Converting Directly From a 401(k) to a Roth IRA

Photo credit: jb

Back in the olden days prior to 2008, it used to be against the rules to convert funds directly from a 401(k) plan (or other CODA plan, like a 403(b)) to a Roth IRA.  At that time, you were required to do the “conversion two-step” wherein you would first rollover or direct-transfer your funds from the 401(k) plan to a traditional IRA, then do a conversion from the trad IRA into your Roth IRA.  This was an unnecessarily complicated process, and the IRS logically waited until it got ridiculous and then relented listened to taxpayers, allowing taxpayers the option of converting directly from these qualified retirement accounts into a Roth IRA.

This earlier process was needlessly complicated, and it often introduced additional room for taxation, especially if you have after-tax money in your 401(k) plan.

The process is identical to the process for converting directly from a traditional IRA to a Roth IRA.  You can make this conversion from your:

• Employer’s qualified pension, profit-sharing or stock bonus plan (including a 401(k) or other plan),
• Annuity plan,
• Tax-sheltered annuity plan (section 403(b) plan), or
• Governmental deferred compensation plan (section 457 plan).

You are allowed to convert all or part of the account. Prior to 2010, there was an income limit on converting directly to a Roth IRA from any account, but that limitation was eliminated. Any pre-tax amount converted must be reported as income in the year of the conversion. If your account includes after-tax amounts, there may be some fancy footwork involved but you may be able to convert the after-tax monies without tax or penalty.

The conversion can be done either via a direct trustee-to-trustee transfer or a rollover.  In general, the trustee-to-trustee transfer is the preferred method since a rollover involves making a check payable to you, which requires the payor to withhold 20% of the rollover. If your 401(k) administrator has the option available, you can request a non-direct rollover (check made out to the new IRA account), which will allow you to bypass the withholding requirement.

Any amount that is not successfully converted (via an indirect rollover) within 60 days would be taxable AND subject to the 10% penalty unless other conditions apply. In other words, when you convert these funds over to your Roth account, in order to pay the tax on the withdrawal you’ll need to either hold out a portion and pay the 10% penalty on those funds, or pay the tax from another source.