There are many benefits to making a 401k rollover to Roth IRA – chief among them the tremendous tax benefits offered by a Roth IRA. However, there are a few things to keep in mind as you decide whether this kind of rollover is right for you specific circumstances.

Firstly, your previous year’s income must not be above $116,000 for someone filing as single and $169,000 for those filing jointly or as married. If your income is above these amounts you don’t qualify for a 401k rollover to Roth IRA but you may qualify for a traditional IRA rollover.

Next you need to decide between an indirect or direct rollover. With a direct rollover your funds are transferred directly from your 401k to your Roth IRA (minus any taxes due on the balance and potential penalty amounts) while an indirect rollover requires you to reinvest the funds yourself within 60 days of the distribution.

Finally, you should consult with a tax professional before you execute the 401k rollover to Roth IRA. Although both of these are retirement savings accounts, their tax treatments are different and you should ensure that you fully understand all of the tax consequences before you proceed.

In contrast to a 401k direct rollover, a 401k indirect rollover does not automatically preserve the tax benefits associated with your 401k account. Because you’re being given the distribution amount directly instead of the transfer being handled by account trustees, the IRS places additional strictures on indirect rollovers to try to ensure you re-invest your retirement savings in another qualified 401k or IRA plan.

The first penalty is an automatic 20% withholding of the account balance that’s designed to pay a portion of the taxes that would be due should you elect not to re-invest the funds in another IRA or 401k account. Although the taxes due if you decide to keep the funds would likely be more than 20%, this insures the IRS that they’ll get at least a portion of the taxes that become due on the distribution.

The second penalty is a 10% early withdrawal fee. Because it can’t be guaranteed that you’ll actually execute the 401k indirect rollover, the IRS also preemptively assesses this penalty based on the assumption that you won’t.

To have these withholding fees credit to your new 401k or IRA account, you must open a qualified IRA or 401k account within sixty days of receiving the distribution check and make a deposit in the amount of the entire original distribution (including the amounts that were deducted in fees and withholding). To recoup the withholding, you must then file the amounts as a credit on the distribution year’s tax return.

As a quick example, let’s assume that you have $30,000 in a 401k account and you decide on an indirect rollover:

Account value: $30,000
Tax withholding: 20% of $30,000 or $6,000
Early withdrawal fee: 10% or $30,000 or $3,000
Total distribution: $30,000 – $6,000 – $3,000 or $21,000

To recoup the $9,000 in fees and penalties, within sixty days you must deposit into a qualifying IRA or 401k account the amount of $30,000. You’ll eventually be credited the $9,000 when you file your tax return but, in the short term, you must come up with that $9,000 on your own.

As you can see, the 401k indirect rollover isn’t the preferred method the IRS wants you to use to rollover your 401k account. It’s designed to place substantial penalties on your retirement funds to help ensure that you’ll actually follow through on rolling over the money into another qualified IRA or 401k account.

(The above is not intended as investment or financial advice and is presented for educational purposes only. Consult a qualified tax or financial professional before you make any decisions about your 401k indirect rollover.)

A 401k direct rollover occurs when you transfer funds from an existing 401k retirement account directly into another 401k account or individual retirement account (IRA). The direct rollover is effected by account trustees which means that, unlike a 401k indirect rollover, you never actually come into possession of the funds. The primary benefit of a direct rollover is that you avoid the paperwork, taxes, and penalties associated with an indirect rollover.

In addition to rolling over your retirement savings into an IRA, you also have the option of doing a 401k direct rollover into your new employer’s 401k plan. This is generally not advised, however, because your investment options are more limited in 401k plans and, should you leave your current employer, you’d just have to rollover your 401k again.

One thing to note for those of you who have large holdings of your past employer’s stock in their 401k is the potential that you may end up paying more in taxes should you rollover your 401k vs. taking the distribution in a lump sum due to the differences in how the net unrealized appreciation (NUA) of the stock is calculated. Without getting into great depth of how tax on 401k distributions is calculated, the basic implications are as follows.

Company stock in a 401k plan is often added to an employee’s account with a cost basis (the value on which taxes are calculated) of much less than market value. When taxes are paid upon distribution of the 401k, they’re calculated on the cost basis and not on the current market value of the stock. Thus, assuming the stock has appreciated, the taxes paid when the gains are realized (the stock is sold) are much less than what would have been paid had taxes been assessed based upon current market value.

But, when stock is rolled over into an IRA, the NUA is calculated differently. The difference between the current market value and the cost basis now becomes taxable and this change could result in a significant amount of additional tax when the stock is eventually sold.

Here’s a quick example assuming the company stock is held for the same time period and grows in value to $100,000 before it’s sold. In the first case, it’s moved into a taxable account and, in the second case, it’s rolled over into an IRA:

Moved into a Taxable Account
$10,000 cost basis
$30,000 market value
Taxes paid (at current income tax level): 31% * $10,000 or $3,100
Distribution penalty: 10% * $10,000 or $1,000

Grows to $100,000
Taxable amount is $100,000 – $10,000 or $90,000
Taxes paid (at capital gains tax rate): 20% * $90,000 or $18,000

Total taxes paid: $3,100 + $1,000 + $18,000 = $22,000

Company Stock Rolled Over
$10,000 cost basis
$30,000 market value
Taxes paid: $0

Grows to $100,000
Taxable amount is $100,000 – $10,000 or $90,000
Taxes paid (at current income tax level): 31% * $90,000 or $27,900

Total taxes paid: $0 + $27,900 = $27,900

Thus, taking the company stock as a distribution instead of doing a 401k direct rollover would save you over 20% in taxes vs. rolling the stock over into an IRA account.

As you can see, the short-term taxes you avoid paying by doing a 401k direct rollover don’t always put you in a better long-term tax situation than had you taken the distribution and paid the taxes and potential penalty instead of simply executing the rollover.

(As is the case with all the information you’ll find on this website, the above is intended as general educational information and should not be taken to be investment or tax advice. Be sure to consult with a tax professional or financial planner before you decide if a 401k direct rollover is appropriate for your individual and specific circumstances.)

You have many options when you retire or change jobs and need to move the 401k you had with your past employer into your current 401k or a traditional or Roth IRA account. Your biggest consideration and the most important reason to know the 401k rollover rules is the potential tax consequences of the various types of 401k rollovers.

Your first option is to take a cash distribution. Because your 401k was funded with pre-tax dollars, taking a distribution makes the deferred taxes on your account balance come due. Also, because 401k funds are meant to be used for retirement, the IRS also imposes a 10% penalty if you’re below age 59 1/2. An additional 20% of the balance will also be withheld as partial payment of the taxes due and, depending on your tax bracket, you could potentially owe additional taxes when you submit your tax return.

Next is the 401k indirect rollover. In this situation you receive a check for your account balance minus the same 10% penalty and 20% tax prepayment as in the cash distribution with one key difference. If you fund a qualified 401k or IRA account with the full balance (including the 30% that has been withheld) within 60 days of the distribution you qualify for a refund of the penalty and tax prepayment amounts.

Although you won’t see this refund until you claim it as a credit when you file your taxes for the year of the distribution, you must fund your new account with the full balance of the 401k account you’re rolling over. The need to come up with this additional 30% within 60 days makes the indirect rollover the least frequently utilized of the 401k rollover rules.

With a 401k direct rollover you don’t receive your retirement funds in a check like the other two rollover options. Instead, you authorize the trustee of your 401k account to transfer the balance to a new qualified 401k or IRA account. You retain your entire retirement account balance and pay no taxes and incur no penalties with this trustee-to-trustee transfer making this type of 401k rollover the most popular.

(As with all 401k rollover rules and IRA rollover rules it’s important to consult a qualified professional adviser before making any decisions regarding rolling over your retirement savings. )

When considering whether to do a traditional IRA rollover or take your retirement savings and do a Roth IRA rollover instead, there are several factors you should take into account.

The first is the fact that traditional IRA funds are in pre-tax dollars while Roth IRA funds are in post-tax dollars. What that means is that a rollover from a traditional IRA to a Roth IRA will trigger a taxable event during the year of the rollover where you’ll have to pay taxes at your current income tax rate on the accumulated balance and growth in your IRA account.

However, after the conversion, your retirement savings will then grow tax free in the Roth account so, assuming you have the funds to account for the taxes, it may be a good idea to pay the taxes on the smaller balance now to avoid taxes on future growth.

In addition, withdrawal requirements for a Roth IRA are eased. Minimum distributions must begin on a 401k at 59 1/2, on a traditional IRA at 70 1/2, but there’s no minimum distribution or age limit on a Roth IRA. This gives your balance more time to compound than these other pre-tax accounts.

In estate calculations, the entire value of your IRA is counted when computing taxes even though a large portion of a traditional IRA will be paid out in taxes upon liquidation. With a Roth, your heirs are not, in effect, taxed twice when your estate is settled.

The tax consequences of a Roth IRA rollover from a traditional IRA can become complicated so be sure to consult a tax professional before making a final decision. But, in the long term, it often makes sense to pay taxes on the rollover now to avoid paying more in taxes at retirement.

A traditional IRA rollover occurs when you transfer assets from one retirement account to another qualifying account (typically another IRA). In most circumstances, it’s a good idea to do a direct rollover to preserve the tax advantaged status of the invested amount and growth within the traditional IRA account (in contrast to a Roth IRA rollover where taxes have already been paid on the invested amount and the growth is accumulating tax-free).

Although traditional IRA rollovers are fairly straight forward, one thing to consider is the potential tax implications of rolling the balance over vs. taking the funds (and incurring a taxable event and a potential penalty) and re-investing the amount in a traditional taxable investment account.

Because distributions from an IRA account are treated as income during the year in which they’re received and long term gains in a taxable account are taxed at the typically lower capital gains tax rate, depending on your individual situation, it may make sense to incur the taxable event and penalty in exchange for the lower capital gains tax rate on the continued growth of the investment.

(As always, be sure to consult a professional and discuss your individual circumstances before making any decisions regarding your traditional IRA rollover.)