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How Are 401k Rollovers Taxed?

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Key Takeaways

Understand Tax Implications: Ensure you’re rolling over accounts of the same tax status to avoid unexpected taxes.

Direct vs. Indirect Rollovers: Choose a direct rollover to simplify the process and avoid early withdrawal penalties.

Higher Tax Bracket Considerations: Consider rolling over to a Roth IRA if you expect to be in a higher tax bracket in retirement.

Monitor Income Levels: Utilize lower income years to roll over pre-tax 401(k) assets to a Roth IRA.

Seek Professional Advice: Consult with a financial advisor to navigate the complexities of 401(k) rollovers and optimize your retirement strategy.

Introduction

After leaving a job, it’s common to leave a 401(k) retirement plan with your former employer. You have several options for your old employer-sponsored retirement plan, such as rolling it over to a new plan or cashing it out. Each choice comes with different consequences.

If you decide to roll over your 401(k) to an IRA (Individual Retirement Account), you likely won’t need to pay any taxes if you complete the rollover properly between accounts of the same tax status. However, you will face taxes if you roll a pre-tax (traditional) 401(k) to a post-tax (Roth) IRA or another tax-exempt vehicle.

In this article, we’ll review the potential tax consequences of a 401(k) rollover and provide guidance on how to complete one with minimal hassle and unexpected expenses.

When is a 401(k) to IRA Rollover Taxed?

The rollover that involves taxation is when you roll a traditional, pre-tax 401(k) to a Roth IRA (or, in rare cases, a Roth 401(k)). This action is similar to declaring your pre-tax 401(k) as income in the year of the rollover, resulting in the entire 401(k) balance being taxed at your highest marginal income tax rate.

For instance, a taxpayer in the highest federal tax bracket (37%) rolling over $10,000 from a 401(k) to a Roth IRA would incur $3,700 in taxes.

To avoid this, ensure you’re rolling your 401(k) to an IRA account of the same tax status. For example, a traditional, pre-tax 401(k) should be rolled into a traditional, pre-tax IRA to avoid any tax consequences. If you’re unsure about the tax status of your 401(k), contact your plan administrator to verify.

Another way to avoid taxes until retirement is to leave your 401(k) plan with your former employer. However, this option may involve high fees and limited investment options, which can be costly in the long run. Therefore, many people prefer rolling over into an account at a new financial institution.

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How Much Will You Pay in Taxes on a 401(k) to Roth IRA Rollover?

Rolling over a traditional 401(k) to a Roth IRA incurs federal taxes and potentially state and local taxes, depending on where you live.

For example, if you have $100,000 in your previous employer’s 401(k) and decide to roll it into a Roth IRA, you’ll owe taxes on the entire amount rolled over. This scenario is equivalent to performing a Roth conversion on a set of traditional IRA assets.

Let’s say you earn $75,000, are single, and live in New York City. Your marginal tax rates might be:

  • Federal tax rate: 24%
  • State tax rate: 5.97%
  • NYC tax rate: 3.88%

Summing these rates gives a total marginal rate of over 33%. Applying this rate to the $100,000 rollover results in a tax bill of approximately $33,000.

This example illustrates the significant tax impact of rolling over pre-tax to post-tax 401(k) accounts. Be deliberate when moving money between these accounts to avoid hefty tax bills.

When Does it Make Sense to Roll a 401(k) to a Roth IRA?

The decision to roll a 401(k) to a Roth IRA depends on various factors, such as expected tax rates in retirement or current income levels.

Higher Tax Bracket in Retirement

If you expect to be in a higher tax bracket in retirement, rolling your 401(k) to a Roth IRA now might be beneficial. This strategy allows you to pay taxes at your current rate and enjoy tax-free withdrawals in retirement.

Lower Than Usual Current Income

If you’re experiencing a lower-than-usual income year, you can take advantage of lower tax brackets by rolling over pre-tax 401(k) assets to a Roth IRA. This approach helps lock in lower tax rates for the rollover amount.

If uncertain about your income for the year, consider first rolling your 401(k) to a traditional IRA and then gradually converting to a Roth IRA at your own pace.

How to Complete a 401(k) Rollover

Direct Rollover

A direct rollover transfers funds directly to your new IRA provider. This method is generally the simplest and helps avoid early withdrawal penalties and income taxes.

Indirect Rollover

An indirect rollover involves the funds being transferred to you first, and you have 60 days to deposit the money into your IRA to avoid taxes and penalties. This method requires more effort and carries the risk of early withdrawal penalties if not completed on time.

Regardless of the method chosen, be aware of Required Minimum Distributions (RMDs) for tax-deferred accounts once you reach age 73.

Conclusion

Consolidating your retirement accounts can simplify account management, reduce fees, and optimize investment strategies. The expert team at Element Squared Private Wealth can help manage the entire process, providing the support you need to consolidate old retirement accounts. With the right investment advice and understanding of your options, you can optimize your retirement savings and achieve your long-term financial goals.

Key Takeaways
  1. Understand Tax Implications: Ensure you’re rolling over accounts of the same tax status to avoid unexpected taxes.
  2. Direct vs. Indirect Rollovers: Choose a direct rollover to simplify the process and avoid early withdrawal penalties.
  3. Higher Tax Bracket Considerations: Consider rolling over to a Roth IRA if you expect to be in a higher tax bracket in retirement.
  4. Monitor Income Levels: Utilize lower income years to roll over pre-tax 401(k) assets to a Roth IRA.
  5. Seek Professional Advice: Consult with a financial advisor to navigate the complexities of 401(k) rollovers and optimize your retirement strategy.
Get Started

Talk To An Advisor

Let's start with your email address:
How familiar are you with our investment philosophy?*(Required)
What kind of investor are you?(Required)
What is your investing experience?*(Required)
Investable Assets(Required)
This field is for validation purposes and should be left unchanged.

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