Keeping track of the many rules governing your retirement plans can be a daunting task. The thing to remember is that your 401(k) is a workplace-sponsored defined contribution pension plan, while your individual retirement account is a privately owned retirement plan.
While being covered under a 401(k) plan at work can affect your ability to make deductible contributions to an IRA, your contributions do not count against one another, nor does a rollover to an IRA count against your contribution limit for the year.
Read More: How to Rollover a 401(k) to a Bank IRA
Rollover Contributions to IRAs
A rollover contribution is a balance transfer from one type of retirement plan to another. If the source of funds is a traditional IRA or retirement plan and the destination is a traditional or Roth IRA, the transaction is called a "rollover." The term "recharacterization," however, is used to describe the conversion of a recently rolled over Roth IRA back into a traditional IRA.
Rollover transactions are treated differently than contributions. Your rollover does not count towards the annual $6,000 contribution limit ($7,000 for those over 50) normally allowed for Roth contributions and deductible contributions to traditional IRAs.
Coordination With Income
While your rollover doesn't count as a contribution, a rollover from a 401(k) plan or traditional IRA, SEP IRA, or SIMPLE IRA into a Roth IRA may affect your ability to make a contribution to a retirement plan that year. This is because the law establishes a maximum allowable modified adjusted gross income to contribute to each type of plan. This income threshold changes periodically.
When you elect to execute a rollover from a tax-deferred retirement plan into a Roth, you must recognize the amount transferred as income. This could put you over the limit for either a Roth IRA or traditional IRA contribution.
Income Limits for Contribution Deductions
As of 2021, a couple filing jointly must make no more than $105,000 to be able to take a full deduction up to the contribution limit, or they can make $105,001 to $124,999 for a partial deduction. If you are filing single in 2021 and make no more than $66,000, you are able to take a full deduction up to the limit as well.
The deduction amount decreases as the income threshold increases. It completely phases out at $125,000 or higher for married filing jointly and $76,001 for single filers.
If your rollover drives your income above these levels, your ability to make new contributions may be reduced or eliminated.
Considerations Before Rolling Over
Consider rolling over a 401(k) balance to a Roth if you want the additional freedom choice. IRAs allow you to select from a much broader array of investment options, including the option to invest the balance in a closely-held small business. Roth IRA accounts may be advantageous if you believe you will be in a higher tax bracket in retirement than you are now.
Rollovers work best if you can pay the taxes using funds that are not in the IRA itself. Be aware that while the asset protection afforded to 401(k) plans has no upper ceiling, the law only protects the first $1 million in IRA balances from creditors.
Read More: How to Combine IRA Accounts
Leslie McClintock has been writing professionally since 2001. She has been published in "Wealth and Retirement Planner," "Senior Market Advisor," "The Annuity Selling Guide," and many other outlets. A licensed life and health insurance agent, McClintock holds a B.A. from the University of Southern California.