Many individuals who leave their place of employment must also decide what to do with their account balance in a company-sponsored 401(k) retirement plan. A former worker who also experiences a drop in income for the year may be able to roll over their 401(k) funds to a Roth IRA with a current tax outcome similar to rolling it over to a traditional IRA.
Funds rolled over from a 401(k) to a traditional IRA generally maintain their tax-deferred status. There is typically no current income tax due, and the distributions and earnings are taxed in a later year when eventually withdrawn. A Roth IRA can also receive funds from a 401(k) account, but the tax consequences are usually different.
Rollovers to a Roth IRA lose their up-front deferral and are included in current income. The advantage of a Roth IRA is that distributions received in later years are tax-free, including the accumulated earnings. If your income in the year of a 401(k) rollover is within limits, you may be able to fund a Roth IRA while incurring little or no increase in the tax figure referred to as taxable income.
Effect of reduction in income
For the tax year in which you leave an employer, you are more likely to experience a drop in earnings. If your total income for the year is less than your standard deduction and personal exemption combined, you are likely to have no taxable income. Consequently, there is no current-year tax difference between funding a traditional IRA and a Roth IRA.
In 2016, the standard deduction for a married couple filing jointly is $12,600. The personal exemption amount for 2016 is $4,050 per individual. If your total income, including the rollover amount, is less than your combined standard deduction and personal exemptions, you have zero taxable income. If so, you might as well fund a Roth IRA instead of a traditional IRA.
Effect of other credits
If the inclusion of 401(k) funds rolled over to a Roth IRA results in taxable income, a traditional IRA should also be considered. However, IRS Form 1040 is designed so that other credits can potentially offset the tax calculated on taxable income. If you are eligible for any offsetting credits, such as the American Opportunity Credit or the Child Tax Credit, you might still be able to fund a Roth IRA with minimal current tax consequences.
At higher income levels, the rollover of 401(k) funds to a Roth IRA is more likely to result in a corresponding increase in taxable income. In addition to current tax treatment, the tax status of future distributions must also be considered. Contact a financial planner for more detailed information about 401(k) rollovers.Share