Some for-profit companies create 401k plans for their employees to assist them in saving for retirement. However, when you leave your job, you may want to roll your 401k plan into a Roth IRA, which is an after-tax account. Reasons for doing this include the tax-free withdrawals that Roth IRAs offer and the fact that Roth IRAs are not subject to required minimum distributions that you must take starting at age 70 1/2 if the money is left in the 401k plan.
When you roll money from a 401k plan to a Roth IRA, you must report the amount of the conversion as taxable income, because you are moving money from a tax-deferred account to an after-tax account. For example, if you roll over $50,000 from a 401k plan to a Roth IRA, you would have to add $50,000 to your taxable income for the year. This income is taxed at your marginal income tax rate and may even push you into a higher tax bracket. For example, if the 25 percent income tax bracket goes from $50,000 to $100,000, the 30 percent tax bracket goes from $100,000 to $150,000, and your taxable income without the rollover equals $80,000, the first $20,000 of the rollover would be taxed at 25 percent and the last $30,000 would be taxed at 30 percent.
When you perform a 401k to Roth IRA rollover, you have only 60 days from the time you receive the funds to redeposit the money in the Roth IRA. If you fail to redeposit the money within that time period, the Internal Revenue Service will consider you to have withdrawn the money permanently, which causes several problems. First, you lose the ability to move the entire amount into another tax-sheltered retirement account. Second, if you are not at least 59 1/2, you will have to a pay a 10 percent early withdrawal penalty.
When you perform a rollover, the financial institution that holds your 401k plan must withhold 20 percent of the amount of the rollover for the taxes and penalties you may owe if you fail to redeposit the money. For example, if you requested a $50,000 rol over, you would only receive $40,000 because $10,000 would be withheld. However, when you redeposit the money, you must redeposit the amount requested, not the amount received. Continuing the example, you would have to redeposit $50,000 even though you only received $40,000. If you only redeposited $40,000, $10,000 would be considered distributed.
To avoid the withholding, you are allowed to do a direct conversion where the money transfers directly to your Roth IRA instead of being paid to you first. When you perform a direct conversion, no money is withheld because, since you do not have access to the money, the transfer cannot fail.