How Rollovers and Roth Conversions Work

What's the difference between a rollover and a Roth conversion?

A rollover moves retirement money from one account to another of the same tax type, and done right, it isn't taxed. Traditional to traditional, Roth to Roth: an old 401(k) into an IRA, say, or into your new job's plan.

A Roth conversion moves pre-tax money into a Roth IRA, and the amount you move is taxed as income the year you convert. You pay the tax now so the money can come out tax-free later.

Both usually come up when you change jobs. When I have, I've rolled my old workplace retirement accounts into IRAs of my own: a traditional IRA for pre-tax money, or a Roth IRA for Roth money.

What are your options when you leave a job?

The 401(k) post covers the choices: leave it in the old plan (if it allows), roll it into your new plan or an IRA, or cash it out. Cashing out is taxed as income and, before age 59½, usually hit with an extra 10% tax (opens in a new tab) too.

Direct vs. indirect rollover

A direct rollover (or trustee-to-trustee transfer) sends the money straight from the old account to the new one, and no tax is withheld.

An indirect rollover pays the money to you, and you have 60 days to deposit it in the new account. The catch: when the payout comes from a workplace plan like a 401(k), the plan must withhold 20% for taxes.

Say your old 401(k) holds $50,000:

• Direct: all $50,000 lands in your IRA, untaxed.
• Indirect: you get a check for $40,000, and $10,000 goes to the IRS. To roll over the full $50,000, you add $10,000 of your own money within 60 days. The withheld $10,000 counts as tax you've already paid, so it comes back when you file, as a refund or a smaller tax bill. Deposit only the $40,000, and the missing $10,000 counts as cashed out: taxed, and maybe hit with the 10% extra tax.

One more rule: you can do only one IRA-to-IRA indirect rollover in any 12 months, across all your IRAs. Direct transfers, Roth conversions, and rollovers from a workplace plan don't count toward it.

The IRS explains rollovers, the 60 days, and the 20% (opens in a new tab), and its rollover chart (opens in a new tab) shows which accounts can roll into which.

How does a Roth conversion work?

You move money from a traditional IRA (or straight from a traditional 401(k)) into a Roth IRA. The amount is added to your income for the year and taxed at your marginal rate, the rate on your top dollars.

In round numbers: convert $10,000 while your top bracket is 22%, and you'll owe about $2,200 more in federal income tax that year (ignoring state tax). A big conversion can push some of that income into a higher bracket.

Why pay tax early? It's the same question as Roth vs. traditional: paying now wins if your rate later would be higher. People tend to consider converting when:

• They expect a higher tax rate in retirement than they have now.
• They're in a low-income year, like a gap between jobs, when their bracket is lower than usual.

Two rules to know:

• The five-year rule. Each conversion has its own five-year clock, starting January 1 of the year you convert. Take converted money out before five years and before 59½, and you may owe the 10% extra tax on it. IRS Publication 590-B (opens in a new tab) has the details.
• There's no undo. You used to be able to reverse a conversion, but conversions made after 2017 can't be recharacterized (opens in a new tab). Once it's done, so is the tax bill.

What's a backdoor Roth?

A Roth IRA has an income limit (opens in a new tab) for contributing, but conversions don't. So people over the limit sometimes put money into a traditional IRA without taking a deduction (a nondeductible contribution), then convert it. That's a backdoor Roth. Since the money was already taxed, converting it adds little or no tax.

The catch is the pro-rata rule. You can't pick which dollars you convert: the IRS looks at all your traditional, SEP, and SIMPLE IRAs together, as of the end of the year. Say you have $90,000 of pre-tax money in an old rollover IRA and add $10,000 nondeductible. Only 10% of your IRA money is after-tax, so converting $10,000 makes about $9,000 of it taxable. (Money still in a 401(k) doesn't count.) Form 8606 tracks this, and Publication 590-B walks through the math.

Keep your paperwork

After my first job, I rolled my retirement account into a traditional IRA. The provider's reporting marked it as a taxable event, and a couple of years later I got a letter from the IRS. I knew it wasn't taxable, because it was a rollover into a traditional IRA. So I went back through my files, pulled the paperwork that showed it, and the provider had to amend its reporting.

What to keep, along with the statements from both accounts:

• Form 1099-R from the account the money left. For a direct rollover, the taxable amount (box 2a) is usually $0, and box 7 shows code G (or H for Roth 401(k) money going to a Roth IRA). The IRS instructions (opens in a new tab) list every code.
• Form 5498 from the IRA that received the money, showing the rollover.
• Your tax return. A rollover isn't taxed, but it is reported on your return (opens in a new tab). Tax software asks about it when you enter the 1099-R.

If a form looks wrong, ask the provider to correct it. And keep those papers for years, not months.

Where my old accounts ended up

My IRAs, Roth and traditional, are at SoFi. I've stopped adding to them, because they're already large enough to last until I can take money out without the extra 10% tax. New money goes into a regular brokerage account I can draw on before retirement age. That's my reasoning for my situation, not a plan for yours.

This is educational, not financial or tax advice. Conversions especially depend on your whole tax picture, so consider talking with a tax professional before making one.

What to take with you

• Rollovers aren't taxed when money moves between the same kind of account: traditional to traditional, Roth to Roth.
• Ask for a direct rollover. An indirect one from a 401(k) withholds 20% that you'd have to replace within 60 days.
• A Roth conversion is taxed as income the year you do it, and it can't be undone.
• Mind the five-year clock on converted money if you're under 59½.
• Know the pro-rata rule before trying a backdoor Roth.
• Keep your 1099-R, your 5498, and your account statements. If a form is wrong, it's your proof.

Want to compare paying tax now vs. later? Try the Roth vs. traditional calculator, or read how Roth and traditional IRAs work.