ex employer traditional 401k to Roth IRA conversion and also trying to do backdoor Roth IRA. What are the Tax Implications?

[Divideby7]

Hello,

I recently quit my ex employer and have funds in both traditional 401K (55k) and Roth 401K (10K). I dont plan to move them to the new employer. Option 1 is to let it stay as is, Option 2 i am thinking of converting to a traditional IRA now and then move it immediately to a Roth IRA. I have been doing the backdoor Roth IRA for last couple of Years. My traditional IRA account has a nil balance currently and plan to do a backdoor again for current year in the month of December. Please advise how i should approach to do the conversion from 401k to Roth IRA and still continue to be able to do a backdoor Roth IRA later. What are the potential tax implications or fines that i can incur with the 401k conversion. Should i complete the 401k (Traditional)-->Traditional IRA--> Roth IRA conversion before December month, so i have a zero balance in the traditional IRA account. I understand for 401k Roth, i can move the money to Roth IRA directly without any penalty or income limits.

Thanks.

[Opus 17 · Accepted solution]

401k Roth account to Roth IRA -- do this directly, as a separate transaction.  No tax implications.

Pre-tax 401k to Roth IRA will be a taxable conversion. The tax consequences of this are challenging to explain.   You could do it in one step, direct from the 401k to the Roth IRA, This would be a conversion that is fully taxable and you would owe about $12,000 of federal income tax, plus state (depending on your other income, of course).  Or you could do it in two steps, from the 401k to a traditional IRA, then from the traditional IRA to a Roth IRA.  You could move the entire amount from the 401k to a traditional IRA tax-free, then only rollover (convert) from the traditional IRA to the Roth IRA, as much as you could afford to pay in taxes at the time.  However, if you have pre-tax funds in a traditional IRA, you can't do a backdoor Roth contribution with other money.

For $55,000 conversion, you would expect to pay $12,000 of income tax.  Do you have $12,000 of other money to pay the tax?  If not, then don't transfer more in any one year than you can pay the tax on.  For example, if you have $2200 available for taxes, do a direct transfer of $10,000 from the pre-tax 401k to the Roth IRA, then pay $2200 to the IRS as an estimated tax payment (www.irs.gov/payments).   Then next year, perform another transfer in whatever amount you can afford to pay the taxes on.

If you do an intermediate transfer of the entire pre-tax 401k to a traditional IRA but can't afford to convert it all to a Roth IRA this year, this will prevent you from doing a true "backdoor Roth IRA" contribution, because you will have a pretax amount in the traditional IRA which means you must use the pro-rata rule on any conversion.

On the other hand, if you can afford to pay the entire tax on the Roth conversion from other money, then it doesn't matter if you convert the 401k in one step or two.  If you rollover $55,000 of pre-tax into the traditional IRA,  then contribute $7000 after-tax, and do the Roth conversion all at once, you will only pay tax on the $55,000 (which is the same amount of tax you would pay if you did a direct rollover from the pre-tax 401k to the Roth IRA). 

As a separate issue, if you do the conversion all at once and owe a tax payment of around $12,000, you may run into issues with penalties for not having enough tax withheld during the year, even if you make the estimated payments on time.  There are some ways to deal with this, I won't go into it now.  But if you want to reply and tell us what kind of schedule you plan to use to convert the pre-tax 401k, we can discuss the payment issues separately.  

Lastly, you should look at the investment options.  Employer plans sometimes offer limited funds, which limits your investment options.  But the employer can usually negotiate lower fees and expense ratios.  For example, I own the same fund in a Roth IRA and a 403b account, and the fund has a 0.2% expense ratio in the employer plan and a 0.9% expense ratio in the private plan.  That could be significant over time.  It might be worth leaving your money in the employer plan if those lower fees and expenses mean you get a higher net rate of return. 

[Divideby7]

Thank you for the detailed explanation, this is very helpful and insight. I need to check the fees associated if i keep it as is, but i was targeting to do a full conversion and paying the taxes. I wanted to follow up and ask if i should pay the estimated taxes when i do the conversion say around Oct month or should i pay the taxes when i doing taxes next year. I ask since i am expecting some tax credits due to solar program. Also isnt the 12k in taxes an estimate and the actual taxes will be based on my gross income levels for the year?

[Opus 17]

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@Divideby7 wrote:

Thank you for the detailed explanation, this is very helpful and insight. I need to check the fees associated if i keep it as is, but i was targeting to do a full conversion and paying the taxes. I wanted to follow up and ask if i should pay the estimated taxes when i do the conversion say around Oct month or should i pay the taxes when i doing taxes next year. I ask since i am expecting some tax credits due to solar program. Also isnt the 12k in taxes an estimate and the actual taxes will be based on my gross income levels for the year?

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In general, you are correct that your tax is calculated on your tax return.  However, the IRS wants you paying into the system over the whole year (by some combination of withholding from your job and making estimated payments), so if you owe money at the end of the year, you can be assessed an underpayment penalty going all the way back to the beginning of the year, even if you pay in full with your tax return.  

OK, here's the problem.  The IRS assumes your income is earned evenly over the whole year, even if it is not, and they want to see payments applied evenly over the whole year.  That means that if you do a Roth conversion in October, for which $12,000 is due, they want to see a $3000 estimated tax payment made before April 15, June 15, September 15, and January 15, 2026.  You haven't made those payments, so you can be assessed a penalty even if you pay the full $12,000 when you make the conversion.  

There are 4 ways to avoid the penalty for underpayment.

1. Make the estimated payment in full when you perform the conversion.  Then, on your tax return, go to the special situations page and choose to calculate a penalty, even if the program does not think you owe one.  Use the Annualized Income method, this is a calculation to show the IRS that your income was not evenly earned over the whole year, but your payments were appropriate to the amount of income in each quester. 

2. Owe no income tax when you file because your solar credit is larger than the tax bill from the conversion.  If you are expecting a $12,000 (or more) solar credit, so that you don't show tax on your tax return, you should not be penalized for not making an estimated payment.

3. Have $12,000 withheld from your conversion. The IRS assumes that withholding is also spread out evenly over the year even if it is not, so you won't look under-paid.  To complete the conversion, send the $12,000 that you set aside for taxes to the Roth IRA instead of the IRS as a tax payment.  Tell the Roth IRA this is a rollover.  They don't need to know or care that it is part of the other rollover, that gets worked out on your tax return.  (If you have $55K, you convert $43K because you have $12K withheld for taxes, but then you deposit $12K as a separate rollover, then it all works out.)

4. Do the conversion in January 2026.  The tax payments will be due in 4 quarterly estimated payments, $3000 each in April, June, September and January 2026.  Here, the "IRS assumes income is spread out" rule works in your favor.  If you owe $12,000 tax on a conversion in January, the IRS will be quite happy to see the payments spread out, and you can invest the money in the mean time to earn a little extra interest.

Now, if you are expecting a solar credit to offset the tax on the conversion, you will want to do #1 or #2, #3 and 4 don't make sense in that situation.  If your solar credit will be less than the $12,000, then you should make a partial estimated payments when you do the conversion and then let the credit cancel out the rest of the tax.