When you have money sitting in a 401k, you may wish to take advantage of the tax benefits that come with a Roth IRA instead of leaving the money in the account. This is common when leaving a job because you will no longer have access to the 401k. At that point, you will have to pay attention to the tax implications of this process.
401k to Roth IRA Basics
When you contribute money to a 401k, you do so with money that has not had any taxes taken out of it. By comparison, when you contribute money to a Roth IRA, you do so with money that has already had taxes taken out of it. Because of this discrepancy, you will have to pay taxes on the money that you convert from a 401k to a Roth IRA. Once you pay taxes on the money that goes into a Roth IRA, you never have to worry about taxes on the money again.
When you decide to convert over to a Roth IRA from a 401k, you will have to pay taxes on the amount in that year. The amount of money that you convert from your 401k will be added to your regular annual income for that year. Then you will pay taxes on it as if you earned that much money all in the same year. This has the potential to put you in a higher tax bracket.
Tax Payment Options
Depending on when you convert your 401k to a Roth IRA, you may have a few different options to consider when it comes to actually paying the taxes. One option is to pay 100 percent of last year's tax amount. You also have the option of paying 90 percent of what you owe for the current year in taxes. Some people also elect to make quarterly payments to the IRS based on what they project they will owe.
Since you will have to pay taxes on this conversion, you need to think about how you will pay them. In some cases, people take money out of the retirement funds to pay the taxes on the conversion. If you can afford to pay the taxes with other money, this would most likely be the best option for you. It will keep your retirement money intact and it will help you avoid setting your retirement back several years.