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Previous Question.

I have decided to roll my 401(k) into a Roth IRA. I use ThinkOrSwim as my broker currently, so I plan on opening an IRA with them. When opening the account I'm presented with the choice between a Rollover IRA and a Roth IRA. The description for the Rollover IRA says its for rolling over a retirement account. My question is: What is the difference between the two? Can I not just open a Roth IRA and roll the funds into that account?

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    Converting regular IRA funds into a Roth IRA will have major tax implications. i.e. you will owe the IRS money. – fennec Dec 11 '10 at 17:54
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    BTW: There is no such thing as a "Rollover IRA". There is a traditional IRA and a Roth IRA. The term "Rollover" refers only to the fact that you are moving the money from one account to another. – JohnFx Dec 11 '10 at 17:58
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    @JohnFX - While they're pretty similar, there are some administrative differences. In particular, you can't contribute any (new) money directly to a rollover IRA - you can only transfer it from existing retirement accounts. – fennec Dec 11 '10 at 20:53
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    @fennec - I think you may be wrong about contributing new money to an IRA that is the result of a rollover. I've done it with no issues. There were rules that discouraged this in the past, but they have since been repealed according to my Internet sources. – JohnFx Dec 12 '10 at 18:29
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If you have the cash on hand to pay the tax on the amount you are transferring I recommend moving to a Roth IRA

An IRA is tax-deferred. You put in pretax contributions in to an IRA, and you are taxed on that money (your contributions and interest earned) when you withdraw it at retirement, age 59 1/2.

The idea being that you will be taking less out per year in your retirement years, putting you into a lower tax bracket. The major problem is most people draw out as much or more a year in their retirement years than when they were working.

A Roth IRA grows tax free You put after tax contributions into a Roth IRA, you have paid taxes on the contributions, and you are never taxed on the growth. When you draw the money out at retirement you don't pay any income taxes on that money.

Let me give you an example:

For this example we will use the following information for both scenario:

  • You are in the 25% fed tax bracket
  • Your mutual fund investment will average 12% a year.
  • You will invest from age 25 to age 65.

We will invest $400 per month for a total of $4800. The current maximum is $5000 if you are under 50 years old

Roth IRA

$400 dollars after taxes is $300

Invest $300 a month, at age 65 you have 3,529,432

You owe no taxes on this money, it doesn't matter how much you take out a year.

IRA

$400 dollars a month is taken pretax out of your paycheck.

Invest $400 per month, at age 65 you have $4,705,909 You owe taxes of 25% as you draw that out for at total tax of 1,176,477

4,705,909 - 1,176,477 = 3,529,432 cash in your pocket

The problem is if you draw out more than $82,400 (current 2010 filing single) per year you will be pushed to a higher tax bracket and take more of your money away.

If you decide to buy a vacation home and you take out $250,000 to pay for it, that's counted as income for that year any you will be in the 33% tax bracket.

Even if you can keep yourself to a low income the government forces your hand and makes you draw out more money at age 70, based on their tables, forcing you into a higher tax bracket

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    Okay, your answer brings a question to mind that I hadn't thought of before: Can I pay the taxes that would be due during the conversion to the Roth IRA with money from the 401(k), or will I have to pay that money out of pocket? Also, Can I convert my IRA to a Roth IRA in the future? – Kyle Trauberman Dec 12 '10 at 6:46
  • Yes you can, but it's not a good idea because you usually won't make up the difference if you take that big of a hit on the money you have invested. How much do you have total in your 401 right now? – Move More Comments Link To Top Dec 12 '10 at 6:59
  • As of the last statement (September 2010), $4,200. – Kyle Trauberman Dec 12 '10 at 7:20
  • Same rules as above if you pay the taxes of $1050, and put all of the $4200 in the Roth you will have $498,320 at Retirement, without ever added more. If you pay the taxes out of the 401 it leaves $3150 that with no other money added grows to $373,740 at retirement. If you can scrap together $1050 to pay the taxes it will be worth $124,579 I don't know your income, but I would do what ever it takes to come up with the tax money even if it meant having a garage sale. – Move More Comments Link To Top Dec 12 '10 at 18:19
  • Considering the number of Americans with underfunded retirements, I'm surprised that "most" people draw out more money in retirement than while working. Is there a reference to prove this? I have seen JoeTaxpayer say elsewhere on this site that unless you expect to have $2 million in your retirement account the Roth IRA is unnecessary (ex: money.stackexchange.com/questions/2917/…). – justkt Dec 13 '10 at 17:44
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A rollover IRA is a traditional IRA. Your rollover contributions are not taxed and rollover or counted against your annual limit, which is income dependent.

A Roth IRA is one where your contributions will be taxed going into the IRA. Note that there are adjusted gross income maximums for contribution to a Roth IRA (see here), and as far as I can tell those income maximums also determine whether or not you can rollover to a Roth IRA.

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    Also, you cannot rollover a 401k directly to a Roth IRA. You need to rollover to a traditional IRA, and then convert some or all of that to a Roth IRA. – KeithB Dec 11 '10 at 22:50
  • @KeithB - I found indications that this changed in 2010 and you can as of this year. – justkt Dec 12 '10 at 22:23
  • Good to know. Its so hard to keep up with all of the changes. – KeithB Dec 13 '10 at 14:26
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    The more correct name for a regular IRA is a "Traditional IRA". – Alex B Dec 13 '10 at 17:39
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Adding to justkt's answer. The big difference to you during the rollover is that moving the money to a Roth IRA, unless it was a Roth 401K, is going to require you pay a lot of taxes on the money you move. I'd suggest not doing that without guidance from a financial advisor.

  • +1 This was my experience. I moved it from my employer into a rollover and there it sits. Neglected for the Roth I started myself. – MrChrister Dec 11 '10 at 17:55
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For reporting purposes, most IRA firms prefer that you roll the 401(k) funds into a Rollover or Traditional IRA and then convert to the ROTH from there. The mid-air conversions (401(k) directly into a ROTH) can get tricky when you go to do your taxes the following year if the 1099 form from the releasing custodian and the 5498 form from the accepting custodian have different numbers due to the conversion amount and taxes withheld if any.

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I saw this confusion with Fidelity and called up their customer support. With Fidelity, Rollover IRA is the same as Traditional IRA. If you are looking to rolling over into a Traditional IRA and a ROTH IRA, you would need to open the two respective accounts - 1 Rollover/traditional and 1 ROTH.

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