As more individuals take control of their retirement savings and navigate the complex world of pensions and IRAs, understanding all their nuances becomes crucial to making the best use of retirement accounts such as their 401(k). But many may wonder which type of Individual Retirement Account (IRA) they should convert their 401(k) into. Here’s everything you should know.
Understanding 401(k) and IRA
Before diving in to these popular retirement vehicles, it’s crucial that we gain an in-depth knowledge of their unique natures:
- Employer-offered 401(k) plans enable employees to invest a portion of their paycheck before taxes are deducted; that way, when withdrawing money, taxes won’t have been assessed until then.
- Individual Retirement Accounts: An Individual Retirement Account, commonly referred to as an “IRA”, is an individually-established tax-advantaged savings plan set up for themselves with tax advantages in mind. There are various kinds of IRAs; Traditional and Roth IRAs being two popular choices among them.
Convert a 401(k) to an IRA
Once you leave an employment position or retire, one option for managing your 401(k) funds could include rolling them over into an individual retirement account (IRA). But which kind?
- Traditional IRA: When rolling over from a 401(k) to a self directed IRA, both accounts offer tax deferral. When doing this move, your rollover event usually won’t incur tax implications until when your money comes time for withdrawal in retirement.
- Roth IRA Conversion: While Roth IRA conversion may be possible, you need to understand its tax ramifications carefully. Roth IRAs are funded using post-tax dollars which have already been taxed; qualified withdrawals in retirement from these plans are tax-free compared with pre-tax contributions in a traditional 401(k). Converting from one to the other can incur taxes when switching funds over; though you’ll likely face significant taxes during conversion if expected tax rates in retirement increase significantly or value other aspects of benefits associated with having one over time versus waiting a traditional 401(k).
Points to Remember for Rollover Process
It is imperative that a direct transfer be carried out between trustees to avoid potential tax penalties for rolling over assets from one trust to the next.
- Age and Withdrawal: Consider when and why you may need access to your funds; Roth IRAs do not require minimum distributions (RMDs) during an owner’s lifecycle compared to Traditional IRAs which do.
- Future Tax Rates: When thinking about future taxes rates, take an objective view on them and if your estimates show higher numbers it may make more sense to pay your due taxes now and convert into a Roth.
- Mix and Match: Your options when rolling over your 401(k) are flexible: whether that involves splitting it between Traditional or Roth IRAs is up to you depending on your financial circumstances and goals.
Navigating the complex world of retirement accounts may seem intimidating, but with a clear understanding of your options you can make informed choices to meet your financial and retirement goals. When making such choices it is wise to consult a financial advisor in order to select an IRA (Traditional, Roth or both), or combination thereof to ensure you take the optimal route based on your unique circumstances.
