Rolling over a 401(k) to a Roth IRA
Al asks: Can I roll my 401(k) into my Roth IRA when I leave my job?
Sort of. How’s that for a satisfying answer?
Here’s the deal. Unless you have a Roth 401(k) (a fairly new and rare beast), a 401(k) is like a traditional IRA, not a Roth IRA. You put pre-tax money into a 401(k): unlike the rest of your paycheck, your 401(k) contribution goes straight into the account without the IRS taking its share via withholding. Of course, you’ll still have to pay taxes later when you withdraw the money… or convert it to a Roth.
If you roll your 401(k) over to a Roth IRA, you have to pay income tax on the entire balance. Since you’re leaving the money in a retirement account, there’s no early withdrawal penalty, but the converted amount is considered income and you could end up in a higher tax bracket. Furthermore, the tax payment has to come from outside the account. For example, if you’re in the 25% bracket and you roll a $50,000 401(k) over to your IRA, you’ll need to cough up $12,500 cash.
The bottom line: Roll it over to a traditional IRA. You won’t pay any tax or penalty and you can look into doing partial Roth conversions, or none at all, depending on your tax situation.
Pros and cons of 401(k)s and 457(b)s
Robert asks: What are the pros and cons of a 401(k) vs. a 457(b)?
If you’ve never heard of a 457(b), you’re probably not eligible for one, but stay with me a minute, just in case.
A 457(b) is a pre-tax savings plan similar to a 401(k). While 401(k)s are widespread, only public employees and certain highly compensated employees in the private sector have access to a 457(b). (Isn’t “highly compensated employee” a great euphemism for your boss’s boss? It’s right up there with “high net-worth individual.”)
If you have access to a 401(k) and a 457(b), you can contribute $17,000 (if you’re under 50 years old) to either or both. Yes, that means $34,000 in total. The main difference between a 401(k) and a 457(b) is that with the 457(b), you can make withdrawals at any age without a penalty, as long as you’re no longer working for the employer where you signed up for the 457(b).
If you’re a public employee, therefore, it generally makes sense to contribute to a 457(b) before contributing to a 403(b) (the government employee equivalent of a 401(k), and I am so sorry for the alphabet soup), as long as you don’t forego a matching contribution.
There’s a special wrinkle to non-governmental 457(b)s, however: unlike a 401(k), the money isn’t entirely yours. Until you actually withdraw it, it’s an asset of your employer and could be turned over to creditors in bankruptcy. The actual risk of this happening is remote, but it’s scary enough that private sector employees should fill their 401(k)s before considering the 457(b).
The bottom line: A governmental 457(b) is excellent, so use it; a private 457(b) is good, but riskier, so use it only if you fill up your 401(k).
Rolling over 401(k) contributions
Craig asks: Can I annually, or even more regularly, roll over contributions I have made to my employer’s 401(k) into my Roth IRA? I am under 59.
No—except in one unusual situation.
Generally speaking, you have to leave 401(k) money in the 401(k) until you change jobs, retire, or quit in a huff and slide out the back of the plane.
Some employers, however, allow in-service distributions of after-tax contributions. What this means:
- You contributed the full $17,000 maximum to your 401(k)
- Your company allows you to contribute additional money, after tax
- That additional money can be rolled over into a Roth IRA
Yes, this means you have to max out your 401(k) before there’s even a chance you can do this. (Actually, sometimes you can also get away with it if you’re over 59-1/2.) If you’re a highly compensated employee (yay!) and are contributing $17,000 already, by all means, ask your benefits office about in-service distributions.
There’s one other situation where you might be able to do rollovers without cleaning out your desk. If your employer’s plan is a SIMPLE IRA, rather than a 401(k) (yes, a SIMPLE IRA is yet another similar pre-tax retirement plan), you can roll over any money that’s been sitting in the plan for at least two years. And you probably should, because SIMPLE IRAs tend to charge high fees and offer lousy investment options.
The bottom line: You probably can’t do this.