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By Jason Topp 24 Comments – The content of this website often contains affiliate links and I may be compensated if you buy through those links (at no cost to you!). Learn more about how we make money. Last edited May 14, 2012.

Oh what a great year for debate on Roth IRA’s and Roth IRA Conversions! Roth IRAs are a great tool for building up retirement savings, but some things have changed for conversions.

2010 has ushered in some new Roth IRA rules -here’s what you need to know about the 2010 Roth conversions.

I recently received a comment from a reader that I thought garnered a little more attention. Here’s what the reader asked:

My wife and I had traditional non-deductible IRAs and converted at the beginning of this year. We assume that the Roth conversions wouldn’t cause us any tax liability since our contributions to the traditional IRAs exceeded their values at the time of the conversion. Have you heard anything about the tax implications of Roth conversions from traditional non-deductible IRAs?

So what we know from the statement above is that they converted to Roth IRAs from Traditional, non-deductible IRAs. We also know that there were no gains in the account, meaning it was strictly contributions – and they’re wondering what their tax implications will be on this move.

This is a GREAT question!

What is a Traditional Non-Deductible IRA

Let’s define what a traditional, non-deductible IRA is so that we are all on the same page.

Generally speaking a traditional IRA allows money to be contributed pre-tax, which means that you get to take a deduction for it. It’s deductible off of your gross income. This also means that when you withdraw from your IRAs this money becomes taxable at that time!

So, for example, you put in $5,000 to a traditional IRA, you are allowed to subtract $5,000 from your income, which in turn gives you less reportable income to pay taxes on.

Of course the IRS has some funky little rules to spoil how much you can stash into traditional IRAs.

Basically, if you already participate in an employer-sponsored retirement plan – meaning you have a 401k, 403b or SEP IRA etc. – AND you make too much money then you get phased out of your “deductibility” of the IRA and the contributions then turn into non-deductible IRA contributions!

It’s as if you put after-tax money into the IRA.

What are the Income Limitations for Deductible IRAs

Let’s take a look at the rules for tax year 2009:

  • If you are a single filer and are covered by an employer-sponsored retirement plan you begin getting phased out of your deductible IRA contributions if you have an adjusted gross income (AGI) between $55,000 and $65,000.
  • If you’re married filing jointly, covered under an employer-sponsored retirement plan then you begin getting phased out between $89,000 and $109,000 AGI.

If you’re making more than this then your entire contribution to the Traditional IRA is non-deductible!

What are the Tax Implications of a Non-Deductible IRA to Roth IRA Conversion

Back to the question at hand – how will this affect me on my taxes?

So here’s a couple things to consider:

  1. What is your basis (contributions to the IRA) and what is the earnings amount? In the reader’s case they didn’t have any gains to worry about. But if they did, they’d have to pay tax on the earnings portion.
  2. If you had no other IRAs in place (including SEP, SIMPLE and Traditional) then you’re good to go – no taxes due!
  3. If you did have other IRAs in place, then you may not be in as great a shape as you thought – you may owe Uncle Sam!

Here’s what I mean on the last two:

The rule with a Non-deductible IRA is that you MUST aggregate all your non-Roth IRAs together as one big account when doing a Roth conversion in order to determine the tax liability.

Here’s an example:

Let’s say you have two IRAs with a total value of $30,000. One is a traditional IRA that has a $15,000 balance and all of that is pre-tax.

The other is a non-deductible IRA that includes $15,000 of nondeductible, or after-tax, contributions and no earnings as in the reader’s case.

If you decide to convert all $30,000 of your IRA money, then $15,000 (the amount you contributed to the non-deductible IRA on an after-tax basis) would not be taxable since you’ve already paid the tax on that money.

But the remaining $15,000 would be taxable because Uncle Sam hasn’t got his piece of that pie yet (it’s pre-tax contributions plus earnings that have not been taxed yet)

Let’s say you only want to convert your non-deductible IRA funds since there are no gains and you’ve already paid tax on the contributions – what happens?

In theory, this is a great strategy, but as mentioned, you have to consider all non-Roth IRAs as one big pie.

The Uh-Oh

In the example above, your already-taxed nondeductible contributions of $15,000 account for 50% of your total, while the $15,000 of pre-tax deductible contributions and investment earnings represent the other 50% of your $30,000 IRA pie.

Whether you convert the entire $30,000 or just a slice of it, 50% is considered taxable income.

It doesn’t matter where you take that slice from (non-deductible or pre-tax) – each has the same ingredients of taxable and nontaxable money as the whole!

What You Need to Do

If you find yourself in this situation, you’ll need to fill out IRS form 8606 and wade through the instructions and the mire!

Related Posts

Source: biblemoneymatters.com

Apache is functioning normally

About the series…

When most people talk about money management, they discuss tactics. Occasionally, you’ll encounter someone who elevates the discussion to strategy, rather than simply scattershot tactics.

But what’s missing from both conversations — both tactics and strategy — is a wider-lens look at how to become a better thinker; how to become a crisp, clear decision-maker.

How to think from first principles. How to better your brain. How to cultivate the wisdom to know the next move.

This series is an attempt to bring first principles thinking into the conversation around money. Welcome to the inaugural post.

Rethinking the FIRE Construct

I’ve been thinking about FIRE in new terms:

Financial psychology

Investing

Real estate

Entrepreneurship

Together, these four concepts encompass everything we need for mastery over our financial life. And the letters are ordered perfectly: start with mindset and master the basics, then shift focus to “the IRE of FIRE” — high-growth activities such as making investments, buying real estate, and starting a side hustle or business.

So I’m trying something new.

With every post in this First Principles series, I’ll share insights into these four domains, with the goal being to fill each post with original and unusual insights.

My commitment to you is to write a series with nuance. Too much personal finance content lives in an echo chamber, rehashing the same tired lines and prescriptive, one-size-fits-all advice. You won’t find that here. This series is built to make you smarter. Together, we’ll uncover mental models, examine frameworks, rethink perspectives, peer at our cognitive biases and emotional triggers, and engage in the deep work of thinking about how to think.

This is a series about how to think from first principles, how to be a better, smarter, wiser decision-maker, told through the lens of money.

Let’s begin — and in today’s introductory post, we’ll kickoff with a deeper look at each of these four concepts.

Financial Psychology

If you say “personal finance 101,” most people immediately think of tactics: building automations, setting up cash reserves, hiding money from yourself. They think of bulk cooking, buying used cars, and the low-hanging-fruit of frugality.

Those tactics are great. But starting there is a mistake.

Bigger, more sustained improvements come from understanding why we spend, why we behave irrationally with money, why there’s a behavior gap between what we pledge and what we do.

The key to finding your financial footing is understanding the psychology of money.

Want to stop spending so much on the weekends? Start by understanding the impulse behind the purchase. We don’t buy items, we buy feelings. Figure out what feelings you’re trying to purchase — and the triggers and root causes behind that — and your spending will adjust naturally.

Want to get (and stay) out of consumer debt? Start with the psychology of debt — both the factors that led you into debt, and the mindset that the debt burden creates.

Most of us know what to do (spend less than you earn, invest the difference), but translating awareness into action is tough. Tactics are necessary, but not sufficient.

Understanding the psychology of money is at the core of mastering our financial mental game. And until we master the mindset, then we’ll never follow through with the tactics.

Investing

Most discussion around investments fall into two categories:

1: The fundamentals. These are the articles that teach basics around how the system works: “the 401k, 403b, and IRA are examples of retirement accounts,” or “stocks and bonds are examples of assets.”

2: The horserace. These are the articles that track what the market is doing today, or this week — market moves, winners and losers.

You can either read evergreen articles on long-term investing, or you can track today’s stock performance; there’s not much information outside of those two domains.

But there are three important elements missing from this conversation:

1: The strategy. Investing decisions need to be made in the context of your life (or as my buddy Joe says on the podcast, “start with the end in mind.”) These strategic discussions around “what’s the end goal?” and “how do I reverse engineer?” often get overlooked, which is why so many investors experience FOMO, the fear of missing out. If there’s no clarity of purpose, then the only goal is “more.” And when the only goal is “more,” then the Next Hot Stock Tip seems too tempting to pass up.

2: The psychology. The greatest investors are the ones who have a strong awareness of investor psychology: fear and greed, FOMO, loss aversion, recall bias, the availability heuristic, our tendency to overvalue what we already own, and other cognitive biases.

3: The new frontier. Cryptocurrencies for conservative, thoughtful, diversified investors. We live in a world with SPACs and NFTs, acronyms that the average investor didn’t know a few years ago. And at the moment, millions of people are learning about these next-frontier innovations primarily from Twitter and TikTok.

I’ll be writing about investments with a focus on these three elements.

SPOTLIGHT ON…

One of the most fascinating trends of today is the decoupling of skills from diplomas.

The established order used to demand that we dig ourselves into debt for a formal education in order to be considered skilled, useful job candidates. The advent of specific skills-based online learning has transformed this, making it possible to land a six-figure career with only a few months of training.

For a deeper discussion around this decoupling — and how it affects anyone who wants a higher-paying job — watch this video conversation that I had with Jonathan Mendonsa, co-host of the Choose FI podcast.

Real Estate

Real estate is one of the few asset classes that’s a hybrid between an investment and an entrepreneurial venture, so it’s perfect that the “R” in “FIRE” fits in-between the “I” of investing and the “E” of entrepreneurship.

Housing prices have soared in 2021, and the psychological response has been fascinating. When macro events happen, our brains grasp for an explanation.

Many people have reflexively reached for the simplistic, reductive explanation that home prices are high because buyers are irrationally exuberant, and that what goes up must come down. Many people have a fear of heights: the soaring new highs of the market must *necessarily* mean that there will come a crash … right?

After all, that’s what happened in 2008 … so isn’t this history repeating itself?

Yet it takes more than new highs to cause a crash. And there are major differences between the market peaks of 2021 and the peaks of 2006-07.

In 2006-07, we faced a housing surplus. Builders were over-developing, speculating that demand would be able to keep up with the huge spike in supply.

In 2021, we face a housing shortage. New construction permits and renovation permits are low. Lumber prices are high. Labor is scarce. New household formation is high. The supply can’t keep pace with demand.

To be clear, this isn’t a prediction of the future. I’m opposed to making predictions (though I’m an advocate of probabilistic thinking).

It’s simply an observation that the factors influencing each run-up are different — so it’s unwise to assume we know what the future holds.

Entrepreneurship

The word “entrepreneurship” is overused, so let’s pause to look at the different concepts and styles of work that fall under this umbrella category.

First, there’s *gig economy* work, like driving for DoorDash or Uber Eats. It’ll get cash in your pocket immediately, but because there are low barriers to entry and few ways to distinguish yourself, the upside is limited.

Next, there are *scalable* side hustles, like building an online business of your own: freelancing, consulting, producing a product or service that carries your own branding. This allows you to distinguish yourself and offers the benefit of a limited startup cost, but it could take months before it turns profitable.

Once you convert side hustles into full-time work, there are two iterations.

There’s self-employment, in which you’re a solo service provider (potentially with a few 1099 contractors).

And then there’s full-blown entrepreneurship, in which you’re running a company with W2 employees, health benefits, vacation policies and a 401k plan.

The confusing thing about the catch-all term “entrepreneurship” is that people online use this to apply to all four of the above-listed situations, and as a result, most information that you’ll find about this topic is muddled.

In this First Principles series, I’ll be clear about which of these four situations I’m referencing, as I write about how to think and act like a successful entrepreneur.

Hope you enjoyed AND learned from this inaugural post in the First Principles series.

Click here if you want future posts like this straight to your inbox with more thoughts, ideas and insights on a new take on FIRE.

See you soon!

Source: affordanything.com

Apache is functioning normally

Typically, most people automatically assume they should roll over their old 401(k) into a traditional IRA. However, a lot of people have been asking about another option lately – and that’s whether you can roll your 401(k) over into a Roth IRA instead.

Fortunately, the definitive answer is “yes.” You can roll your existing 401(k) into a Roth IRA instead of a traditional IRA. Choosing to do so just adds a few additional steps to the process.

Whenever you leave your job, you have a decision to make with your 401k plan. Most people don’t want to let an old 401(k) sit idle with an old employer, and could benefit immensely by moving those funds somewhere that could benefit them more in the long run. Let’s see if I can help you make “cents” of the situation.

But first, let’s look at the rules behind the strategy of rolling over your 401k into a Roth IRA.

Table of Contents

Need to open a Roth IRA?

My favorite online broker is Ally Invest but you can check out our recap on the best places to open a Roth IRA and the best online stock broker sign-up bonuses. There are many good options out there, but I have had the best overall experience with Ally Invest. No matter which option you choose the most important thing with any investment is to get started.

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Roth IRA Rollover Rules From 401k

As a reminder, you must generally be separated from your employer to roll your 401k into a Roth IRA. However, some employers do permit an in-service rollover, where you can do the rollover while still employed. It’s permitted by the IRS, but not all employers participate.

Before January 1, 2008, you weren’t able to roll your 401(k) into a Roth IRA directly at all.  If you wanted to do so you had to complete a two-step process.  (Keep in mind that this would also apply to old Simple IRA’s, SEP IRA’s and 403b’s, 457, and qualified pensions, too)

  1. Open a Traditional IRA.

  2. Convert the Traditional IRA to a Roth IRA.

However, the law changed shortly after and this option became available. Still, just because the law has made this option available doesn’t mean you can definitely roll your old 401(k) into a Roth IRA no matter what.  Unfortunately, it all depends on your plan administrator.

For example, recently I had two clients who intended to roll their old retirement plans into a Roth IRA.

One client had an old military retirement plan- Thrift Savings Plan (TSP) – and the other had an old state retirement plan.  After helping each of them complete the required paperwork, I came across an interesting discovery.

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The TSP rollover paperwork had a box you could mark if you wanted to roll over the plan into a Roth IRA (the instructions had been added to make sure you had a Roth IRA already established).  However, the state retirement plan did not give that option.

The only option was to open a traditional IRA to accept the rollover and then immediately convert it to a Roth IRA.  That certainly seemed like a hassle at the time, and it definitely was.

However, this man’s state retirement plan is not the only one I’ve encountered with these extra “rules.”  Many 401(k)’s and 403(b)’s come with the same “No-Roth IRA Rollover” option.  This option was supposed to be mandatory in 2010, but some still do it on a voluntary basis.

At the end of the day, this means you should explore this option thoroughly before automatically assuming it would work in your case. Ask questions, consult your financial advisor, and read through all of your rollover paperwork carefully before you begin moving in this direction.

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Recap on Roth IRA Conversion Rule

These days, nearly anyone can take all of their traditional IRAs and old retirement plans and convert them to a Roth IRA.  The amount you convert will be taxed, but it still can be an attractive move for those that feel that taxes are going nowhere but up.

How Do I Rollover if I Receive the Check?

If you receive a distribution check from your 401(k) rollover to a Roth IRA, then chances are good they will hold around 20% for taxes. If you want a direct 401(k) rollover to a Roth IRA, you may want to send that check back to your employer 401(k) provider and ask to be sent all of your eligible retirement distribution directly to your new Rollover IRA account (not as a check, or they will just give you 80% again).

You have 60 days upon receiving the check to get the money into the Roth IRA- no exceptions!  So don’t procrastinate on this one.

What About the Roth 401k?

If your employer offers a Roth 401k and you were savvy enough to take part, the path to a rollover will be much easier.  When you’re converting one Roth product to another, there is simply no need for conversion.  You would simply roll the Roth 401(k) directly into the Roth IRA with the help of your plan provider.

Roll Your 401(k) by Following These Steps

  1. You have to have a Roth IRA open/established before you can do any of this.
  2. Ask your plan provider about the paperwork required to roll your plan over, then complete the paperwork in a timely manner.
  3. Enjoy the tax-free growth of your Roth IRA!

4 Signs It Makes Sense to Roll Your 401(k) into a Roth IRA

If you’re thinking of rolling your 401(k) into a Roth IRA instead of a traditional IRA, you have plenty of reasons to do so. Not only do Roth IRAs let you invest your dollars in the same investments as traditional IRAs, but they offer additional perks that can help you save money down the line. Here are four signs that a Roth IRA might actually be your best bet.

1. You expect to pay higher taxes in the future.

Since Roth IRAs use after-tax dollars, you’ll have to pay taxes upfront on any funds you roll over. However, you won’t have to pay taxes on your distributions, which could be extremely beneficial if you’re taxed at a higher rate when you reach retirement. You’ll pay taxes either way – now or later. But with a Roth IRA, you can rest assured your withdrawals will be tax-free.

2. You want to take withdrawals when you’re ready, and not a minute before.

While traditional IRAs force you to begin taking withdrawals at age 70 ½, Roth IRAs do not have this stipulation. Because of this, you can squirrel your Roth IRA funds away until you’re ready to use them.

3. You expect to earn more money in the future.

If you plan to earn lots of money in the future – or earn a high income now – you should consider rolling your funds into a Roth IRA instead of a traditional IRA. For single filers in 2023, the maximum income allowable for contributions to a Roth IRA starts at $138,000 and ends at $153,000. Learn more about Roth IRA rules and contribution limits here.

For married filers, on the other hand, the ability to contribute to a Roth IRA begins phasing out at $218,000 and halts completely at $228,000 for 2023. The more you earn in the future, the harder it will become to contribute to a Roth IRA and secure the benefits that come with it.

4. You want to increase your tax diversification.

Contributions to traditional IRAs are tax-advantaged, meaning you won’t pay taxes on your invested funds until you begin taking withdrawals at retirement. Roth IRAs, on the other hand, are taxed up front but offer tax-free withdrawals after age 59 ½.

If you’re unsure how your tax and income situation might pan out in the future, having both types of accounts – a traditional IRA and a Roth IRA – is a smart move in terms of diversifying your future tax exposure.

401k to Roth IRA Rollover Rules Details
Eligibility You can roll over a 401k to a Roth IRA if you have left the employer sponsoring the 401k and are no longer contributing to the plan. Some plans also allow in-service rollovers, but it’s best to check with your plan administrator for details.
Taxes When you roll over a 401k to a Roth IRA, you will owe income taxes on the amount you convert. This is because contributions to a 401k are made with pre-tax dollars, while contributions to a Roth IRA are made with after-tax dollars.
Conversion Limitations There is no limit on the amount you can convert from a 401k to a Roth IRA. However, the amount you convert will be added to your taxable income for the year in which you make the conversion, which could have tax implications.
Timing You can convert a 401k to a Roth IRA at any time, but it’s important to consider the timing of the conversion carefully. If you convert when your income is higher, you will owe more in taxes.
Penalty-Free If you are 59 ½ or older, you can convert a 401k to a Roth IRA penalty-free. If you are younger than 59 ½, you may be subject to a 10% early withdrawal penalty on the amount you convert.

The Bottom Line – Rolling Over 401k into a Roth IRA

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Rolling your 401(k) into a Roth IRA is a smart decision for many investors, but it may not be right for everyone.

Some financial advisors may suggest rolling over your 401k into a Roth IRA to take advantage of the tax-free growth the account offers. While this can be a great option for some, it’s important to consider if you’ll be able to afford to pay the taxes on your contributions and earnings when you eventually withdraw them.

Before you pull the trigger, make sure to investigate all of your options and consider speaking with a tax professional. When it comes to complex investment vehicles and taxes, what you don’t know can hurt you

FAQs on Rollover 401k to Roth IRA

Can you roll over 401k to Roth IRA without penalty?

Yes, you can roll over funds from a 401(k) to a Roth IRA without incurring any penalties, but there are some important rules and restrictions to be aware of.

First, you’ll need to meet the eligibility requirements for a Roth IRA, which include having earned income and not exceeding certain income limits. If you’re eligible, you can roll over funds from your 401(k) to a Roth IRA by asking your 401(k) plan administrator to transfer the funds directly to your Roth IRA account. This is known as a “direct rollover” and it allows you to avoid paying any taxes or penalties on the funds.

However, there are limits on how much you can contribute to a Roth IRA each year, and there may be tax consequences if you exceed those limits. It’s important to consult with a financial advisor or tax professional before making any decisions about rolling over funds from a 401(k) to a Roth IRA. They can help you understand the rules and restrictions and determine if a rollover is the right move for your financial situation.

What are the disadvantages of rolling over a 401k to a Roth IRA?

There are a few potential disadvantages to rolling over funds from a 401(k) to a Roth IRA. These include:

1. Tax implications: When you roll over funds from a 401(k) to a Roth IRA, you’ll have to pay taxes on the amount you roll over. This can be a disadvantage if you’re in a high tax bracket and don’t have other funds available to pay the taxes.

2. Loss of employer matching: If your employer offers matching contributions to your 401(k), you’ll lose out on those contributions if you roll over your funds to a Roth IRA.

3. Loss of certain benefits: 401(k) plans may offer certain benefits, such as loan provisions and hardship withdrawals, that are not available with a Roth IRA. If you roll over your funds to a Roth IRA, you’ll lose access to these benefits.

Overall, rolling over funds from a 401(k) to a Roth IRA can be a good move for some people, but it’s important to carefully consider the potential disadvantages and consult with a financial advisor before making any decisions.

What is the tax penalty for rolling 401k to Roth IRA?

If you roll over funds from a 401(k) to a Roth IRA, you’ll have to pay taxes on the amount you roll over. This is because funds in a 401(k) are pre-tax, meaning you don’t have to pay taxes on them until you withdraw the funds. When you roll over the funds to a Roth IRA, you’re essentially withdrawing the funds and then depositing them into the Roth IRA, so you’ll have to claim that amount of reportable income.

Since you’re “rolling over” and not taking a distribution you won’t have to pay the 10% early withdrawal penalty if you’re under the age 59 1/2. If you do choose to this be prepared to pay the taxes on the rollover out of pocket. Otherwise if you use your 401k money to pay the taxes you will be penalized on that amount.

What is the Roth five year rule?

The Roth 5 year rule is a requirement for certain tax-free withdrawals from a Roth IRA. In order for a withdrawal from a Roth IRA to be tax-free, the account must have been open for at least 5 years and the withdrawal must be made after the age of 59 1/2. If these conditions are not met, the withdrawal may be subject to taxes and penalties.

The Roth 5 year rule applies to both contributions and earnings in a Roth IRA. For example, if you make a contribution to a Roth IRA and then withdraw it within 5 years, the withdrawal will be subject to taxes and penalties unless it meets one of the exceptions to the rule. The same is true for earnings on your contributions – if you withdraw earnings from a Roth IRA within 5 years, they will be subject to taxes and penalties unless an exception applies.

There are a few exceptions to the Roth 5 year rule, including:

-Withdrawals made to pay for qualified higher education expenses
-Withdrawals made to pay for qualified first-time homebuyer expenses
-Withdrawals made due to the account holder’s disability
-Withdrawals made by a beneficiary of the account after the account holder’s death

It’s important to understand the Roth 5 year rule and the exceptions to it before making any withdrawals from a Roth IRA. If you’re not sure whether a withdrawal will be subject to taxes and penalties, it’s a good idea to consult with a tax professional.

Source: goodfinancialcents.com