How to Transfer Your 401(k) to a Roth IRA While You're Still Employed
Written by Tiffany Woodfield, Associate Portfolio Manager, CIM® CRPC® and John Woodfield, Portfolio Manager, CIM® CFP®
"Can I transfer my 401(k) to a Roth IRA while still employed?"
This question commonly comes up when doing retirement and tax planning. Technically you can't transfer your 401(k) to a Roth IRA, but you can do a conversion.
With a Roth conversion, you can take the tax now rather than pay the tax later. If you're going to have a higher future income, doing this may be the only way you can use a Roth.
TABLE OF CONTENTS
- Rollover vs. Conversion vs. Transfer
- Can You Move Your 401(k) to a Roth IRA while Still Employed?
- How to Roll Over Your 401(k) to a Roth IRA while Still Employed
- In-service Rollovers and Conversions
- Downsides of Converting Your 401(k) While Still Employed
- Benefits of Converting Your 401(k) While Still Employed
- Main Reasons to Convert Your 401(k) Now Instead of Waiting
- Essential Rules for Moving Your 401(k) to a Roth IRA
- What Is the Five-year Rule?
- Tax Implications of Doing a Conversion
- Conversions for Americans or Green Card Holders Moving to Canada
- Having a 401(k) in Canada
- What You Can Do Instead of a Conversion
- Common Questions about 401(k) to Roth IRA Conversions
Rollover vs. Conversion vs. Transfer
The terms rollover, conversion and transfer are often used interchangeably but mean different things. A rollover is when you move funds from one tax-exempt plan to another. With a rollover, tax is not incurred. For example, you don't pay tax when a 401(k) is rolled over to an IRA.
But with a conversion, tax is incurred. For example, if you convert a 401(k) to a Roth IRA. Meanwhile, the term transfer is generally used when the nature of the account does not change, tax is not incurred, and the funds are moved from one institution to another. However, taxes can be incurred in some instances (such as an IRA to a Canadian RRSP transfer).
Can You Move Your 401(k) to a Roth IRA while Still Employed?
In short, yes, you can move your 401(k) to a Roth IRA while still employed. However, you should contact your administrator to find out if this will be possible for you. Converting a 401(k) or 403(b) to a Roth IRA has been allowed since 2008. But not all administrators are on board. Also, it is not the right strategy for everyone. An accountant and financial advisor will be your ally when making this decision.
How to Roll Over Your 401(k) to a Roth IRA while Still Employed
The first step in this rollover is contacting your administrator to ensure they have a conversion option. If allowed, you may have an employer Roth IRA already established. In this situation, request a move from the 401(k)/403(b) to the Roth. If you do not have an employer plan, you should request that your employer send the funds directly to the Roth IRA. This is the direct method.
If your employer sends you a check, they will withhold 20%. This is the indirect method. And you will have 60 days to move the funds to the Roth. There are no exceptions, and you may face penalties if you do not comply.
In-service Rollovers and Conversions
An "in-service rollover or conversion" is the transfer of assets from your employer's 401(k) plan to an IRA or Roth IRA. This enables an employee to move money out of a 401(k) when they are still employed, enabling the employee to manage future cash flows and taxation better.
Downsides of Converting Your 401(k) While Still Employed
The downside of converting your 401(k) to an IRA while employed is that the amount is fully taxed at your present marginal rate. But this is only a downside if your future taxes are lower. Of course, future tax rates are unknown, so a Roth conversion does carry risk. There is also the five-year rule to consider, which is explained below.
Benefits of Converting Your 401(k) While Still Employed
There are three significant benefits of rolling over your 401(k) or 403(b):
- You can avoid future taxation on a retirement account that may be brought into income at a higher marginal tax level than your present tax level. In other words, you may be able to pay less tax in the long term.
- You can better manage your future tax since a Roth IRA does not have mandatory distributions when you are in your 70s.
- You can use a Roth IRA even if your income is too high to contribute to a Roth.
Main Reasons to Convert Your 401(k) Now Instead of Waiting
Rules change, so if this works for you now from a tax point of view, it makes sense to do it sooner rather than later. But again, seek advice from your financial advisor and accountant before doing this.
Essential Rules for Moving Your 401(k) to a Roth IRA
It is best to have the 401(k) administrator send the funds directly to the Roth. You can have up to a 20% holdback if this is not done. This could mean you lose 20% of the money you've accrued in your 401(k)!
If you receive a check directly from your administrator, you have 60 days to move the funds to a Roth. There are no exceptions. Not depositing the Roth within 60 days means you give up the benefit of the Roth.
What Is the Five-year Rule?
The five-year rule refers to how you must have had the Roth IRA for five years before withdrawing tax-free earnings from the account.
The five-year timer starts on January 1st of the year the funds landed in the account. The Inherited Roth IRAs timer begins when the original account owner made their first contributions.
Tax Implications of Doing a Conversion
When doing a Roth IRA conversion, the total amount is taxable in the year it was completed. If you receive a check from your employer and deposit that into a Roth, you have a 20% withholding tax. This means you have to come up with the shortfall from personal funds. Having your employer send the funds directly to the Roth IRA is much better.
Conversions for Americans or Green Card Holders Moving to Canada
If you’re an American or Green Card holder moving to Canada, it’s important to do your planning right. You must complete this strategy before leaving the USA. A Canadian resident who does this conversion will be responsible for paying the full tax—at higher Canadian rates—on the amount withdrawn from the 401(k) or 403(b). Also, a Canadian resident is prohibited from establishing or adding to a Roth IRA.
Note that if you are moving your Roth IRA to Canada, you must follow specific rules to keep it tax-free.
- You need to file a one-time treaty election by April 30th, the year after you became a resident of Canada.
- You must not add to your Roth IRA as a resident of Canada. If you contribute, you will "contaminate" the Roth and lose its tax-free growth status.
If you would be exempt from tax in the US as a US resident, then you should also be exempt from tax in Canada so long as you follow Canadian rules.
Having a 401(k) in Canada
Nothing prohibits a Canadian resident from having a 401(k), an IRA or a Roth IRA so long as you set it up before becoming a Canadian resident. It is good to check with your plan's administrator since they could have an issue with your Canadian residency. Moreover, if you’re retiring to Canada, you’ll want to do the appropriate planning.
What You Can Do Instead of a Conversion
Alternative options include moving the funds to an IRA or just leaving the funds in the 401(k) or 403(b). Taking the cash into income is seldom the best choice. Those under 59 ½ who dissolve a retirement plan will incur penalties.
Common Questions about 401(k) to Roth IRA Conversions
How often can you convert a 401(k) to Roth IRA without paying taxes?
You will always pay taxes on the conversion since you are moving from a tax-deferred plan to a tax-exempt one, bringing in taxable income. There are no limits to the number of rollovers you can do each year so long as you are not issued a check and are subject to the 60-day rule.
Can I move my 401(k) to another company while still employed?
Most people roll over their 401(k) into an IRA after they change jobs or when they retire. Most 401(k) plans allow employees to roll over funds while working. It is best to contact the plan administrator to see what options are available.
Next Steps
If you’re a Canadian resident or are planning on moving to Canada and need assistance with moving and optimizing your investments, estate planning, wealth management and portfolio management, please get in touch. At SWAN Wealth, we specialize in Canadian financial planning, cross-border financial planning and cross-border wealth management.
Articles About Your 401(k) and Cross-Border Financial Planning
If you’re planning a cross-border move, these articles and guides will help you simplify your move and ensure you’ve covered everything.
401k in Canada - How to Stay Onside with the IRS and Avoid a Large Tax Bill
Is a 401(k) Taxable in Canada?
Should You Move Your 401k to Canada?
How to Turn Your 401k to a RRSP If You’re a U.S. Citizen Moving to Canada
Cross-Border Estate Planning Guide
Roth IRA Canada: How to Manage Your Investments Across the Border
Retiring to Canada - A Financial Planning Guide
Financial and Tax Planning for US Citizens Living in Canada
About the Authors
Tiffany Woodfield is an Associate Portfolio Manager licensed in Canada and the USA, and the co-founder of SWAN Wealth Management, along with her husband, John Woodfield. Tiffany advises clients who live in Canada and the United States and want to simplify their cross-border financial plan, move their assets across the border, and optimize their investments to minimize their tax burden. Together Tiffany and John Woodfield help their clients simplify their cross-border finances and create long-term revenue streams that will keep their assets safe whether they live in Canada or the US.
John Woodfield is a Financial Management Advisor (FMA), a Chartered Investment Manager (CIM), and a Certified Financial Planner (CFP), and in 2007 was inducted as a fellow of the Canadian Securities Institute (FCSI). As a portfolio manager and CFP®, he works with clients across Canada. John Woodfield’s clients are families, individuals and business owners who understand the importance of comprehensive wealth and investment plans driven by the lifestyle they want to lead.
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