The pros and cons of rolling your retirement into a Roth IRA

If you have a traditional defined benefit pension plan where you work, you may have the option of taking the money as a lump sum when you leave your job or retire. One option is to transfer your pension funds into a Roth Individual Retirement Account (IRA). Discover the pros and cons of rolling your retirement into a Roth IRA.

Converting a Pension to a Roth IRA: An Overview

The two major types of employer retirement plans include: a defined contribution plan and defined benefit plan, commonly known as traditional pension.

Defined contribution plan

With a defined contribution plan such as a 401(k) or a 403(b)you contribute money from your salary and your employer can match part of your contributions With a defined contribution plan, you can decide how the money will be invested, in the range of options offered by the plan.

Defined benefit plan

With a pension or defined benefit plan, your employer funds the plan and promises you a certain retirement benefit, usually based on salary and years of service. Your employer makes the investment decisions and is responsible for delivering the promised benefits.

To leave your job

When you leave your job, you can generally take your defined contribution plan money with you. However, you may not be able to take your defined benefit plan with you unless your employer’s plan rules allow you to do so. When you retire, your defined benefit plan may give you a choice between regular payments for the rest of your life or a lump sum.

Amount of lump sum will be calculated based on your age, interest rates, the amount of benefits you would be entitled to in the future and the extent to which you are vested in the plan.

If you leave your job, you can often leave your pension behind with your employer and start collecting monthly benefits after you reach retirement age, unless your employer terminates his pension plan.

In some cases, you won’t have a choice; if your pension is worth $5,000 or less, your employer is allowed to hand it over to you as a lump sum, whether you want it or not. This is called cash-out.

The benefits of rolling over your pension into a Roth IRA

Fee-free withdrawals

Once your money is in Roth IRAsyou’ll enjoy all the tax advantages that a Roth offers. After you’ve had a Roth account for at least five years, your withdrawals will be tax- and penalty-free as long as you’re age 59½ or older. There are also flexible ones exceptions to these rules.

More control over investments

With a Roth IRAsyou will have control over how your money is invested while your employer makes these decisions with your pension. For example, you can invest more aggressively than your employer did in the hope of a higher profit if you are willing to take it on risk.

Easier access to your money

Thanks to its flexible exceptions for early withdrawals, you can withdraw money from Roth at almost any time (although fees and penalties may apply). With your pension, you generally have to wait until at least age 59 1/2 to receive anything. However, some defined benefit plans allow loans.

No Required Minimum Distributions (RMD)

Non-Roth retirement accounts such as Traditional IRAsthey are subject required minimum distributions (RMD) after reaching the age of 73 (for those born between 1951 and 1959) or 75 (for those born in 1960 or later). Your employer’s defined benefit pension may also require you to start receiving distributions at a certain time. In both cases, you will have to pay tax on the money you receive.

A Roth IRA doesn’t require you to take money out during your lifetime, making it possible to leave the entire account to your heirs if you want and can afford it.

Disadvantages of rolling over your pension into a Roth IRA

You will owe taxes in advance

If you decide roll Your pension lump sum into a Roth IRA, you will owes income tax on money just like you would any other Roth IRA contribution. After that, the money in your Roth will grow tax-deferred and be eligible for totally tax-free withdrawals if you follow the rules.

Liability for investments

Instead of leaving the burden to your employer, you’ll be responsible for deciding how to invest the money in your IRA. You can see this as an advantage or a disadvantage depending on how comfortable you are investment management.

No guarantees

When your money is in a pension plan, your employer promises that you will receive a certain dollar amount of benefits in the future. While some employers do not honor their promises for one reason or another, your benefits may be covered by the federal Pension Benefit Guaranty Corp. However, Roth IRAs offer no such guarantees.

When a Retirement IRA to Roth Rollover Makes Sense

If your retirement lump sum is relatively small, rolling it over to a Roth IRA and paying taxes on the money now could be a worthwhile compromise, especially if you’re young and the Roth IRA will have years, even decades, of growth ahead of you because those money will then come to you tax-free in retirement.

Consider your tax bracket

With a higher amount, you’ll want to be more careful. A consideration is yours tax category. If you roll over your pension into a Roth, it may put you in a higher tax bracket for that tax year.

For example, let’s say you’re single and you modified adjusted gross income (MAGI) is $100,000 per year. As a result, the highest marginal tax bracket in 2024 is 22%, and this bracket ends at $100,525. The next higher tax bracket is 24%. So if you roll a $50,000 lump sum into a Roth, you’ll be in the 22% tax bracket for the first $525 and the 24% tax bracket for the remaining $49,475.

Roll over to a traditional IRA

One way to reduce the tax cost would be to roll your lump sum into a traditional IRA and convert it gradually into a Roth IRA. You will still owe tax on the money you convert, but you will have some control over the tax bracket.

With a traditional IRA, you won’t owe rollover taxes as long as you meet the rules for either one direct reversal or a 60 day rollover.

In a direct rollover, your pension administrator will transfer the money directly to the financial institution that will hold your IRA or make a check out to that institution and give it to you for deposit. The pension trustee will write you the check and you will have 60 days to deposit all or part of the money into the IRA; the administrator will also withhold 20% for taxes. If you miss the 60-day deadline, you’ll owe taxes on the full amount.

However, if you’re nearing retirement age, you may be better off either leaving your retirement money with your employer or simply rolling it into a traditional IRA and not converting it to a Roth. In any case, you will end up paying tax on the distributions you receive, but you may be in a lower tax bracket.

conclusion

If you have a traditional workplace pension, you may have the option of taking a lump sum when you change jobs or retire. Then you can reinvest that money. if you convert it to a traditional IRAyou won’t have to pay any taxes until you make withdrawals. If you choose a Roth IRA, you’ll have to pay tax on the money upfront, but future withdrawals can be tax-free. If you decide to go with the Roth, you can reduce the tax impact by putting the money in first a traditional IRA and converting it to a Roth IRA over a number of years.