So you’ve left your old job behind and are now looking to roll your 401(k) account into an IRA. No more worrying about your former company having control over your hard-earned money—it’s time for you and your savings to thrive in greener pastures. But with this exciting decision comes an important question: which type of IRA is the best fit for you? With traditional and Roth IRAs to choose from, it’s crucial to understand the key differences to make the right choice. Let’s dive in and discover the best path forward for your financial future.
Benefits of a Traditional IRA
Prior to 1997, there was only one kind of IRA, which is now referred to as a traditional IRA. It is a tax-deferred retirement account, meaning it’s funded with pre-tax money and the taxes are paid when the money is withdrawn in retirement. This is a great benefit because you have more money available to invest if you don’t have to pay taxes out of it first. Also, people often find themselves in lower tax brackets in retirement, so you may pay less in taxes than you would have originally.
IRAs can be invested in just about everything except life insurance or collectibles, so it’s easy to make a good return on your money. Unlike employer-sponsored retirement plans, with an IRA you are the complete owner and the plan is in no way tied to your employment. You can change jobs as frequently as you want and it does not impact your account or your ability to contribute to it (as long as you have earned income). You can even withdraw money penalty-free before age 59½ if it’s for a qualified first-time home purchase or education expenses.
Benefits of a Roth IRA
Out of the Taxpayer Relief Act of 1997, a new kind of IRA was born, named after Senator William Roth of Delaware, who was the chief legislative sponsor of the act. Roth IRAs differ from traditional ones in a few key ways. The biggest difference is the tax treatment. Whereas traditional IRAs are tax-deferred, with a Roth you pay all taxes up front. The key, though, that makes Roths so popular, is that you don’t have to pay taxes on any of the growth. Everything generated by compounding interest is yours, and the government doesn’t take any of it if you follow the rules.
Roths also differ from traditional IRAs in that there are no required minimum distributions. So, you can leave your money in the account to grow for perpetuity, instead of being required to start taking withdrawals (and stop contributions) at age 73 like with a traditional account. Some people even utilize Roth IRAs as a way to provide tax-free income for their children or grandchildren. In addition to the traditional IRA’s allowances for special withdrawals, contributions (not growth) can be taken out at any time for any reason without penalty.
There are income limitations on who is allowed to open a Roth IRA. However, anyone can convert a traditional IRA into a Roth through a “backdoor conversion.”
Roth Rollover Considerations
Because of the different tax treatment of the two types of IRAs, there are tax consequences depending on the type of account you roll your 401(k) into. A normal 401(k) can be rolled into a traditional IRA without paying taxes. A Roth 401(k) can be rolled into a Roth IRA without paying taxes. However, to roll a normal 401(k) into a Roth IRA creates a tax liability. Since your 401(k) is pre-tax and a Roth IRA is after tax, you may have to pay ordinary income taxes on the money to move it from one to the other. In order to roll a normal 401(k) into a Roth IRA, you should have sufficient money saved elsewhere to cover the tax bill.
One final thing to be careful of when rolling over 401(k) funds into an IRA is whether the money is sent to you or directly to your IRA custodian. If your old 401(k) plan writes you a check, they are required to withhold 20% for the IRS. However, if you don’t deposit the full original amount into an IRA within 60 days, it will be considered a withdrawal and you may be penalized. For example, say you have a $100,000 401(k) you want to roll over. Your previous employer writes you a check for $80,000 because they are required to withhold $20,000, or 20%. You, however, are required to deposit $100,000 into your new IRA in order to avoid the penalty, so you have to find the remaining $20,000 somewhere else in order to complete the transaction. It is much easier to do a direct rollover, or trustee-to-trustee transfer, where your previous employer sends the money directly to the IRA custodian and nothing is withheld for taxes.
Which IRA Is Better for You?
Considering the differing tax treatment, a Roth IRA is typically better for younger people who have more time to save and, therefore, take advantage of compounding interest. If you are nearing retirement, and will be needing the money early in retirement, you may be better off with a traditional IRA. Many people choose a Roth regardless of their age so they won’t be required to take distributions and they can leave the money to their families. If you make too much money to be eligible for a tax deduction for a traditional IRA, you would be better off with a Roth, though it may be more appropriate to implement a “backdoor” conversion to do so.
Choosing the right IRA to roll your 401(k) into is a crucial decision that can impact your financial future. Your individual situation and priorities should be considered when making this choice. Seeking advice can provide valuable insights and clarity in navigating this important decision.
If you’re ready to take control of your financial future and roll your old 401(k) into an IRA, don’t hesitate to reach out to me directly at (732) 856-4324 or schedule an introductory meeting online. Our team is here to help you make the best move for your unique financial goals.
Oscar Casas is the chief executive officer at Tranquility Path Investment Advisors, an independent Registered Investment Advisor firm dedicated to putting their clients first, always. Oscar has over a decade of experience helping clients plan for a confident retirement. He is known for being an empathetic and compassionate listener and for prioritizing his clients’ needs and goals above all else. He acts as a coach, advising his pre-retiree and retiree clients through all the ups and downs on their financial journey. He loves that he has the opportunity to make a difference in people’s lives and take some of the stress off their shoulders.
Oscar has a bachelor’s degree in finance, a master’s degree in personal financial planning, and is a CERTIFIED FINANCIAL PLANNER™, Chartered Retirement Planning Counselor℠, Master Planner Advanced StudiesSM and Accredited Behavioral Finance Professional℠ professional. When he’s not working, you can find him enjoying the outdoors with his three children. He is an avid tennis player who also loves golf, the beach, snowboarding, traveling, and volunteering.