401(k) plans are employer-sponsored retirement plans that allow employees to save for their retirement and receive matching contributions from the company. Once an employee leaves a company, he can roll his 401(k) into other retirement savings accounts such as Traditional IRAs and Roth IRAs. Traditional IRAs are taxed like 401(k)s in that contributions are typically deductible from your earnings and all distributions are taxable. Contributions to Roth IRAs, on the other hand, are taxed, but all growth and distributions are income tax free.
Pick a custodian for your new Roth IRA. This custodian can be a bank or an investment company. You will typically want to use cash vehicles such as deposit accounts or money market funds for the initial rollover.
Fill out the paperwork to roll your old 401(k) into your new traditional IRA. Some 401(k) programs will allow you to roll money directly into a Roth, but it is more typical to transfer your 401(k) funds into a traditional IRA before you convert these funds into a Roth IRA.
Fill out the Roth conversion paperwork to turn your new IRA into a Roth IRA. You will need to pay income taxes on the full amount of the conversion in the current tax year at your marginal income tax rate, but future growth and distributions will be tax free after age 59 1/2. You will also be able to withdraw your converted contributions tax free and penalty free before age 59 1/2, as long as you leave them in the Roth for at least five years.
Invest your new Roth IRA as you see fit. Now that your new Roth IRA is funded, you can invest the funds into the investment vehicle of your choice.
Tips & Warnings
- A Roth conversion or any rollover can only be done once the 401(k) participant is no longer working for the company that sponsors the 401(k).
- Use Form 8606 to report your Roth conversion funds on your income tax return.
- Don't forget about the tax bill that will come due next April 15th.