Keeping track of the many rules governing your retirement plans can be a daunting task. The thing to remember is that your 401k is a workplace-sponsored defined contribution pension plan, while your individual retirement account is a privately owned retirement plan. While being covered under a 401k plan at work can affect your ability to make deductible contributions to an IRA, your contributions do not count against one another, nor does a rollover to an IRA count against your contribution limit for the year.
A rollover is a balance transfer from one type of retirement plan to another. If the source of funds is a traditional IRA or retirement plan and the destination is a traditional or Roth IRA, the transaction is called a "rollover." The term "recharacterization," however, is used to describe the conversion of a recently rolled over Roth IRA back into a traditional IRA. Rollover transactions are treated differently than contributions. Your rollover does not count towards the annual $5,000 contribution limit ($6,000 for those over 50) normally allowed for Roth contributions and deductible contributions to traditional IRAs.
Coordination With Income
While your rollover doesn't count as a contribution, a rollover from a 401k plan or traditional IRA, SEP IRA, or SIMPLE IRA into a Roth IRA may affect your ability to make a contribution to a retirement plan that year. This is because the law establishes a maximum allowable modified adjusted gross income to contribute to each type of plan. This income threshold changes periodically. When you elect to execute a rollover from a tax-deferred retirement into a Roth, you must recognize the amount transferred as income, which could put you over the limit for either a Roth IRA or traditional IRA contribution.
As of 2011, in order to make a full $5,000 deductible contribution to an IRA, those covered by a retirement plan at work have to have incomes of less than $56,000 per year, or $90,000 if you are married and file a joint return. If you are not covered by a retirement plan at work, then there is no upper income limit for single taxpayers, but married taxpayers filing jointly must show an income of $169,000 or less. The limits for Roth IRAs are $107,000 for single taxpayers and $169,000 for couples. If your rollover drives your income above these levels, your ability to make new contributions may be reduced or eliminated.
Consider rolling over a 401k balance to a Roth if you want the additional freedom choice. IRAs allow you to select from a much broader array of investment options, including the option to invest the balance in a closely-held small business. Roth IRA accounts may be advantageous if you believe you will be in a higher tax bracket in retirement than you are now. Rollovers work best if you can pay the taxes using funds that are not in the IRA itself. Be aware that while the asset protection afforded to 401k plans has no upper ceiling, Congress only protects the first $1 million in IRA balances from creditors.