401(k) vs Roth IRA?

November 30, 2005 9:33 AM

401(k) vs Roth IRA? Rollover? Confusion....

My wife left her job in May, with a ok sized 401(k) account. she hasnt done anything with it, no contributions or deductions. we want to be able to have a little more access to that money just in case (new baby due in jan), and half listened to a thing on NPR about Roth IRA. Tried googling and only got more confused....so any links, advice, etc would be greatly appreciated.

posted by ShawnString to work & money (16 comments total)

There are others here with much more in-depth knowledge, but in a nutshell:
- 401(k) accounts accrue capital gains tax-free until withdrawl, at which time they are taxed as normal income
UNLESS
- you withdraw before age 59.5, then you pay capital gains, normal income tax, and a penalty tax (usually about 10-15%), by which time any gains you may have realized are gone, gone, gone. After taxes, a 20k withdrawl can easily become only 12k in cash.
- Roth accounts are built with after (income) tax money, and so withdrawls are tax-free (I don't think there is an age prior to which you pay a penalty, but I could be wrong).
- Converting a 401(k) to a Roth usually involves taking a loss, because you must pay at least some tax.
- Using either account as an "emergency" fund (for your baby, for example) is a bad idea - seldom do people pay back these accounts in full, and you lose on the miracle of compounding interest.
There's more at this part of the Motley Fool site, they use pretty simple language, but take your time and do the math - really understand this - it's your future you're risking here.
posted by dbmcd at 9:48 AM on November 30, 2005

I took my OK 401k and rolled into a Rollover IRA. You have all of the benefits (and restrictions) of an IRA but you are not hit with taxes for the rollover. The real condition being that you can only contribute to the Rollover IRA by rolling 401ks into it.

Pretty much you won't be able to access the money until you're 59 and a half w/o taking a big tax hit, though. There are a few exceptions to this, such as purchasing a first house. There may be other exceptions. You should look into that. I'd call up Fidelity or Ameritrade and pose as a potential customer. Both firms have been very help to me with my idiot n00b questions.
posted by xmutex at 10:07 AM on November 30, 2005

You most likely will want a Rollover IRA, not a Roth IRA. And don't use it as an emergency fund.

What You Need to Know About IRA Rollovers

Frequently Asked Questions about IRA Rollovers
posted by kirkaracha at 10:09 AM on November 30, 2005 [1 favorite has favorites]

You can (and probably should) rollover into an IRA. Why rollover? Because the company your wife left is the custodian of the 401(k) money. Anything you do with it must involve the custodian/former company. Stuff like this makes me uncomfortable. With the IRA, your wife "owns" the money--the relationship is between and the bank/mutual fund/whatever to which the funds were rolled over.

Roth vs. traditional? I'm not sure if you can rollover into a Roth. If so, you will have to pay taxes on the rollover funds as if they were income (this is because the money comes out tax-free at retirement). With traditional, you won't pay taxes. The other advantage with traditional is that you can withdraw up to $10,000 penalty-free to pay for a first-time home purchase. (Note 1: There are some "tricks" you can do to avoid the taxes even if you don't have the traditional IRA, but that's another AskMe question) (Note 2: IRAs don't care about babies as far as I know, so your January arrival shouldn't have an impact on your rollover decision). Best of luck.
posted by GarageWine at 10:14 AM on November 30, 2005

If memory serve me correct, Roth IRA's are cool because they can be used, without penalty, towards a first time home purchase or education. Based on your income, you can only contribute up to $3500? a year into the Roth. Don't quote me on this.
posted by jasondigitized at 10:17 AM on November 30, 2005

You can (and probably should) rollover into an IRA.

With the caveat being: think carefully (and perhaps with the advice of a certified planner) about whether you want to "comingle" the qualified money in your wife's 401k with a Roth IRA. It's a one-way process. If you move that money into a rollover IRA as suggested above, you have the benefits of a traditional IRA plus she can always move the money back into a qualified plan at a new employer. If you convert it to a Roth, you're going to pay taxes on it as if you earned the money this year (which very well may push her, and you if you file jointly, into a different tax bracket, costing you additonal money).

My understanding is the main factors in this decision are the amount of money and your wife's age/ planned retirement age. If she's got a ways to go or if it's not too much money, the benefits of a Roth down the road could certainly outweigh the upfront costs. But a new baby in January might make a huge tax hit in April difficult.

If things still work the way they did when I knew anything about this, you have 60 days to figure it all out after they cut your wife a check (if they do that).

Disclaimer: I have like 0 investments at this time and my Series 6 expired years ago in a state you probably don't live in. All of this advice was current as of 1999. In sum: suing me is a poor investment strategy.
posted by yerfatma at 10:22 AM on November 30, 2005

Don't put it into a Roth IRA! You'll have to pay all kinds of taxes. Why?

Roth IRA: You can only invest income that you've already paid state and federal taxes on into a Roth IRA. When you take the money out, you don't have to pay any tax on it.

Why do this? If you're not making much money now and you expect to be in a higher tax bracket when you retire, it makes sense to pay the income tax now, then get the money tax-free later.

401-k, rollover IRA, traditional IRA: You can put income into these before you pay your state and federal income taxes. In other words, if you make $100,000 but you invest $10,000 into one of these accounts, you only pay taxes on income of $90,000. When you take the money out, then you have to pay income taxes on it. If you take the money out before retirement age, you also have to pay penalties (though you can move it to other kinds of retirement accounts, sometimes).

Why do this? Contributing money to a pre-tax account now means you'll get to keep money that would otherwise be going to the federal government. If you expect to have a lower income when you retire, then it makes sense to put off paying income taxes until you're in a lower tax bracket. Also, 401-ks make sense because you can often get "free money" in the form of a match from your employer when you do it.

If you move from a pre-tax account (401-k) to a post-tax account (Roth IRA), at the very least you'll have to pay income taxes on the 401-k. You may also have to pay the penalty for early withdrawal, though I'm less clear on this.
posted by croutonsupafreak at 10:34 AM on November 30, 2005

well she is 31 (well will be in...3 days) and the total she has in the 401k is >$35k. i know that any retirement fund is not a fund to be easily "raided" but we may have some big hospital costs from the new lil one (and if his big suster is any indication, he maybe born in dec). thats why i was looking at the Roth.
posted by ShawnString at 10:36 AM on November 30, 2005

Bear in mind that you can loan yourself money from a 401(k), and this loan is tax-free. You do have to repay yourself (with interest). I don't think a Roth IRA can do that.
posted by profwhat at 11:07 AM on November 30, 2005

Although it's probably better to leave the money there, if it's making decent interest, and take out a low interest rate loan somewhere else. Tough call the way the market is today.
posted by knave at 11:32 AM on November 30, 2005

I could be wrong on this although my wife and I are both over 50 years old and were told the maximum we could put into a Roth IRA is $4,500.00 each or $9,000.00 per year. My CPA and investment advisors say to fund the ROTH to the maximum each year -- the reason I'm not sure why -- but that is what I do.
posted by orlin at 11:39 AM on November 30, 2005

If you are taking the funds from a retirement plan, you will probably have to place them in a traditional because odds are that the plan admin will only do a direct rollover (that is, the funds go to your new custodian directly, and you don't get a penalty for "touching" the money) to a traditional IRA. If, after the funds are in the traditional, you want to convert it to a Roth, that's your business. Keep in mind that you are correct, the funds will be taxed as income, etc, if you do convert to a Roth. That extra 35K in "income" could bump you up another tax bracket, and then you're paying a lot more than just tax on the retirement fund.

Re: "Rollover" IRA -- there really is no such thing. This is basically an advirtising term. Yes, you are "rolling over" the funds from your Retirement plan into the IRA, but the IRA type is always, always, going to be Traditional. (I deal with this stuff for a living on a daily basis -- so feel free to email me if you would like to talk about it. I can't count the number of people I've helped do exactly what you are doing. )
posted by Medieval Maven at 1:02 PM on November 30, 2005

Be careful in any fund move. One of the biggest impediments to making money in a retirement fund is fees and a lot of the people advertising hard (ie, INGDirect) have above-average fees on their IRAs. Vanguard is the industry low-cost leader.

And I Nth the "don't touch it." You can loan yourself money if it's a catastrophic situation but if you withdraw you're going to get hit with penalties that would likely make it cheaper to spend that money on credit cards instead, and that's pretty damned bad. There are some exceptions but you'll pay 10% in addition to income taxes on that money, meaning 20% to 45% (though if you're in the 35% bracket you probably wouldn't be asking this question).

And maybe you end up eating catfood in retirement as a reward.
posted by phearlez at 1:23 PM on November 30, 2005

"Rollover" IRA -- there really is no such thing

Or maybe there is. Yes the "rollover" IRA is like a Traditional and not a Roth, but the point isn't the tax rules for the IRA so much as the status of the money. Put your 401k funds into a rollover IRA and you can move them back into a 401k (or other retirement plan). Comingle them with other IRA monies and they're never going back into an employer plan.
posted by yerfatma at 1:27 PM on November 30, 2005

I'm not going to get into a pissing contest on this, but "Rollover IRA" is an advirtising term. The technical term that you're actually referring to is "Conduit:"

A separate IRA established pursuant to a rollover from a qualified retirement plan. No intermingling of other funds such as regular (non-rollover) IRA contributions is permitted. Money in a conduit IRA may be rolled into a new employer's plan (if allowed), thereby preserving any favorable tax treatment associated with the distribution. There is no limit on the contributions transferred to a conduit IRA.

The word "rollover" is over used and leads to confusion and errors.
posted by Medieval Maven at 2:32 PM on November 30, 2005

And, just to clarify further, if the IRA is a "Conduit" it is a Traditional IRA, meaning that the funds in that IRA are all pre-tax. Whether or not a Traditional IRA is a "Conduit" IRA is something specified by the account owner at opening. Some places may treat them slightly differently, but for reporting to the IRS there is no "Rollover IRA" distinction -- they just know whether or not you completed a rollover from an employer plan and whether or not it was direct or indirect based on the bank's reporting and the 401(k) plan's reporting.
posted by Medieval Maven at 2:38 PM on November 30, 2005