. However, you can still execute a conversion from a traditional IRA to a Roth IRA. If your income is over the limit, you can still roll the 401k over to a traditional IRA, and then convert the traditional IRA to a Roth IRA.

Income Taxes

If you rollover a 401k into a traditional IRA, there is no tax consequence. However, if you roll assets in either a 401k or a traditional IRA into a Roth IRA, you must pay ordinary income taxes on the full amount.

Time Limits

If the 401k sends you a check directly, the plan will withhold 20 percent of the balance to pay any income taxes that would be due if you didn't execute the rollover. If you take the funds directly, you have 60 days to complete a rollover to either a traditional or Roth IRA account. If you fail to complete the transaction, you will need to pay income taxes on the entire amount withdrawn, plus a 10 percent penalty if you are under age 59 1/2, or under age 59 if you have left the company that sponsored the 401k plan.

Net Unrealized Appreciation

If your old 401k contained a significant amount of company stock, you may be able to defer paying taxes on those assets, while simultaneously qualifying the stock for more favorable capital gains treatment. This is due to net unrealized appreciation. If you take the company stock in kind, rather than in cash, you can pay income tax only on your tax basis in the company stock, and defer the rest. For this reason, you may want to keep your company stock in a separate account from the rest of your 401k plan.