Americans saving for retirement focus on ensuring their nest eggs will sustain the lifestyles they hope to enjoy once their working years are behind them.
That desire to make the most of every dollar — across retirement accounts, including 401(k)s and Individual Retirement Accounts (IRAs) — reflects a healthy and valid concern about their long‑term financial security.
After years of reporting on retirement and other personal finance worries, I’ve seen how people typically look for dependable guidance as they navigate financial rules that can influence their future stability.
Calls to vigilance from organizations such as AARP and Vanguard alert savers to significant rules around 401(k) to IRA rollovers and the tax considerations that accompany them.
“A rollover IRA and a traditional IRA both follow the same tax rules once the funds are in the IRA,” Vanguard wrote. “A Roth IRA uses after-tax money. You may be eligible to make contributions if you have earned income and fall within the Roth IRA income limits.”
AARP focused on a warning about Roth IRAs.
“Many financial advisers recommend Roth individual retirement accounts (IRAs) because they allow for tax-free withdrawals,” AARP wrote. “That’s certainly an attractive feature.”
“But if you’ve been stockpiling money for decades in a traditional 401(k), consider carefully before converting the funds to a Roth IRA — the price for those tax savings later is a potentially large tax hit now.”
AARP urges caution on 401(k)-to-Roth IRA conversions
Those considerations should not scare Americans away from proceeding with a Roth IRA conversion, according to AARP. But the advocacy group for Americans over 50 encourages people to learn about specific pitfalls to avoid when making the move.
A Roth IRA is funded with after‑tax income, meaning the money you put in has already been taxed. As a result, withdrawals later in life are generally tax‑free and free of penalties once people are at least 59-and-a-half and the account has been open for five years.
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Unlike a traditional IRA, a Roth IRA does not require one to begin taking required minimum distributions (RMDs) at age 73, allowing the balance to keep growing without interruption. If the account is passed on to children, they can also take withdrawals without owing taxes, provided they empty the account within a 10‑year period, according to AARP.
“These benefits come at a cost,” wrote AARP. “You must pay taxes on the amount of pretax contributions you convert. Ideally, you want to pay those taxes with money outside of your 401(k).”
“If you withdraw money from your plan to pay the tax bill, you’ll shrink the account, reducing the amount available for tax-free growth,” AARP continued. “Even if you can afford the tax bill, a large conversion could push you into a higher tax bracket, resulting in a higher tax rate on other income.”
Vanguard emphasizes benefits of 401(k)-to-IRA rollovers
There are several advantages to moving a 401(k) savings account into an IRA, each of which can give a person greater oversight and flexibility in shaping their long‑term financial strategy, according to Vanguard. Here are a few:
- Investment flexibility — Moving a 401(k) into an IRA typically gives savers access to a wider selection of investments, from individual stocks and bonds to mutual funds and ETFs, which can support broader diversification and long‑term growth.
(A clarification note: “While the investment options may be fewer in a 401(k), employers have a legal obligation — known as a ‘fiduciary duty’ — to curate and continually monitor a list of funds that’s best suited to their workers,” according to CNBC.) - Streamlined account management — Combining multiple retirement accounts into a single IRA can make it easier to track performance, adjust allocations, and stay focused on long‑range financial objectives.
- Protection from unwanted taxes or withdrawals — Completing a rollover when leaving an employer helps prevent early‑withdrawal penalties, unexpected taxes, or automatic distributions that might otherwise be triggered.
(Source: Vanguard)
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IRS addresses Roth IRA rollover concerns
Many people rolling 401(k)s over to Roth IRAs have additional questions regarding after-tax funds, the Internal Revenue Service (IRS) explained.
One such question is whether one can roll over just the after-tax amounts in their retirement plan to a Roth IRA — and leave the remainder in the plan.
“No, you can’t take a distribution of only the after-tax amounts and leave the rest in the plan,” the IRS wrote. “Any partial distribution from the plan must include some of the pretax amounts.”
“Notice 2014-54 doesn’t change the requirement that each plan distribution must include a proportional share of the pretax and after-tax amounts in the account,” the IRS emphasized. “To roll over all of your after-tax contributions to a Roth IRA, you could take a full distribution (all pretax and after-tax amounts), and directly roll over pretax amounts to a traditional IRA or another eligible retirement plan, and after-tax amounts to a Roth IRA.”
Another question the IRS addressed is whether one can roll over their after-tax contributions to a Roth IRA and the earnings on those contributions to a traditional IRA.
“Yes. Earnings associated with after-tax contributions are pretax amounts in your account,” the IRS explained. “Thus, after-tax contributions can be rolled over to a Roth IRA without also including earnings.”
“Under Notice 2014-54, you may roll over pretax amounts in a distribution to a traditional IRA and, in that case, the amounts will not be included in income until distributed from the IRA.”
Related: Dave Ramsey, Charles Schwab raise red flag on IRAs, Roth IRAs
