Ask Money

Converting a 401(k) into a Roth

Chris Farrell Mar 2, 2011

Question: Hi Chris, I have an old 401k from a previous employer that I would like to take control of. I remember hearing there was a chance that in 2011 the powers that be may allow one to roll an old 401k into a Roth IRA account. I thought I would wait till then to figure out what to do with the 401k. Given that it is now 2011, do you know any of the information on the subject? I’ve done a couple quick searches and haven’t come up with anything. If this is not possible what would you recommend? Thanks! Wade, Seattle, WA

Answer: The most common way to take control of an old 401(k) plan is through a rollover IRA. There are no tax consequences or penalties imposed on a rollover so long as the money goes directly from your former employer into the rollover IRA account (which is why it’s also called a tr5ustee to trustee rollover).

But you’re right, there is another option. The old rules that put up obstacles to converting a 401(k) into a Roth-IRA have been changed. You can go directly from a 401K) into a Roth. You won’t pay a penalty, but you’ll owe ordinary income taxes on the conversion.

Whether you put the money into a traditional IRA or a Roth-IRA, I would check with the folks in human resources before doing anything since companies have different procedures and forms to fill out. Get their check list of things to do. The same goes with the investment company you’ve chosen to place your Roth-IRA.

By most accounts the single best retirement savings plan is the Roth IRA. The main reason: Since you’ve already paid tax on the money going in, you don’t have to pay taxes on accumulated gains when you withdraw the money during retirement. That said, you need to figure out whether it really makes sense for you to pay the tax bill now versus later.

A reasonable rule of thumb is that it’s worth considering if you have additional savings to tap for the tax bill. It doesn’t make sense if you use withdrawn 401(k) money to meet the tax levy. The odds of a conversion working in your favor increase the longer the money has to compound, too.

But this is only a starting point. Doing the calculation right takes an effort. A good place to start running the numbers is at analyzenow.com:

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