A recent pension law change simplified the rules for rolling over assets from a 401(k) plan to a Roth IRA, and another change in 2010 means almost anyone can make such a move. You can now accomplish your objective in one move, instead of the two steps previously required, and that could make this a convenient way to guarantee tax-free income during retirement.
If you participate in a 401(k) plan at work, you get to defer part of your pre-tax salary to your account. You can generally contribute up to $16,500 to a plan in 2009 and 2010 ($22,000 if you’re age 50 or over). In addition, your employer may make matching contributions up to a maximum percentage of your salary. Account investments grow without being taxed, and there’s no tax due until you begin taking distributions from your account. Those withdrawals are taxed as ordinary income. Although there’s normally a 10% penalty tax on withdrawals before age 59½, you may qualify for one of several exceptions (for example, early retirement at age 55).
One way or another, you have to pay the piper one day on the money in your 401(k). But you may be able to absorb the income tax hit now, by converting your account to a Roth IRA. Though the amount you convert will be fully taxed—assuming it consists entirely of tax-deferred contributions and the investment gains attributable to those contributions—later distributions from the Roth during retirement normally aren’t subject to any taxes.
Prior to the Pension Protection Act of 2006 (PPA), it took two steps to transfer funds from a 401(k) plan to a Roth IRA (assuming your employer plan permitted such transfers). First, you had to roll over funds to a traditional IRA, a transfer that’s exempt from tax liability if completed within 60 days. Next, you had to convert the traditional IRA to a Roth IRA and pay the resulting tax. To further complicate matters, Roth conversions had previously only been allowed in a year in which your adjusted gross income is $100,000 or less.
Now, these strict rules have been loosened. Under the PPA, you can transfer 401(k) assets directly to a Roth IRA. This change applies to distributions made after 2007. What’s more, as of January 1, 2010, the $100,000 ceiling no longer applies, and for conversions in 2010, you can spread out the tax you owe over the following two years.
The IRS has also issued guidance allowing tax-free 401(k) transfers to a Roth IRA of up to the amount of after-tax contributions you may have made to your employer plan (Notice 2008-30). That could be better than a two-step transfer, because when you convert from a traditional IRA to a Roth, the tax-free amount is limited to a pro-rated portion of nondeductible contributions to all of your IRAs. With a one-step transfer, it doesn’t matter what’s going on in your other retirement accounts.