When you leave an employer, there are several ways to handle your 401(k). A 401(k) rollover into your new employer’s retirement account is one choice. A rollover into a traditional IRA is also an option. A third alternative is to rollover into a Roth IRA. None of these count as a contribution under IRS guidelines, but some may incur a tax liability.
What are retirement savings contribution limits?
The IRS has specific guidelines for contributing and taking distributions from retirement savings accounts. One of these deals with annual contribution limits to 401(k) plans and IRAs. Those limits may change from year to year, so it’s best to check them frequently. In 2023, the maximum annual contribution limit for a 401(k) plan is $22,500. The IRA limit is $6,500.
If you’re over fifty, the IRS allows you to make “catch-up” contributions since your retirement age is approaching. The catch-up annual contribution limit for a 401(k) plan is $30,000. It’s $7,500 for IRAs. That’s for both traditional and Roth IRAs. Contributions to traditional IRAs are tax-deferred. Roth IRA contributions are made with after-tax dollars.
Contribution and tax guidelines for 401(k) rollovers
Your 401(k) rollover does not count as a contribution, so you’ll still be able to contribute up to the maximum contribution limit set by the IRS. If you’re rolling your 401(k) into a new 401(k) or a traditional IRA, there won’t be a current year tax liability on that money. Since contributions come from your paycheck pre-tax, you’ll pay taxes when you withdraw the funds.
A Roth IRA is different. Your 401(k) rollover still doesn’t count as a contribution, but you will need to pay income tax on it because you’re converting the money from pre-tax savings into after-tax savings. The amount of your 401(k) rollover will be added to your total income for the year the rollover is made. That could put you in a higher tax bracket.
One of the drawbacks to rolling into a Roth IRA is that you’ll still be prohibited from withdrawing money without paying a 10% early withdrawal penalty. That means you’ll need to pay the additional income tax out of pocket. On a positive note, you can withdraw the funds tax-free when you retire. That extra money can make a difference when you’re on a fixed income.
Financial planning with a 401(k) rollover
Employees who have spent multiple years at a company could have several thousand dollars saved in their retirement fund when they change jobs. Asking a financial planner to help you manage those funds is a sensible move, even if you’re simply rolling them over into a new retirement account. There will be a tax liability at some point. It’s prudent to plan for that.
Financial planning becomes even more important if you rollover into a Roth IRA or cash the plan out. The Roth option will create a tax liability based on your total annual income. Cashing out will cost you 20% in taxes plus a 10% early withdrawal fee. You’ll need to make plans to offset or absorb those costs. A financial planner can help you with that.
The Bottom Line
A 401(k) rollover is not considered a contribution under IRS rules. It’s also not taxed if you roll the funds into another 401(k) or traditional IRA. It counts as income if you roll it into a Roth IRA. Income tax on the funds will be due when you file your taxes next year. Hire a financial planner to help you get the maximum return from your retirement savings.