Last week’s blog post, Don’t Forget About Your SEP-IRA for Roth IRA Conversions, made the point that most people who are considering doing a Roth IRA conversion think about using a traditional IRA account into which deductible and/or nondeductible contributions have been made. Many people don’t realize that other types of retirement plans are also eligible for a Roth IRA conversion. One such plan is the popular 401(k).
Many employers allow former employees to keep their 401(k) plans intact, however, there’s an often-overlooked catch which I’ll get to shortly. As a result, 401(k) plans often lie dormant for years after an individual parts ways with his/her employer. In addition to limitation of investment choices, this can also result in an unpleasant surprise for a plan participant’s beneficiaries upon the plan participant’s death. This is due to the fact that employers that permit former employees to retain their 401(k) plans generally don’t allow them to do so indefinitely. Most plans require immediate distribution of plan assets at death, resulting in immediate taxation and the abrupt end of tax-deferred growth of the plan.
The lack of investment choices and the exposure to immediate taxation upon death are two great reasons, in my opinion, to move 401(k) plan assets into another tax-deferred vehicle as soon as possible following employment termination. Before 2008, besides a new employer’s 401(k) plan, the only choice available for rollover of 401(k) plan assets was a traditional IRA account. If you wanted to move your 401(k) plan assets into a Roth IRA, a two-step process was required whereby you first needed to roll 401(k) funds over to a traditional IRA account and then do a Roth IRA conversion of your traditional IRA.
As a result of a change made by the Pension Protection Act of 2006, beginning in 2008, funds from 401(k) plans can now be rolled directly to a Roth IRA via a Roth IRA conversion. Unlike 401(k) plans, with both Roth and traditional IRA’s, there are generally a myriad of investments from which you can choose, depending upon the financial institution you use as your custodian. Unlike traditional IRA’s where assets continue to grow tax-deferred until distributed, all pre-tax contributions and earnings are taxable upon conversion to a Roth IRA, with future earnings and growth accumulating tax-free inside the Roth IRA.
At a minimum, with limited exceptions which are beyond the scope of this blog post, most 401(k) plans should be rolled over to a traditional IRA upon separation from employment. Before doing this, however, a 401(k) plan participant should evaluate whether it makes more sense instead to do a Roth IRA conversion. As with all Roth IRA conversion decisions, there are many factors to consider. These include, but are not limited to, the size of the 401(k) plan, amount of pre-tax contributions and earnings, availability of losses and deductions to offset income from the conversion, current and projected income tax brackets, the plan participant’s age and general health, potential beneficiaries, and affect on taxation of Social Security benefits, Medicare premiums, and qualification for college financial aid.
Do you have a dormant 401(k)? If so, consider converting to a Roth IRA.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.