Go Directly From a 401(k) to a Roth

Do you want to transfer your 401(k) plan assets to a Roth IRA? Under a recent tax law change, you can make the move in one fell swoop. Previously, it took two separate steps. In addition, another tax law provision taking effect this year may encourage this direct approach.

Background: With a 401(k) plan, you can defer part of your salary to a separate account, within generous annual limits. For 2010, the deferral limit is $16,500 ($22,000 if you are 50 years of age or older). The deferrals, plus any employer “matching” contributions, can grow without any tax erosion.

However, when you withdraw amounts from the 401(k) account—usually upon retirement—the distributions are taxed at ordinary income rates. Currently, the top tax rate for ordinary income is 35%. The top rate is generally expected to rise in future years.

In contrast, “qualified distributions” from a Roth that has been in existence at least five years are completely exempt from tax. A qualified distribution is one that is made after reaching age 59½, received on account of death or disability, or used to pay first-time homebuyer expenses (up to a lifetime limit of $10,000). Thus, there is a tax incentive to transfer 401(k) assets to a Roth, even though you must pay income tax on the transfer of funds (as you do with a conversion of a traditional IRA to a Roth).

Initial problem: Prior to 2008, you could not roll over funds directly from a 401(k) to a Roth. Instead, you had to take two steps:

1. Transfer the 401(k) funds to a traditional IRA.

2. Convert the traditional IRA to a Roth and pay the tax liability.

Effective for transfers after 2007, you can use a direct 401(k)-to-Roth rollover. In other words, you no longer have to take the interim step of converting the 401(k) assets to a traditional IRA. 

Another potential problem: Previously, you still could not complete a one-step transfer in a year in which your modified adjusted gross income (MAGI) exceeded $100,000. But this barrier has been removed.

Beginning in 2010, any individual—regardless of the amount of his or her income—can roll over funds directly from a 401(k) to a Roth. Furthermore, for a transfer occurring in 2010, you can elect to have the taxable income from the transfer split evenly over the following two years (2011 and 2012), if it suits your purposes.

The IRS recently offered additional guidance for one-step transfers. It clarified that you can transfer funds directly from one of several types of qualified plans, including a 401(k), 403(b) and 457(b) plan.

Also, if you roll over funds directly to a Roth, the rollover is not subject to the usual automatic 20% income tax withholding requirement. Finally, a beneficiary may also roll over plan funds directly to a Roth. In this case, a surviving spouse (but not a nonspouse beneficiary) may treat the Roth IRA as his or her own.

Should you transfer funds directly from a 401(k) to a Roth? The answer depends on your family’s circumstances. Your professional advisers can help determine the best course of action for your situation.