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I am rolling a 401k from a former employer to an IRA or Roth. I am trying to figure out the tax consequences of doing so. My understanding is, is that my contributions to the 401k were not taxed going in, so I need to roll it over into a traditional IRA to avoid taxes at this time.

Is this correct? Do I even have an option of putting it into a Roth IRA?

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3 Answers

up vote 7 down vote accepted

Do you have a current employer with a 401(k)? If so, and if the fees are low AND the ability to borrow half the balance is important to you, consider a transfer.

I don't recommend a transfer/conversion to a Roth. The best way to proceed is to transfer to an IRA and decide from there if and how much to convert to Roth. I don't know your current income, tax bracket, or balance that might get converted. A total conversion runs the risk of costing more in taxes than leaving it to grow in the traditional IRA. On the other hand, a methodical partial conversion can 'fill your bracket' each year, and potentially avoid higher rates down the road.

A conversion is not good or bad, in and of itself. One can only tell for a given individual whether it's right for them.

Edit - Understand, this topic can be the subject of a book. In fact, there are many books that cover Roth IRAs and traditional IRAs. Every option can lead to a lengthy discussion, which is fine, as there are option that work for some, but not others. For example, if one has 18% credit card debt and a payment so high they can't afford new 401(k) deposits and miss the matching employer contribution, the 401(k) loan at about 4% currently can free up their high CC payment to allow for these deposits. If this were the case, then even my warning of "low fees" needs to be closely evaluated. Given how many people owe money at these high rates, this situation is far from a contrived example. I'll agree that the advice for most should still be to transfer to the traditional IRA, and consider whether a partial conversion makes sense. It's worth adding here, you can withdraw from your employer's 401(k) upon separation at 55 or older with no penalty. To avoid the penalty in the IRA requires a Sec 72(t) withdrawal, which can be tricky.

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Employer-sponsored plans are notorious for high fees, though. :( –  fennec Oct 20 '11 at 3:49
    
Absolutely, fennec. Which is why I stated "if the fees are low..." That 1 basis point that Vanguard is higher than my fund would cost us quite a bit each year. Also, the "And ability to borrow." If the 401(k) loan can clean up some 18% credit card debt, the numbers may still favor the 401(k) despite a bit higher fee. Again, it all depends on the OP's exact situation. –  JoeTaxpayer Oct 20 '11 at 11:54
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The decision whether to roll over to a Roth IRA or non-Roth account (IRA or 401K) should be based on your current tax rate and the tax rate expected at retirement.

If you think that at the retirement your tax rate would be higher than it is now - roll over to Roth and pay taxes now, taking advantage of the lower rate.

If you think that your current tax rate is higher than what you expect to have at the retirement time, roll over to a regular IRA or 401k with the current employer.

Pretty simple.

As to whether to roll over to IRA or current 401K - I'd say IRA. Usually 401K accounts are much more limited with regards to the investment options, while the fees are higher. Since there's no matching on roll-overs and there's no cap, the benefits of the 401K over IRA are irrelevant, and you only get the limitations, without the gains.

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My 401(k) S&P fund charges 5 basis points. Can you do better in an IRA? Also - the conversion is not an all-or-none. And the tax rates are not now-or-at-retirement, there's every year till then. The best conversion strategy is when one converts just enough to top off their 15% bracket. The worst is when someone converts $1M, borrows to fund the tax bill (and shoots right through the top bracket) and finds they are in the 10% bracket at retirement as they have no pre-tax savings remaining. –  JoeTaxpayer Oct 19 '11 at 22:08
    
@Joe, what does this sentence mean: "My 401(k) S&P fund charges 5 basis points. "? –  littleadv Oct 19 '11 at 22:13
    
a basis point is .01%. One hundredth of a percent. That's the fee for my company 401(k) S&P fund . .05% or 1/20 of 1% per year. –  JoeTaxpayer Oct 19 '11 at 22:32
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No, I work for a large company, they negotiated well. I've not seen fees this low in ETFs. I do agree, most 401(k) funds are far higher than ETFs you buy in your IRA or other acct. Good to research before making any decision. –  JoeTaxpayer Oct 19 '11 at 22:48
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Vanguard's S&P500 ETF runs you 0.06%. Their mutual fund does as well (Admiral shares, $10k minimum). –  fennec Oct 20 '11 at 3:59
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The difference between a traditional and a Roth IRA are that in the traditional, you pay no taxes on the income now, but you do when you withdraw them. Contributions to a Roth, in contrast, are taxed now, but not when you withdraw them.

For the Roth to be the better choice, the taxes you pay now should be less than what you would pay if it were a Roth. In other words, if your income from your retirement account is going to be higher than what you currently earn, then you should choose a Roth.

Assuming that you wish to live on the proceeds of the account (rather than drawing down the principal (I know, there are RMDs to worry about as well, but to keep this simple I'll ignore them)), and that you will have an annual real return of 5%:

With 10 years to save, Roth is the better deal when you contribute 13% or more of your income. With 15 years to save, you need to contribute about 8% or more for the Roth to be a better choice. With 20 years to save, your minimum contribution for a Roth to make sense would be about 5% of your income.

Naturally, there are a lot of assumptions in there. For one, I didn't account for inflation or CPI increases - but I also chose a pessimistic rate of return. I'd recommend seeing a CPA or investment advisor to talk about your specific numbers.

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