If you’re gazing at your old 401k statement, wondering why it can’t be tax free, maybe it makes sense to explore changing it to a Roth IRA. A Roth IRA plan grows tax-free when used for retirement and is tax deferred when used for other uses, such as a child’s education or first home purchase. Converting your Roth IRA is more attractive now than ever before. Beginning in 2010, Roth IRA conversions are available for everyone, not just those people who earn $100,000 or less.
Call your old employer to make sure you’ve officially terminated employment. You aren’t allowed to roll over a current 401k plan, so it’s best to avoid all the work of changing until you’ve verified that you can start the change process. Find out the employment termination date while you’re on the phone. You may need this information for your rollover paperwork.
Search for a company to serve as your Roth IRA trustee. If you’re comfortable choosing investments on your own, you’ll save a few dollars by selecting an online or discount brokerage firm. If you’d rather have help, find a full-service brokerage firm by asking for referrals from friends. Once you’ve interviewed a few candidates and identified a possible broker to hire, check their experience and record on the Financial Industry Regulatory Authority BrokerCheck website (see Resources).
Fill out rollover paperwork to move your 401k to a Roth IRA. If you decided to use a broker, he’ll determine the necessary paperwork and direct you on the process to complete the rollover. If you’re using an online or discount broker, consult their website for 401k rollover paperwork. You may need to call your 401k provider to find out what they’ll need to release your funds to the IRA. They may have their own paperwork you’ll need to complete as well.
Create a tax fund. If you're doing this in 2010, you’ll pay half the taxable amount as income in 2011 and the other half in 2012. After 2010, you’ll need enough outside your Roth IRA to pay income tax on the converted amount that year. These funds must come from outside your Roth IRA or you’ll be subject to tax on these dollars because converted money can’t be touched for five years. You’ll also pay a 10 percent penalty if you’re under age 59 ½.
File the correct paperwork at tax time. You’ll receive a 1099-R from the 401k provider to use for your taxes. According to the IRS, you should use the amount shown in box 1 of the 1099-R to report your conversion on Form 1040, lines 16a and 16b; Form 1040A, lines 12a and 12b; or Form 1040NR, lines 17a and 17b. From that amount, subtract any contributions that were taxable to you when made. Enter the remaining amount, even if zero, on Form 1040, line 16b; Form 1040A, line 12b: or Form 1040NR, line 17b. In 2010, you must also file Form 8606 to report the rollover.
As a former financial advisor to companies and individuals for 16 years, Joe Andrews knows financial planning and marketing from start-ups to personal budgets. He also writes on motor racing, board games and travel. Andrews received his B.A. from Michigan State University in English. He is currently working on a young adult novel.