Rollover 401k To Roth IRA
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When an IRA Doesn't Pay
Let's say your company retirement plan account holds some appreciated employer stock, and you leave your job. You may be better off withdrawing the shares and holding them in a taxable account instead of rolling them over into your IRA. (You can still roll over everything else.) Assuming the shares are received as part of a lump-sum distribution (usually this means a complete liquidation of all your company retirement accounts in the same calendar year), you'll be taxed only on the amount the plan paid for the stock. But if the stock has been appreciating, this could be a small fraction of current market value (although this could still be a significant number).
The tax is at ordinary income rates (which can be set as high as 35%), but here's the benefit: The net unrealized appreciation when the shares are distributed to you (the difference between the market value and the plan's cost for the shares) will qualify for the 15% maximum long-term capital gains rate (0% if you're in the 10% or 15% rate bracket). Even better, that capital gains tax is deferred until you sell the shares. Any additional appreciation also qualifies for the 15% rate if you hold the shares more than 12 months before selling.
Last but not least, if you die while still owning the shares, your heirs will get a basis stepup for all appreciation after the shares come out of your retirement account up to the date of death. This means that appreciation never gets taxed. In contrast, if you roll the shares over into an IRA, you or your heirs will eventually pay tax at ordinary rates — up to 35% — on all these gains when withdrawals are made from the account. And there's no break for your heirs if the stock is still in your IRA when you pass away.
What Comes Out Must Go Back In
If you take cash from a qualified retirement plan account, you must roll over cash into your IRA, rather than some other asset of equal value. Ditto if you are simply rolling funds from one IRA to another. You cannot, for example, do what the poor guy in the court case did and use cash withdrawn from a retirement plan or IRA to buy stock and then attempt to roll over the shares. If you try this type of maneuver, the door is shut on any rollover and you'll be taxed on the withdrawal.
If you are not 59 1/2, you will generally owe the 10% "premature withdrawal" penalty tax as well. What should you do? Roll over the cash into your IRA and then buy the stock. (The taxpayer in the court case couldn't wait because he had to meet a stock subscription deadline.)
Now if you withdraw stock from a qualified plan or IRA account, it's OK to roll those shares over into an IRA. In fact, it's mandatory. You can't sell the shares and then roll over an equal amount of cash, nor can you roll over different shares of equal value. So the rule for tax-free rollovers is: cash to cash, stock to stock, and ashes to ashes.
Using an IRA Rollover As a Short-Term Borrowing Source
Every so often you may face a temporary cash crunch when you desperately need some extra dough, but just for a short time. You will have the necessary cash in a month or so, but that doesn't help right now. A potential solution is "borrowing" from your IRA account, which can be done with virtually zero paperwork, no delays from balky loan officers, and no interest charge.
You simply withdraw the needed funds and make sure you then replace the money within 60 days. You are considered to have made a tax-free IRA rollover.
The money can be deposited back into the same IRA account it came from or into a different account, but each account can receive only one of these rollover deposits during any 365-day period. ("Direct" or "trustee-to-trustee" rollovers from another IRA into the account in question don't count for purposes of the one-year waiting period rule, nor do rollovers of distributions from qualified retirement plans.) But remember: If these guidelines are violated, you are considered to have made a taxable IRA withdrawal, and you may owe the 10% premature withdrawal penalty.
IRA to IRA Rollovers (Including the Roth)
If you are simply transferring funds from one IRA to another, as in a rollover to a Roth IRA, there is no 20% withholding to worry about. So a withdrawal check can be made out in your name with no adverse tax consequences as long as the other IRA has not received any other rollovers within 365 days. (Again, "direct" rollovers into that account don't count for purposes of the 365-day waiting period rule.)
However, you must still get the money into the other IRA within 60 days, or you will be taxed on the withdrawal. For more on whether you should roll over into a Roth, see our story "Roth IRAs: To Convert or Not."
Should You Consider a 2010 Roth Conversion?
Changes in tax legislation in 2010 will create opportunities for many investors to convert tax-deferred retirement assets to a Roth IRA, which can help generate tax-free retirement income for you and potentially your beneficiaries. Under the Tax Increase Prevention and Reconciliation Act of 2005, the $100,000 modified adjusted gross income requirement will be repealed indefinitely on January 1, 2010, greatly expanding the number of people eligible for a Roth IRA conversion. All investors who have made retirement contributions to employer-sponsored retirement plans (e.g., 401(k), 403(b), 457) or traditional, SEP or SIMPLE IRAs will be eligible. When you convert to a Roth IRA, you currently must pay income tax on the full amount you transfer in the year of conversion. If you convert in 2010, however, you can spread the tax liability over two years (2011 and 2012).
All conversions made after 2010 will be subject to taxation in the year of conversion.
Converting to a Roth has many benefits, but this strategy is not appropriate for everyone. There are tax implications that you will need to consider, and it is strongly recommended that you speak with your tax advisor before making any decisions.
2010 Roth IRA Conversion Questionnaire
The questions below are designed to help you and your Financial Advisor further explore whether a Roth conversion strategy makes sense for you:
1. Do you have assets invested in IRAs or employer-sponsored retirement plans? ❏ YES ❏ NO
2. If you answered yes to Question 1, has the value of those assets declined due to the recent economic downturn? ❏ YES ❏ NO
3. Do you anticipate that your tax bracket will be higher in retirement? ❏ YES ❏ NO
4. Do you want to leave a tax-free asset to your children or heirs? ❏ YES ❏ NO
5. Do you want to potentially reduce the taxable value of your estate? ❏ YES ❏ NO
6. Will you have sufficient income from non-retirement-account sources to support you in retirement? ❏ YES ❏ NO
7. Do you have tax deductions that exceed your income or non-refundable tax credits? ❏ YES ❏ NO
8. Do you want to increase your tax-free savings as part of your overall portfolio strategy? ❏ YES ❏ NO
9. Are you temporarily in a lower income tax bracket? ❏ YES ❏ NO
10. Do you have funds outside of your IRA to pay the income taxes that a Roth IRA conversion will trigger? ❏ YES ❏ NO
If you answered “yes” to any of the questions above, you may want to consider a Roth IRA conversion. Your Financial Advisor, together with your tax advisor and others, can help you determine whether this strategy will help you achieve your retirement and other financial goals. When you meet, be sure to bring this worksheet as a starting point for a productive conversation.