Enhance your retirement with a Roth IRA

The case for moving some of your 401K (or traditional IRA) money to a Roth IRA each year starting now.

401K vs. Roth IRA - differences

401K (or traditional IRA): Contributions are tax deferred - money going in is tax free, but you pay tax when you take the money out.

Roth IRA: You pay taxes on contributions, but gains are tax free if the money has been in the account for at least 5 years.

401K and Roth IRA - similarities

If you withdraw the money prior to age 59 and a half, you will pay a penalty.

Roll Overs

As of mid 2022, rolling over 401K money to a Roth IRA incurs no penalty at any age, there is no limit on the roll over amount, no income cap, and no work restriction. However, you still pay federal and maybe state tax on the amount you roll over.

Some Roth IRA advantages

Because Roth IRA withdrawals are not part of your taxable income;

  1. When you begin drawing Social Security, you may pay less tax on your benefits. Unlike traditional retirement account withdrawals that are considered income when determining the percentage of your Social Security benefits that are taxed, Roth IRA withdrawals do not count toward SS benefits taxation.

  2. Taking money from a 401K account might increase your income to the level that you have to pay an extra "income-related monthly adjustment amount, or IRMAA" for Medicare, whereas money from a Roth IRA is not counted as income.

  3. Your heirs will appreciate not having to pay tax on the money from your Roth IRA, especially if they are already in a high income tax bracket.

When to move money from a 401K to a Roth IRA

  1. You should consider doing this early in your career because;

    1. If you start rolling over 401K money to a Roth IRA early in life, you can;

      1. Move a relatively small amount every few years to avoid large increases in income taxes, and

      2. Pay the tax while your income is less and you are in a lower tax bracket.

    2. You could be enjoying many years of reduced state income taxes. In Arkansas the first $6,000 you take from your traditional retirement account (including roll overs) is state tax free - your adjusted gross income for Arkansas tax is reduced by up to $6,000. This state tax reduction is available no matter your age. 27 states, allow a reduction in state taxes.

      Because you may have to pay a transaction fee everytime you withdraw money from your IRA (including rollovers), you may want to wait until you are ready to rollover a good percentage of $6,000.

    3. The longer your money is invested, the more it grows, and the more tax you avoid when you withdraw it.

    4. Your income may increase beyond the limit that you are allowed to open a Roth IRA, but once you have an existing Roth IRA, there is no income limit for roll overs.

    5. Future IRS rules may limit the allowed roll over amount. Start the process early to avoid those caps.

  2. Even in retirement, you may be paying a greater tax percentage than now due to tax increases and inflation which will put you into a higher tax bracket even if the real value (purchasing power) of your income does not increase.

  3. During a market slump when your retirement fund has taken a loss - let's say your retirement account is down by 20% when you roll part of it into a Roth IRA. You pay taxes on the amount you rollover, but when the market recovers you will have paid only 80% of the taxes that you would have paid in normal times, and you will pay no tax on the increase in value or future earnings.

  4. If your income decreases enough to put you in a lower tax bracket, you pay less tax on the rollover amount that year.

To avoid a tax underpayment penalty, you may need to increase your payroll tax deductions. If you cannot afford to pay taxes on your retirement rollover, and if you participate in your company's stock purchase plan, consider cashing out some of that money when the stock price is high. You can use that money to offset the increased tax being withheld from your paycheck.

You may be able to reduce taxes on IRA withdrawals

  1. This does not apply to 401K accounts, but it is easy to rollover money to an IRA where you can save on taxes.

  2. After age 59 1/2, use the money for charitable contributions such as a charitable gift annuity (life time income), or charitable remainder trust.

  3. If your charity can accept appreciated stock, you may avoid paying tax on the increase in value.

  4. After age 70.5, a QCD, qualified charitable distribution, from an IRA results in no federal taxes if you follow the IRS rules. If you are at the age when you are required to take money out of your IRA, all or part of your RMD (Required Minimum Distribution) can be a QCD, qualified charitable distribution. You could reduce your tax liability on the RMD to zero. If your RMD is $3,000, but you give $3,000 to charity anyway, do the qualified charitable distribution and you don't pay any federal tax on the RMD. That money is not included in your adjusted gross income (AGI). More on RMD strategies.

Withdrawal rules and early withdrawal penalties by H&R block. You may rollover money from your retirement account into a Roth IRA at any age, but if you are younger than 59 and a half, do not take money from your retirement account to pay the tax.

There is no limit to how much you can rollover from your retirement account, but you may want to do the rollovers over a period of several years to avoid getting into a higher tax bracket. This Investopedia article has more details about how to do a rollover. For more pros and cons of Roth IRAs, see this from CNBC.

Hopefully this info will be a good starting place for research and planning in order to maximize your retirement savings. Tax rules may change from time to time. Please consult your tax adviser or accountant prior to acting on any of these recommendations.

Charles Young hopes you find this advice helpful. God bless.

Updated 2/2023 | Index of some of my other pages