All retirement plans are not created equal. Once you know the differences among them, you can make better decisions as to which strategies will work best for your retirement goals, and if a rollover is necessary.
A rollover simply means taking your money out of one retirement fund and placing it into a new one — one that provides more opportunity for your money to grow or to help consolidate your money into one location.
At first glance, retirement plans can seem complex and confusing. If you’re young, and retirement is a long way off, it’s very tempting to put this task aside and get back to it…someday.
However, now is the time to understand what a retirement plan can do for you and your future. A few proactive steps now may make a huge difference in your financial situation later in life.
Upon a closer look, you may learn that your current retirement plan may not give you the maximum financial power and opportunity that will support your plans. Educate yourself now, and see if a rollover may be a good option for your retirement fund.
Realize first that there are actually two types of 401(k)s:
• Traditional 401(k)
• Roth 401(k)
The Roth 401(k) is a relatively newer idea. It came into existence as a result of the Pension Protection Act of 2006 , but it’s still not completely on the radar (meaning your employer may not yet offer it).
The Difference between a Roth IRA and a Roth 401(k)
• Unlike the Roth IRA, the Roth 401(k) does not require a limit on income in order to participate.
• In 2020, A Roth 401(k) allows employees to contribute up to $19,500. For employees age 50 and over, an additional $6,500 per year is allowed.
• Withdrawals of contributions and earnings are not taxed on a Roth 401(k), as long as it’s considered a qualified distribution . That means the account must be held for at least five years and the withdrawal is made on account of disability, on or after death, or after reaching age 59 ½.
• Contribution to a Roth IRA is limited to $6,000 for the year . For employees age 50 or over, an additional $1,000 is allowed.
• A Roth IRA allows distributions at any time while the owner is alive.
We’ll take a deeper dive on the Roth IRA in a bit, but first understand why a 401(k), as common as it is, may not always be your best bet for your retirement plans.
Limitations of the Traditional 401(k)
Not all 401(k)s are created equal—not all companies are able to match employee contributions, or may do so at different percentages.
When moving on to another job, it may be difficult to keep track of the 401(k) left behind at the last job, unless you keep in touch with the company that services the account.
You also don’t want your plan to fall into inertia from inattention—you’ll need to keep after it to make sure it’s balanced and earning the money you’ll need for retirement.
What is a Roth IRA Conversion?
A Roth IRA conversion is when you roll over another account into a Roth IRA. Typically, those are retirement accounts, such as a 401(k) or a traditional IRA.
Once you establish your Roth IRA account, you may only contribute to it if you earn less than $137,000 if you’re single, and $203,000 for married couples filing jointly (more about this below).
Benefits of a Roth Retirement Plan
The major benefit of a Roth strategy is that you pay income tax as you build the account, and not when you withdraw the funds during your retirement. In other words, a Roth IRA lets you pay taxes now, not later.
That’s one reason why people may consider a Roth IRA over a traditional 401(k) or traditional IRA as part of their retirement strategy.
Sounds like a plan, except for one small complication—not everyone is eligible to contribute to a Roth IRA. It all boils down to your income level. The Roth IRA has very specific income limits .
Once upon a time, you were able to convert your traditional IRA to a Roth IRA only if your income was below $100,000. Now, high-income professionals can convert to a Roth by paying the tax on that conversion.
Here’s a quick summary on who is eligible to contribute to a Roth IRA:
• If you’re single, you can earn up to $137,000 (that’s your modified adjusted gross income, or MAGI for short); contributions can start at $122,000.
• If you’re married and filing jointly, your MAGI needs to be less than $203,000, with reductions beginning at $193,000.
Doing the math on MAGI: Take your adjusted gross income from your tax returns and add back your original deductions (example: student loan interest).
The Roth IRA limitations don’t stop there, though. Your income has to be considered “earned income,” which simply means money you’re paid for work you performed within the year you contribute.
Here’s what counts as earned income:
• Work wages
• Self-employment income
• Profit distributions (if you own a small business)
• Disability retirement benefits in lieu of pensions or annuities
• Jury duty pay
• Accrued vacation pay
Here’s what is not considered earned income:
• Dividends from investments
• Income from rental property
• Pension payments
• Social security
• IRA distributions
If You Already Have a Roth IRA
Under the 2017 Tax Cuts and Jobs Act , you can no longer “undo” a Roth IRA conversion. That act used to be called a “recharacterization.” Once you have a Roth IRA, there’s no going back to whatever investment you had before.
You are allowed to withdraw funds anytime from a Roth IRA, but unless the withdrawal is a qualified distribution, it may be subject to tax and possibly a penalty. As a general guideline, you can withdraw your contributions tax and penalty-free. This is still a non-qualified distribution, it’s just not subject to tax.
If you withdraw any earnings that have been in the account for less than five years, you will likely be required to pay income tax and an additional penalty. This is known as the five-year rule .
Earnings withdrawn through a non-qualified distribution after five years is only subject to income tax. Of course, the best strategy is to only make qualified distributions and skip the tax and penalty altogether.
How that five-year rule is calculated—your Roth IRA earnings starts on January 1st of the year you make your first contribution. For example, if you make your first Roth IRA contribution on June 15, 2020, your Roth IRA earnings officially start on January 1, 2020.
You can make contributions to your Roth IRA all the way up to April 15th of the next year. Remember, you also have to be at least age 59 ½ for you to be qualified to withdraw.
The Benefits of Converting to a Roth IRA
Converting to a Roth IRA frees you of money-limit restrictions, as opposed to starting a Roth IRA from scratch. Said another way, as long as you are converting to a Roth IRA, you are not restrained by income limits, because you are performing a conversion.
This is called a “backdoor Roth IRA” because you are backing into it from another investment source. This may or may not be the right situation for you and your finances, but it’s at least an option to be aware of.
Additional Benefits of a Roth IRA
• Contributions can be made to the account at any age.
• There are no “required minimum distributions (RMD).” This is unlike the traditional IRA, where you are required to start withdrawing money at age 70 ½.
• If you have a non-working spouse, they can also open a Roth IRA based on your earnings, and if you’re filing jointly as a married couple.
• You can participate in a Roth IRA even if you participate in other retirement plans.
Some Strategies to Consider when Rolling over to a Roth IRA
Taking Advantage of Both a 401(k) and a Roth IRA
Consider maxing out your employer’s 401(k) plan in order to get that employer match if offered.
Considering Including Your Spouse
If you have a non-working spouse, and you are filing jointly, you can contribute to their Roth IRA as well.
Keeping an Eye on Annual Contribution Limits
If you go over the Roth IRA limits for the year, you may have to pay a 6% penalty each year on any excess funds that you contribute.
Proceeding With Caution When you Rollover Money Between Accounts
There is no limit on the number of times you can transfer a retirement account directly between custodians or convert funds in a Traditional IRA to a Roth, but it’s important to be careful when transferring indirectly between your own IRAs or using a 60-day rollover as it could possibly result in a tax penalty .
Patience: Waiting to Withdraw Money
You have to be 59 ½ years old in order to withdraw your money without paying taxes. You also have to have owned your account for at least five years.
Consider listing both primary and contingent beneficiaries for your Roth IRA. If there are no beneficiaries, the money in your account could wind up in probate court, along with the applicable attorney fees. Keep your paperwork updated, especially if you decide to change your beneficiaries list.
Considering a New Plan
Perhaps it’s the stress of starting a new job, or simply forgetting that you have a 401(k) that needs upgrading. It’s ultimately going to be left up to you if you want to roll that old 401(k) into a new plan.
When leaving an old job for a new one, don’t leave your old 401(k) in the dust. Neglecting a former employer’s 401(k) can mean you are paying fees that you don’t even know about. Think about it—your former company is still maintaining that account—they may be charging you for their service.
If you decide it is the right move for you and your circumstances, rolling your 401(k) into a Roth IRA is relatively simple:
• First, open a new Roth IRA account.
• Contact the company that currently holds your current 401(k) and request a transfer. You’ll most likely have to fill out a few forms.
• Keep an eye out to make sure the transfer happens.
• Take another look at your overall retirement plan strategy.
SoFi Invest® can work with you to figure out your retirement plan. SoFi advisors can help you figure out if rolling over a 401(k) if the right move for you.
An investment account with SoFi lets you endeavor to maximize your money’s potential in a number of ways, without fees. You get to choose from more than just one option.
You can opt for active or automated investing—either way you choose, you won’t be paying any fees. You can learn more about traditional and Roth IRAs by making a no-obligation appointment with a SoFi Financial Planner.
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