Fix My Portfolio: I have $6,000 in an old 401(k): Should I do a rollover or convert it to a Roth IRA?

Dear Dawn, 

I’m glad you’re considering all the good options for your old 401(k) and trying to avoid the worst choice, which would be cashing out the money and spending it. Sometimes people see a relatively small balance like that and think: What’s the difference? They could use the money now, and they just take the check and the savings evaporate, then they’re hit with the taxes and a 10% penalty if they are younger than 59 ½. 

You say you want to avoid that, so your options are to open a rollover IRA at pretty much any financial institution and put in the whole amount, wait for your new job to allow you to open an IRA and transfer the full amount there or convert the full amount to a Roth IRA and pay the tax due on the transaction out of your own pocket. 

Let’s break those down.

Open your own account

Rollover IRAs are pretty simple and shouldn’t take you more than a few clicks online or a phone call. You’ll need to open an account, if you don’t have one already, and may need to provide some documentation. It’s no more complicated than opening a checking account. Then direct your workplace plan administrator to transfer the funds directly. If they need to cut a check, opt to not withhold taxes and make out the check to the new custodian for your benefit (FBO). With a direct rollover, you won’t owe taxes, so you can just move the whole amount. You have to make sure the money changes hands within 60 days, though, or you’ll end up owing the tax and the early withdrawal penalty. 

Move it to your new workplace plan

If your new workplace would let you open a retirement account immediately, you could do the rollover immediately in the same fashion as to your own IRA account. But your employer has put in a lag, and that can complicate things. Your old employer may be eager to get your account off its books, as they often are with smaller accounts and that could accelerate your timeline.

“Sometimes the threshold is $1,000, sometimes $5,000, I’ve seen it as high as $10,000. You typically have 90 days or they may do auto-distribution,” says Lawrence Sprung, a certified financial planner and founder of Mitlin Financial in Hauppauge, N.Y. 

If you miss your window, your old employer will likely send you a check, minus 20% for taxes that are automatically withheld. You have 60 days from the time of the distribution to get that money into a rollover account if you don’t want to pay the taxes and early withdrawal penalty. But, at that point, you will have to make up that 20% out of pocket to deposit the whole $6,000, and then you can claim it as a credit on your next tax return, says Sprung. 

Converting to Roth IRA

If you convert the money into a Roth, you’ll pay tax on the $6,000 as ordinary income and then enjoy tax-free growth going forward. If you’re in the 22% tax bracket, that will cost you somewhere in the neighborhood of $1,300, assuming you’re single and make $50,000, according to a Roth IRA conversion calculator provided by Schwab. But the exact amount will depend on your overall tax situation. 

If you are able to average a 7% return on your money over the next 20 years, until you’re 72, then you’d have about $23,000. If you were to keep that same amount in a traditional IRA or 401(k), you’d then, presumably, owe about $5,500 at that point if you were in the same tax bracket as now. But that’s the big unknown about the value of Roth conversions. 

“It all depends on what you’re trying to accomplish,” says Sprung. If you’re in a low tax bracket now – 24% or lower – it probably makes the most sense, because the consensus is that tax rates will be higher in the future. 

“Pay the taxes now on the $6,000 and, if things work out, you’ll have created about $18,000 with no tax liability,” Sprung adds. 

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