A 401k rollover to Roth IRA is a financial move that some former employees are taking to centralize   financial planning and improve their asset allocation plan. You will need to make sure you make the right decision as the wrong one can be very costly indeed.

First some general primers on 401(k) plans and Roth IRA retirement plans before we delve into specifics about rollovers from one retirement savings plan to another.

The 401(k) is popular as a way for employees to invest gross earnings into a retirement plan. The funds  can stay invested until age 59½ and must be withdrawn by age 70½. The principal benefit of 401(k) plans is that you can invest what you would have otherwise lost to ordinary income taxes, compound this extra money to a greater amount over time, and then only later pay ordinary income taxes on the withdrawals from the 401(k) itself. In this way funds are tax-sheltered, often for decades.

The Roth IRA is a newer retirement plan that only permits net income to be invested. The upside here  is that the money is tax-sheltered for the duration of the investment and also benefits from tax-free withdrawals from age 59½, if the plan was setup at least five years earlier. Unlike the 401(k), no withdrawals are mandatory, so it is one way to keep post-tax money tax-sheltered almost indefinitely.

When an employee leaves their employment, they have the choice whether to leave the funds built up in their 401(k) plan, or to rollover those funds into a Roth. The management costs may be lower than the costs of a 401(k), especially as the 401(k) sponsor is allowed to increase their annual charges for former employees. Those with a Roth can decide who they wish to administer it, and if they choose a good administrator like a large mutual fund family, for instance, Vanguard, Schwab or American Century, then they have a much wider range of investments to choose between.

When rolling over monies from a 401(k) – or indeed several 401(k) plans with different former employers – to a Roth IRA savings account, you will need to bear in mind that there is a tax burden to resolve. You will have benefited from investing gross income into the 401(k), but you are only permitted to invest net income into a Roth, therefore early withdrawal penalties and additional taxes need to be settled in the current tax year in order resolve this issue with the IRS. The size of the tax bill will depend on the value of the 401(k) to be rolled over.