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A 401(k) is great—until you want to take your money out.
If you’re younger than 59 ½, you’ll be hit with a 10% penalty for withdrawing money out of a 401(k) account, and that’s on top of income taxes you’ll owe on the amount withdrawn.
This is one of the reasons you might choose to convert your 401(k) into a Roth IRA. Like a 401(k), a Roth IRA is a tax-advantaged investment account. But unlike a 401(k), it offers the potential for tax- and penalty-free withdrawals. If you’re planning to be financially independent before traditional retirement age, or if you want to reduce the taxes you’ll owe later in life, converting a 401(k) into a Roth IRA might be a smart strategy.
You’ve got to plan ahead, though, because this type of conversion often comes with an immediate tax bill plus a five-year waiting period before you can withdraw the funds without penalty. Here’s what to know about converting a 401(k) into a Roth IRA, according to experts.
How Does a 401(k) to Roth IRA Conversion Work?
Converting a 401(k) into a Roth IRA gives you greater ownership and direction over your money. A 401(k) is a tax-advantaged retirement account that is managed by an employer, while a Roth IRA is a tax-advantaged retirement account that is managed by you.
In practice, this means you’ll open a Roth IRA account at an online brokerage firm (here are the 5 best places recommended by NextAdvisor) and then roll any money in your 401(k) into your new account.
Beware: this will likely be a taxable event. Most, but not all, 401(k) accounts are tax-deferred. This means that you’ve never paid any taxes on the money within. Roth IRAs, on the other hand, are post-tax, meaning that they must contain only money that has already been taxed. If you have a tax-deferred 401(k), also known as a traditional 401(k), you will owe ordinary income taxes on the amount of money you convert into a Roth IRA.
Experts recommend diversifying your investments into different buckets: some in a tax-deferred account like a 401(k), and others in a post-tax account like a Roth IRA.
For example, if you convert $50,000 from a traditional 401(k) into a Roth IRA, “the IRS is essentially saying, ‘Hey, that’s …….