Moving money from an old 401(k) to a Roth IRA (individual retirement account) can set you up for tax-free withdrawals later in life. But before you do so, you should iron out the details of your current-year tax tab, so you won’t be caught off guard.
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There are different tax rules for a 401(k) and a Roth IRA
If your employer offers a traditional 401(k), you’ll have a chance to trim your tax bill for the current year. In 2022, you can contribute up to $20,500 if you are under 50. Every dollar you contribute can reduce your taxable income for the year.
Let’s say you are 35 years old and earn $85,000. If you contribute $20,500 (the maximum employee contribution) to a 401(k) in 2022, your taxable income drops to $64,500. You contribute pre-tax dollars to your 401(k) and agree to pay taxes on the contributions and earnings when you withdraw the money.
But if you don’t want to deal with taxes when you retire, you might want to consider a Roth IRA conversion when you leave your job. Here are some features that attract many retirement savers to a Roth IRA:
You pay your tax bill now instead of worrying about a tax hike later.
You bypass taxes on the growth in the account every year.
There are tax-free withdrawals after you reach 59 1/2.
Let’s say you had $100,000 in your former employer’s 401(k). You can roll over the money into a Roth IRA. But proceed with caution. Going from a pre-tax account like a 401(k) to an after-tax Roth IRA account can stir up tax trouble if you aren’t careful.
Ask these questions before moving your money
Before you proceed with a 401(k) to Roth IRA conversion, consider the following questions:
How much money do you expect to earn in 2022?
How much money do you have tucked away in your old 401(k)?
Will the Roth IRA conversion push you into a higher tax bracket?
Do you have money saved to cover a tax bill?
Understand how taxes work
Taxes can throw a wrench into your plan if you’re not careful. Every dollar you transfer from a traditional 401(k) to a Roth IRA will be taxed at the ordinary income rate. These are the same rates you pay on any money you earn from working.
Here are the 2022 ordinary income tax rates, so you won’t be left in the dark:
Rate
Single
Married Filing Jointly
Head of Household
10%
$0 to $10,275
$0 to $20,550
Up to $14,650
12%
$10,276 to $41,775
$20,551 to $83,550
$14,651 to $55,900
22%
$41,776 to $89,075
$83,551 to $178,150
$55,901 to $89,050
24%
$89,076 to $170,050
$178,151 to $340,100
$89,051 to $170,050
32%
$170,051 to $215,950
$340,101 to $431,900
$170,051 to $215,950
35%
$215,951 to $539,900
$431,901 to $647,850
$215,951 to $539,900
37%
Over $539,900
Over $647,850
Over $539,900
Table source: Author. Data source: IRS.
Calculate your potential tax liability
Here are two questions you want to think about:
How much do you plan to transfer from a 401(k) to Roth IRA?
What is your marginal tax rate?
Let’s say you transfer $30,000 from an old 401(k) to a Roth IRA. Your gross income will go up $30,000. If your marginal tax rate were 22%, your tax tab could increase by $6,600. You need to pay close attention to how much you can transfer from your 401(k) to a Roth IRA before your income is pushed into a higher tax bracket. This could cause your tax bill to go even higher.
If you are unemployed in 2022, it might be a smart idea to stuff money into a Roth IRA this year. You’ll gain access to lower tax rates. Also, if you expect to make less this year than in the years ahead, it’s a good time to consider how a Roth IRA conversion could protect you from future tax hikes.
Don’t give away money to Uncle Sam if you don’t have to
If you’re considering moving money from an old 401(k) to a Roth IRA, you need to evaluate if this is the best year to do it. There are many factors to consider, such as your gross income, marginal tax rate, and 401(k) balance.
In an ideal world, you would want to do a Roth IRA conversion in a year when you will pay the least taxes. But if you don’t mind the tax bill this year, you can make the move. Be sure to ask the right questions, and don’t do this alone to ensure you’re not faced with unexpected taxes or penalties.
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