If you are thinking about converting all or some of your 401k into a Roth IRA, it is wise to consult a financial advisor first. Converting will generate taxable income; so it’s essential that the potential effects are thoroughly considered before moving ahead with any decisions.
One strategy to reduce tax burdens is converting funds over time, particularly if you expect to be in a higher tax bracket at retirement or plan on working beyond age 67.
What is a Roth IRA?
Roth IRAs are tax-deferred retirement accounts where contributions are made with after-tax money and withdrawals in retirement are tax-free. This option may be especially attractive to people expecting higher tax bills later.
Contributions: Anyone aged 18 or over with earned income (such as salary, hourly wages, tips, bonuses, self-employment income and commissions) is eligible to contribute to a Roth IRA. Investment income, Social Security benefits or retirement distributions do not count towards “earned” income.
Earnings Withdrawal from a Roth IRA: Withdrawing earnings is usually tax- and penalty-free after five years have been invested; however, early withdrawal penalties of 10% could apply if withdrawals occur prior to age 59 1/2.
There are also some exceptions to the early withdrawal penalty; for instance, your Roth IRA funds can be withdrawn without incurring penalties for first-time home purchases or college expenses.
Taxes on a Roth IRA conversion
Converting traditional IRAs to Roth IRAs has numerous tax benefits; however, conversion can have income-tax ramifications which should be carefully evaluated prior to any Roth conversion decision being made.
Your converted amount will be added to your taxable income for the year and may place you into a higher or lower tax bracket.
Bracket bumping can help mitigate this tax burden, by keeping converted dollars within your current tax bracket so as not to incur a large tax bill at once.
Roth conversion may be beneficial to retirees with low income, while it should not be undertaken by those anticipating paying a higher tax rate in retirement than today. To make sure your conversion goes as smoothly as possible, consult with an experienced tax pro or financial advisor first before embarking on one on your own.
How to roll over a 401k to a Roth IRA
Rollover your 401k into a Roth IRA can be accomplished via several methods. One is for your new employer to transfer the funds directly into your new Roth IRA account either electronically or by mail.
Another option for rolling over your 401k into an IRA with an external provider, giving you more investment choices than available through traditional mutual fund 401ks. Most plans offer mutual funds; however, investors who seek greater freedom over how their money is invested may prefer this route.
If this option appeals to you, consider opening an IRA account with one of the leading online brokerage firms, like SoFi, Fidelity or Betterment. These firms typically provide a simple account-opening tool which makes opening your IRA simple and fast – plus they have teams of financial advisors available who can assist with retirement planning needs – plus interview up to three advisors matching your goals and budget free of charge!
Investment options in a Roth IRA
IRAs are excellent ways to save for retirement and take control of your investments. There are two types of IRAs – traditional and Roth – each providing distinct tax benefits.
No matter which IRA option you select, remember that investing in stocks is the best way to help grow your account over time. Bonds or fixed income funds offer lower risks but generally offer lower returns.
Target-date funds offer another way to diversify and adjust your asset allocation as you approach retirement. These mutual funds tend to focus on specific years in life and gradually adjust their investments as you reach each goal over time.
ETFs and mutual funds are two popular choices among investors looking to diversify their Roth IRA investments, each offering its own strengths – though ETFs tend to be cheaper to purchase than their mutual counterparts.