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Do A Direct 401(k) To Roth Rollover

In the not-so-distant past, it wasn’t particularly easy to roll over funds from a 401(k) plan to a Roth IRA, which can provide tax-free income during retirement or for your heirs. Now, it’s a relative snap. What’s more, the IRS recently provided guidance on how to complete this maneuver.

Prior to the Pension Protection Act of 2006 (PPA), it took two steps to complete a 401(k) to Roth rollover, and it was possible only if your income didn’t exceed a specified limit. First, you transferred funds from your 401(k) to a traditional IRA. Next, you converted the traditional IRA to a Roth, paying income taxes on the amount of the conversion. But you could do this only in a year in which your modified adjusted gross income (MAGI) didn’t exceed $100,000.

The PPA fixed part of the problem. Beginning in 2007, you were allowed to roll over funds directly from a 401(k) plan to a Roth, bypassing the traditional IRA. But you still might have been blocked by the $100,000 limit.

That impediment no longer exists. Based on a tax law change that took effect in 2010, you may now convert to a Roth regardless of your annual MAGI. (For conversions that were completed in 2010, you were able to split taxable conversion income between 2011 and 2012. That allowed  you to postpone the tax hit of converting to a Roth, and may have saved tax  overall.)

The IRS recently issued rulings clarifying aspects of a direct rollover. The guidance included these points:

• You can convert to a Roth IRA from retirement plans including 401(k)s, 403(b)s, and 457(b)s.
• A direct rollover to a Roth isn’t subject to automatic 20% withholding. But you can agree to voluntary withholding.
• Beneficiaries may make rollover contributions to Roth IRAs. Also, surviving spouses who complete a rollover to a Roth IRA may treat the Roth IRA as their own.
• If funds in a designated Roth 401(k) account are rolled over to a Roth IRA, the rollover isn’t taxable, whether or not the transfer is a “qualified distribution.”
• Other transfers, except for amounts representing after-tax contributions to your plan, are taxable.
• If you own company stock in a 401(k), you will not be taxed on the “net unrealized appreciation” (NUA) of the stock when it’s distributed. But you can’t avoid tax on the NUA by rolling over assets directly to a Roth.
• If you’re married, you no longer need to file a joint return to benefit from the rollover provisions.

This is just an overview. We can work with you to weigh the merits of a Roth conversion and help you follow the rules governing such transfers.