In case you have ever left a job where you had a traditional IRA or 401(k) plan, you are most likely aware of the various rollover options for these workplace retirement accounts. One common option is rolling over a 401(k) into a Roth IRA.

Rolling over a traditional 401(k) into a Roth IRA may not be an obvious step given that traditional 401(k)s are funded with pre-tax dollars and Roth IRAs are funded with after-tax dollars. However, since the IRS puts income limits on Roth participants, a 401(k) rollover is one of the few opportunities more affluent savers have to acquire a Roth IRA.

Roths have several advantages over traditional IRAs, the more usual rollover option— withdrawals from these plans in retirement are tax-free and do not have required minimum distributions (RMDs).

• Should I Convert my 401k to a Roth IRA?
• Is it a Good Idea to Convert IRA to Roth IRA?
• Which is a better choice for your Savings Plan a Traditional IRA or a Roth IRA?
• What is the 5 year rule for Roth IRA?
• Does it make sense to have a Roth and Traditional IRA?
• How much should I have in my 401k?

Should I Convert my 401k to a Roth IRA?

First, let’s define some terms. A 401(k) and a Roth IRA are two types of retirement savings accounts. In both cases, investors make contributions to the accounts while they are still working, and account managers invest those funds in a diverse portfolio of stocks, bonds, mutual funds, and CDs. Ideally, the investments grow and the account holder has a nice nest egg to draw from during retirement.

Read Also: Investing for Retirement: The Complete Guide

The biggest difference between a 401(k) and a Roth IRA is when the money is taxed. With a 401(k), investors make contributions to the account before taxes. The 401(k) contribution is subtracted from Joe’s paycheck before taxes are calculated. But when Joe retires, he will have to pay income tax on any money he withdraws from his 401(k).

Roth IRAs are the other way around. If Joe makes a contribution to a Roth IRA, he cannot deduct those contributions from his taxable income. In essence, he pays taxes before he invests.

The upside of a Roth IRA is that you won’t have to pay any taxes on the money you withdraw from your Roth IRA after retirement. That’s why a Roth IRA is said to grow “tax-free.” So why should you convert?

Remember that the biggest difference between a 401(k) and a Roth IRA is when the income is taxed. With a 401(k), taxes are deferred until after retirement.

With a Roth IRA, you pay taxes now but can take the money out tax-free when you are retired. For that reason, the decision to convert from a 401(k) to a Roth IRA depends on your current income tax rate and the rate you expect to pay when you retire.

The rule of thumb is this: If you expect to be in a higher tax bracket when you retire, convert to a Roth IRA. Here’s why. If you currently pay a 25 percent tax on your income, it’s better to pay now and reserve your tax-free Roth IRA distributions for retirement, when you are in the 35 percent tax bracket.

But why would anyone be in a higher tax bracket after they retire? Let’s use Joe as an example. Joe makes a nice salary, but for most of his working years, he had the benefit of several large deductions and tax breaks that lowered his taxable income.

Joe is married, has four kids, and owns his home, so he always filed jointly, took deductions for each dependent, and deductions for mortgage payments. He also maxed out his 401(k) contributions every year (the 2013 limit is $17,500), further lowering his taxable income.

By the time Joe retires, he won’t be able to take any of those deductions, and he won’t be making contributions to his 401(k). Even if he’s taking in less income after retirement — from savings accounts, investments and Social Security — he may have more taxable income, putting him into a higher tax bracket. That’s when tax-free Roth IRA distributions pay off.

There are other advantages with a Roth IRA conversion. With a 401(k), you are required to start withdrawing from the account at age 70½. There’s no such required minimum distribution with a Roth IRA. If Joe wants, he doesn’t have to touch the money in his Roth IRA at all.

Joe has always wanted to leave something behind for his kids and grandchildren. With a Roth IRA, Joe’s heirs can also withdraw money from the account tax-free after he’s gone

Is it a Good Idea to Convert IRA to Roth IRA?

An IRA conversion is simply changing the account classification from a traditional IRA to a Roth IRA. Beginning in 2010, the federal government began allowing investors to convert their traditional IRAs into Roth IRAs, regardless of the amount of income they earned.

In general, people can invest in a Roth IRA only if their modified adjusted gross income (MAGI) falls below a certain limit. For example, if you’re married filing jointly and earn more than $206,000 a year in 2020 (up from $203,000 in 2019), you can’t invest in a Roth IRA; single and head of household filers have a cutoff of $139,000 (up from $137,000 in 2019).

But there are no income limits for conversions. Like most investment decisions, a Roth IRA conversion has its pros cons disadvantages.

Pros

A key benefit of doing a Roth IRA conversion is that it can lower your taxes in the future. While there’s no upfront tax break with Roth IRAs, your contributions and earnings grow tax-free. In other words, once you pay taxes on the money that goes into a Roth IRA, you’re done paying taxes, provided you take a qualified distribution.

While it’s impossible to predict what tax rates will be in the future, you can estimate if you’ll be making more money, and therefore, be in a higher bracket. In many cases, you’ll pay less in taxes in the long run with a Roth IRA than you most likely would with the same amount of money in a traditional IRA.

Another perk is that you can withdraw your contributions (not earnings) at any time, for any reason, tax-free. Still, you shouldn’t use your Roth IRA like a bank account. Any money you take out now will never get the opportunity to grow. Even a small withdrawal today can have a big impact on the size of your nest egg in the future.

Moving to a Roth also means you won’t have to take required minimum distributions (RMDs) on your account when you reach age 72. If you don’t need the money, you can keep your money intact and pass it to your heirs.

Cons

The largest disadvantage of converting to a Roth IRA is the whopping tax bill. If, for example, you have $100,000 in a traditional IRA and convert that amount to a Roth IRA, you would owe $24,000 in taxes (assuming you’re in the 24% tax bracket). Convert enough and it could even push you into a higher tax bracket.

Of course, when you do a Roth IRA conversion, you risk paying that big tax bill now when you might be in a lower tax bracket later. While you can make some educated guesses, there’s no way to know for sure what tax rates (and your income) will be in the future.

Yet another common issue that many taxpayers face is contributing the full amount and then converting it when they have other traditional IRA, Simplified Employee Pension, or SIMPLE IRA balances elsewhere.

When this happens, you’re required to compute a ratio of the monies in these accounts that have been taxed already versus the aggregate balances that have not been taxed (in other words, all tax-deferred account balances for which you deducted your contributions versus those for which you didn’t). This percentage is counted as taxable income. Yeah, it’s complicated. Definitely get professional help.

Another drawback: If you’re younger, you have to keep the funds in your new Roth for five years and make sure you’ve reached age 59½ before taking out any money. Otherwise, you’ll be charged not only taxes on any earnings, but also a 10% early withdrawal penalty—unless you qualify for a few exceptions.

Pros

• Contributions and earnings grow tax-free.
• You can withdraw contributions at any time, for any reason, tax-free.
• You don’t have to take required minimum distributions.
• Those normally ineligible for a Roth IRA can use it to create the account and a tax-free pool of cash.

Cons

• You pay tax on the conversion when you do it—and it could be substantial.
• You may not benefit if your tax rate is lower in the future.
• You must wait five years to take tax-free withdrawals, even if you’re already age 59½.
• Figuring taxes can be complicated if you have other traditional, SEP. or SIMPLE IRAs you’re not converting.

Which is a better choice for your Savings Plan a Traditional IRA or a Roth IRA?

The biggest difference between a Roth and a traditional IRA is how and when you get a tax break: The tax advantage of a traditional IRA is that your contributions are tax-deductible in the year they are made. The tax advantage of a Roth IRA is that your withdrawals in retirement are not taxed.

Thus most advice on the Roth IRA vs. traditional IRA topic begins with a question: Do you think your tax rate will be higher or lower in the future?

If you can answer that question definitively, you can theoretically choose the type of IRA that will give you the biggest tax savings: If you expect to be in a higher tax bracket in retirement, choose a Roth IRA and its delayed tax benefit. If you expect lower rates in retirement, choose a traditional IRA and its upfront tax advantage.

It’s hard to anticipate what your tax rate will be in retirement, particularly if you’re decades away from leaving the workforce. Fortunately, there are other ways to determine whether a Roth or traditional IRA is best for you.

Check if you Qualify

The IRS rules on IRA eligibility may make the Roth vs. traditional decision for you. Your income will determine:

• If you’re eligible to contribute to a Roth.
• How much of your contribution to a traditional IRA you can deduct from this year’s taxes. Traditional IRA deductibility is restricted only if you or your spouse has access to a workplace savings plan like a 401(k).

Worth noting: You can contribute to a traditional and a Roth IRA during the same year, as long as the total amount does not exceed the maximum allowable contribution limit. In 2020, the most an individual is allowed to contribute per year is $6,000, or $7,000 if you’re age 50 or older.

Why the Roth IRA works for most savers

Here’s why it may be better to go with the Roth vs. traditional IRA for those who qualify.

1. Early withdrawal rules are much more flexible with a Roth. Although early withdrawals from retirement accounts are generally discouraged, if you do have to break the seal on the cookie jar, the Roth allows you to withdraw contributions — money you put into the account; not earnings — at any time without having to pay income taxes or an early withdrawal penalty.

Dip into a traditional IRA before retirement and the IRS isn’t as lenient: You’ll likely be socked with a hefty 10% early withdrawal penalty and owe taxes at your current income tax rate on the money you take out. There are a few exceptions to this rule — see our page on traditional IRA withdrawal rules for details — but you’ll need to proceed much more carefully than you would with a Roth.

2. The Roth has fewer restrictions for retirees. Traditional IRAs require you to start taking required minimum distributions (RMDs) at age 72.

Unless you’re inheriting the Roth IRA, it has no required minimum distribution rules: You’re free to let your savings stay put in the account to continue to grow tax-free as long as you live.

3. Unless you’re an extremely disciplined saver, you’ll end up with more after-tax money in a Roth IRA. Yes, both types of IRAs offer a tax break. But there’s an oft-overlooked benefit to the way the Roth treats taxes: Because your tax break doesn’t arrive till retirement (via tax-free withdrawals), you won’t be tempted to spend it before then.

With a traditional IRA, the tax benefit is delivered annually when you file your taxes, which makes it easy to fritter the money away on any number of things.

To come out even in terms of after-tax savings, you have to be disciplined enough to invest the traditional IRA tax savings you get every year back into your retirement savings. If that seems unlikely to happen, then you’d be better off saving in a Roth, where you’ll arrive at retirement with more after-tax savings.

4. Funding a Roth in conjunction with your 401(k) provides tax diversification. The classic 401(k) plan offered by most employers provides the same tax benefits as a traditional IRA. Although some workplaces offer a Roth 401(k) option for employees, if yours doesn’t, diverting some of those retirement savings dollars into a Roth IRA will give you more options for managing your tax burden in retirement.

What is the 5 year rule for Roth IRA?

One of the much-touted boons of the Roth IRA is your ability—at least, relative to other retirement accounts—to withdraw funds from it when you wish and at the rate you wish. But when it comes to tax-advantaged vehicles, the Internal Revenue Service (IRS) never makes anything simple.

True, direct contributions to a Roth can be withdrawn anytime, without tears (or taxes). Withdrawals of other sorts of funds, however, are more restricted: Access to them is subject to a waiting period, known as the 5-year rule.

The 5-year rule applies in three situations:

• You withdraw earnings from your Roth IRA.
• You convert a traditional IRA to a Roth IRA.
• You inherit a Roth IRA.

You need to understand the 5-year rule—or rather, the trio of 5-year rules—to ensure that withdrawals from your Roth don’t trigger income taxes and tax penalties (generally, 10% of the sum taken out).

Roth IRA Withdrawal Basics

As you know, Roths are funded with after-tax contributions (meaning you get no tax deduction for making them at the time), which is why no tax is due on the money when you withdraw it. Before reviewing the 5-year rules, here’s a quick recap of the Roth regulations regarding distributions (IRS-speak for withdrawals) in general:

1. You can always withdraw contributions from a Roth IRA with no penalty at any age.
2. At age 59½, you can withdraw both contributions and earnings with no penalty, provided your Roth IRA has been open for at least five tax years.

A withdrawal that is tax- and penalty-free is called a qualified distribution. A withdrawal that incurs taxes or penalties is called a non-qualified distribution. Failing to understand the difference between the two and withdrawing earnings too early is one of the most common Roth IRA mistakes.

In sum, if you take distributions from your Roth IRA earnings before meeting the 5-year rule and before age 59½, be prepared to pay income taxes and a 10% penalty on your earnings. For regular account-owners, the 5-year rule applies only to Roth IRA earnings and to funds converted from a traditional IRA.

5-Year Rule for Roth IRA Withdrawals

The first Roth IRA 5-year rule is used to determine if the earnings (interest) from your Roth IRA are tax-free. To be tax-free, you must withdraw the earnings:

• On or after the date you turn 59½
• At least five tax years after the first contribution to any Roth IRA you own

Note for multiple account-owners: The five-year clock starts with your first contribution to any Roth IRA—not necessarily the one you’re withdrawing funds from. Once you satisfy the five-year requirement for one Roth IRA, you’re done.

Any subsequent Roth IRA is considered held for five years. Rollovers from one Roth IRA to another do not reset the five-year clock.

5-Year Rule for Roth IRA Conversions

The second 5-year rule determines whether the distribution of principal from the conversion of a traditional IRA or a traditional 401(k) to a Roth IRA is penalty-free. (Remember, you’re supposed to pay taxes when you convert from the pre-tax-funded account to the Roth.) As with contributions, the 5-year rule for Roth conversions uses tax years, but the conversion must occur by Dec. 31 of the calendar year.

For instance, if you converted your traditional IRA to a Roth IRA in Nov. 2019, your five-year period begins Jan. 1, 2019. But if you did it in Feb. 2020, the five-year period begins Jan. 1, 2020. Don’t get this mixed up with the extra months’ allowance you have to make a direct contribution to your Roth.

Each conversion has its own five-year period. For instance, if you converted your traditional IRA to a Roth IRA in 2018, the five-year period for those converted assets began Jan. 1, 2018. If you later convert other traditional IRA assets to a Roth IRA in 2019, the five-year period for those assets begins Jan. 1, 2019.

It’s a bit head-spinning, admittedly. To determine whether you are affected by this 5-year rule, you need to consider whether the funds you now want to withdraw include converted assets, and if so, what year those conversions were made.

Try to keep this rule-of-thumb in mind: IRS ordering rules stipulate that the oldest conversions are withdrawn first. The order of withdrawals for Roth IRAs are contributions first, followed by conversions, and then earnings.

If you’re under 59½ and take a distribution within five years of the conversion, you’ll pay a 10% penalty unless you qualify for an exception.

Exceptions to the 5-Year Rule

Under certain conditions, you may withdraw earnings without meeting the 5-year rule, regardless of your age. You may use up to $10,000 to pay for your first home or use the money to pay for higher education for yourself or for a spouse, child, or grandchild.⁵

The IRS will also allow you to withdraw funds to pay for health insurance premiums, if you become unemployed, or if you need to reimburse yourself for medical expenses that exceed 10% of your adjusted gross income.

5-Year Rule for Roth IRA Beneficiaries

Death is also an exception. When a Roth IRA owner dies, beneficiaries who inherit the account can take a distribution without incurring a penalty—no matter whether the distribution is principal or earnings.

However, death does not totally get you off the hook of the 5-year rule. If you, as a beneficiary, take a distribution from an inherited Roth IRA that wasn’t held for five tax years, the earnings will be subject to tax. But thanks to the withdrawal order mentioned above, you still may end up owing no taxes since earnings are the last part of the IRA to be distributed.

With the 5-year withdrawal option, you have the flexibility of taking a distribution each year or a lump sum at any point before the Dec. 31 date mentioned above. Be aware, however, that if you fail to fully deplete the IRA by Dec. 31 of that fifth year, you face a 50% penalty of the amount left in the account.

Roth IRA Beneficiaries Under the SECURE Act

The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 changed a key rule for Roth IRA beneficiaries. Previously, anyone who inherited a Roth IRA could choose to take distributions spread out over a lifetime.

This was part of a rule referred to as a Stretch IRA. However, under the new law, only a spouse can stretch the Roth IRA out for a lifetime. Any other beneficiary, such as a child, must close out the account within a decade.

Does it make sense to have a Roth and Traditional IRA?

You may maintain both a traditional IRA and a Roth IRA, as long as your total contribution doesn’t exceed the Internal Revenue Service (IRS) limits for any given year, and you meet certain other eligibility requirements.

The IRS limit for both 2019 and 2020 is $6,000 for both the traditional and the Roth IRA combined. If you’re aged 50 or older, a catch-up provision allows you to put in an additional $1,000, for a combined total of $7,000.

Divvying Up Your Contributions

A person who’s less than 50 years old could contribute $3,000 to a traditional IRA and another $3,000 to a Roth IRA. Whether your traditional IRA contributions are tax-deductible and whether you’re eligible to contribute to a Roth IRA at all will depend on your income and other factors.

In a traditional IRA, you’ll generally pay tax on the income you contribute when you withdraw the money in retirement. The income you contribute to a Roth IRA also is taxable, but you usually pay this tax prior to contributing the funds, so withdrawals from a Roth are not taxed if you meet certain conditions.

If you can afford it, and if you’re eligible for both, having both types of IRAs gives you a choice of taxable or tax-free income when you eventually make your withdrawals.

How much should I have in my 401k?

Any mental health professional will tell you that comparing yourself to others isn’t good for your peace of mind. However, when it comes to retirement savings, having an idea of what others do can be good information.

It can be hard to determine exactly how much you’ll need for your own post-career days, but finding out how others are planning—or not—can offer a benchmark for setting goals and milestones.

401(k) Plan Balances by Generation

The good news is that Americans have been making an effort to save more. According to Fidelity Investments, the financial services firm that administers more than $7.3 trillion in assets, the average 401(k) plan balance reached $112,300 in the fourth quarter of 2019.

That’s a 7% increase from $95,600 in Q4 2019.² It’s worth noting that the Q1 2020 amounts will likely be different based on the economic volatility caused by the global pandemic.

How does that break down by age? Here’s how Fidelity crunches the numbers:

Twentysomethings (Age 20–29)

• Average 401(k) balance: $10,500
• Contribution rate (% of income): 7%

Thirtysomethings (Age 30–39)

• Average 401(k) balance: $38,400
• Contribution rate (% of income): 8%

Among millennials (which Fidelity defines as those born between 1981–1997), IRA contributions increased by 21% compared to Q4 2018. This generation contributed approximately $373 million to IRAs, 46% more than in the previous fourth-quarter. Roth IRAs accounted for 73% of millennial contributions.

Fortysomethings (Age 40–49)

• Average 401(k) balance: $93,400
• Contribution rate (% of income): 8%

The jump in the account balance size for Gen Xers could reflect the fact that these folks have logged a good couple of decades in the workforce, and have been contributing to plans that long. The slightly larger contribution rate may reflect the fact that many are in their peak earning years.

Fiftysomethings (Age 50–59)

• Average 401(k) balance: $160,000
• Contribution rate (% of income): 10%

The jump in the contribution rate for this group suggests that many are taking advantage of the catch-up provision for 401(k)s, which allows people age 50 and over to deposit more (an extra $6,000 in 2019 and $6,500 in 2020) than the standard amount.

Sixtysomethings (Age 60–69)

• Average 401(k) balance: $182,100
• Contribution rate (% of income): 11%

Savings-wise, it’s now or never for this group. The fact that the contribution rate is as high as it is suggests that many baby boomers are continuing to work during this decade of their lives.

Seventysomethings (Age 70–79)

• Average 401(k) balance: $171,400
• Contribution rate (% of income): 12%

As of Jan. 2020, the Further Consolidated Appropriations Act removed the age limit that made it impossible for individuals 70½ or older to make contributions to traditional IRAs. This opened up an additional retirement savings option for those currently working or running their own business.

Of course, we’re living in a vastly different world in 2020 than we were in 2019. How each generation’s ability to save for retirement will be affected by the financial impacts of the COVID-19 pandemic is uncertain.

What should you aim for, savings-wise? Fidelity has some pretty concrete ideas. By the time you’re 30, the company calculates you should have saved an amount equal to your annual salary.

If you are earning $50,000 by age 30, you should have $50,000 banked for retirement. By age 40, you should have three times your annual salary. By age 50, six times your salary; by age 60, eight times; and by age 67, 10 times. If you reach 67 years old and are earning $75,000 per year, you should have $750,000 saved.

8.8% The average employee 401(k) contribution rate (as a percentage of salary).

There’s also the tried-and-true, what some might call old-school, 80% rule: Save as much as you would need to have the equivalent 80% of your salary for about 20 years.

Read Also: Should You Put Extra Income Toward Debt or Retirement? We do the Math

That would require about $1.2 million for that same person making $75,000 if you don’t factor inflation into the mix. That number goes up to between $1.5 million and $1.8 million depending on how you do try to factor it in.

However you choose to calculate it, everyone agrees that’s a lot of money.

Conclusion

The sad but true part is that most Americans don’t have nearly enough savings to sustain them through retirement.

How do you avoid that fate? First, become a student of the retirement savings process. Learn how Social Security and Medicare work, and what you might expect from them in terms of savings and benefits.

Then, figure out how much you think you’ll need to live comfortably after your nine-to-five days are past. Based on that, arrive at a savings goal and develop a plan to get to the sum you need by the time you need it.

Start as early as possible. Retirement may seem a long way away, but when it comes to saving for it, the days dwindle down to a precious few, and any delay costs more in the long run.