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: Contributions are taxed, but withdrawals can be 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, but there is no penalty for rolling over money from a 401K to a Roth at any age. However you still pay federal and maybe state tax on the amount you roll over.

Roth IRA advantages

  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 are not part of your taxable income and do not count toward SS benefits taxation.

  2. 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 have to 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.

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

There can be advantages to rolling over money from your 401K to your Roth IRA versus putting money directly into your Roth IRA.

  1. Avoid Limits / Restrictions
    1. No limit on the roll over amount
    2. No income cap
    3. No age or work restriction

  2. In 27 states, you may be able to avoid paying state tax on some of the rolled over amount. 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. By regularly moving some of your 401K money to a Roth IRA prior to retirement, you can enjoy many years of reduced Arkansas taxes.

You should consider doing this early in your career because;

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

  2. Even in retirement, you may be paying a greater tax percentage than now due to inflation and tax increases.

  3. 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.

You may want to limit the amount you roll over if;

  1. Your retirement money is invested conservatively and not expected to increase much in value.

  2. You plan to donate part of your RMD (Required Minimum Distribution) to charity to avoid taxes on the donated amount. Certain contributions made through "qualified charitable distributions" - funds sent directly to the charity from a traditional IRA - are excluded from your taxable income. If your age requires you to take annual required minimum distributions, RMD, from your IRA, 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 tax on the RMD. That money is not included in your adjusted gross income (AGI).

Investopedia has a good article on how to do a Roth IRA rollover including the pros and cons. There is no limit to how much you can rollover from your retirement account, but you will not want to rollover more money than you can pay tax on. Also, to avoid an underpayment penalty, you may need to increase your payroll tax deductions.

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 are a few other ways that people at any age may might qualify for reduced taxes on IRA distributions.

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 set that money aside or put it in a fixed income fund until you need it to pay the tax on the rollover into your Roth IRA.

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

Charles Young wrote this in an effort to offer some quick and simple advice. God bless.


Index of some of my other pages