What to Do with a 401(k) When You Leave Your Employer

by | Mar 25, 2025 | Podcast, Retirement & IRAs

For many Americans, their 401(k) is their largest investment account—and the main source of income they’re counting on for retirement. But when you leave your job, what happens to that money? What’s the best move to keep your savings protected and growing?

The wrong decision could cost you thousands in taxes, penalties, or missed investment opportunities. In this guide, we’ll break down everything you need to know about your 401(k) after leaving an employer—including vesting rules, rollover options, and tax implications—so you can make the best choice for your financial future.

Let’s go over your options, the pros and cons of each, and how to roll over your 401(k) the right way—without triggering unnecessary taxes or penalties.

Infographic: what to do with your 401(k) when you leave your job. Check your vested balance, compare four options, and use a direct rollover to an IRA
Infographic: what to do with your 401(k) when you leave your job. Check your vested balance, compare four options, and use a direct rollover to an IRA

Step 1: Check Your Vested Balance

Before making a move, the first thing you need to do is determine how much of your 401(k) actually belongs to you.

Understanding Vesting

Your 401(k) balance is split into two parts:

1. Your Contributions

The money you contributed from your paycheck. This is 100% yours, no matter what.

2. Employer Contributions (Match or Profit-Sharing)

This money may be subject to a vesting schedule. If you leave before you’re fully vested, you lose part (or all) of the employer contributions.

How to Check Your Vested Balance:

  • 1Get your latest 401(k) statement – It will show vested vs. unvested balance.
  • 2Review your company’s vesting schedule – This is outlined in your Summary Plan Description (SPD).

Know what you’re walking away with – Unvested employer contributions do NOT transfer when you leave.

Example: If your employer has a three-year vesting schedule and you leave after two years, you may only keep 66% of the employer match. If you leave too soon, you could be walking away from thousands of dollars in unvested money.

Once you know your true balance, you’re ready to decide where to move your funds.

Step 2: Weigh Your 401(k) Rollover Options

When you leave your employer, you have four main choices for handling your 401(k). Let’s go through each one.

Option 1: Leave Your 401(k) with Your Old Employer

Some people leave their 401(k) behind at their old job because it seems like the easiest choice. But in most cases, this is a mistake.

Cons of Keeping Your 401(k) at Your Old Job:

  • ✕High fees – The average small business 401(k) charges 1.5% in fees, which could cost you thousands over time.
  • ✕Limited investment options – Most plans restrict you to mutual funds and target-date funds—often with subpar performance.
  • ✕Lack of control – You can’t make quick investment decisions, and accessing funds requires employer approval.

Bottom Line: If you no longer work there, why should your money stay there?

Option 2: Roll It Into Your New Employer’s 401(k)

If your new job offers a 401(k) plan, you may have the option to roll over your old 401(k) into the new one.

Cons of Moving to a New 401(k):

  • ✕No financial benefit – Rolling over doesn’t give you extra employer matching.
  • ✕Still limited investment options – You’re typically stuck with mutual funds or target-date funds.
  • ✕More restrictive withdrawal rules – 401(k) plans often have tighter restrictions than IRAs.

Key Insight: Just because your new job has a 401(k) does NOT mean you should roll your old one into it.

Option 3: Cash Out Your 401(k)

You can withdraw your 401(k) as a lump sum when you leave—but this is one of the worst financial mistakes you can make.

Why Cashing Out Is a Disaster:

  • ✕10% Early Withdrawal Penalty – If you’re under 59½, you automatically lose 10% to the IRS.
  • ✕Massive Taxes – Your withdrawal is treated as ordinary income, which could push you into a higher tax bracket. For traditional 401(k)s the entire distribution is taxable. For Roth 401(k) balances, only the earnings are taxable if distributed early.

Example: If you cash out a $100,000 401(k):

$60,000
$30,000
10% Penalty -$10,000
30% in Taxes -$30,000 (depends on your state/federal tax bracket)
Final Amount Received $60,000

That’s 40% gone instantly.

When Cashing Out Might Make Sense:

  • ✓You’re 59½ or older and ready for retirement.
  • ✓You have no other financial options in an emergency.

For most people, this is the worst choice.

Option 4: Roll Over to an IRA

Rolling your 401(k) into an IRA gives you more control, lower fees, and better investment choices.

Why an IRA Is the Best Move for Most People:

  • ✓Lower fees – No employer plan fees eating into your returns.
  • ✓More investment choices – Could be a brokerage IRA for stocks/ETFs (like Schwab or Fidelity), or a Self-Directed IRA for real estate, private companies, and funds (like at Directed IRA).
  • ✓Greater control – No employer restrictions.
  • ✓Easier Roth conversions – Convert to a Roth IRA for future tax-free growth.

How to Rollover to an IRA Without Taxes or Penalties:

  • 1Use a direct rollover – This is critical to avoiding taxes. Your 401(k) provider should send the funds directly to your new IRA provider.
  • 2Do NOT take a check in your name – If the check is made out to you, it’s a distribution. You have 60 days to redeposit it into an IRA—or the IRS treats it as taxable income.
  • 3Some providers still mail checks – If they do, make sure it’s made out to your IRA provider, not to you personally.

Example: A 401(k) account owner requested a rollover, but the provider sent the check to the account owner. He didn’t redeposit it into an IRA and is now subject to taxes and penalties—and those funds can’t go back into a tax-advantaged account like an IRA.

Best Practice: Always request a direct rollover to the IRA provider to avoid a distribution, penalties, and taxes.

Special Situations to Check Before You Move Your 401(k)

A few situations change the math. Check these before you sign any rollover paperwork.

Leaving at 55 or Older: The Rule of 55

If you leave your job in or after the year you turn 55, withdrawals from that employer’s 401(k) aren’t hit with the 10% early withdrawal penalty. You still owe regular income tax on them. For qualified public safety employees in a government plan, and for private-sector firefighters, the age drops to 50 (or 25 years of service under the plan, if that comes first).

WATCH OUT

This exception only covers money that stays in that employer’s plan. It doesn’t apply to IRAs. If you roll everything into an IRA and later need cash before 59½, the 10% penalty can apply again. If you might need some of this money before 59½, factor that in before you roll it all over.

Leaving With an Unpaid 401(k) Loan

If you still owe on a 401(k) loan when you leave, the unpaid balance is often taken out of your account and treated as a distribution, called a loan offset. That makes it taxable, and the 10% penalty can apply if you’re under 59½.

You can avoid that by depositing the same amount into an IRA by your tax return due date, including extensions, for the year of the offset. For the full rules, see What Happens to a 401(k) Loan When You Leave Your Job?

Rolling Over a Roth 401(k)

Match each type of money to the right account. Pre-tax 401(k) money goes to a Traditional IRA, and Roth 401(k) money goes to a Roth IRA (or your new employer’s Roth 401(k)). If your plan holds both, you may need two rollover requests, one for each.

One timing catch: the years your money spent in the Roth 401(k) don’t count toward the Roth IRA’s five-year clock for tax-free earnings. If you contributed to a Roth IRA in an earlier year, your clock started with that first contribution.

If the Plan Pays You Instead: The 20% Withholding Trap

When your old plan pays the money to you rather than directly to your IRA, it must withhold 20% of the taxable amount for federal income tax, even if you plan to roll it over. To roll over the full amount, you have to make up that 20% from other money within 60 days.

EXAMPLE

You have $100,000 in your 401(k), and the plan sends you a check. It withholds $20,000 for taxes, so you receive $80,000.

To roll over the full $100,000, you deposit the $80,000 plus $20,000 of your own savings into an IRA within 60 days. The $20,000 that was withheld is credited toward your taxes when you file your return.

If you deposit only the $80,000, the missing $20,000 is treated as a taxable distribution. If you’re under 59½, it can also face the 10% penalty.

$100,000

Balance in your 401(k)

$20,000

Withheld for taxes

$80,000

Check you receive

A direct rollover avoids all of this, because nothing is withheld.

Small Balances Can Be Moved Without You

If your balance is small, your old plan may be allowed to cash it out or move it into an IRA in your name without waiting for your instructions. After you leave, watch for plan notices so you get to choose where your money goes.

How a Rollover to a Self-Directed IRA Works

Rolling into a self-directed IRA works the same way as rolling into any other IRA. A self-directed IRA is a Traditional or Roth IRA held with a custodian that allows alternative assets like real estate, private companies and funds. Here’s how it works with Directed IRA:

  1. 1Sort your money. Check your 401(k) statement for pre-tax and Roth balances.
  2. 2Open the matching IRA. Open a Traditional IRA for pre-tax money and a Roth IRA for Roth money.
  3. 3Request a direct rollover. Use your 401(k) provider’s rollover form (sometimes one per type of money) and have the funds sent to Directed Trust Company for your IRA, not to you.
  4. 4Give Directed IRA a heads-up. Let the team know a rollover is on the way so it lands in the right account.
  5. 5Invest. Once the funds arrive, you choose the investments and direct the IRA to make them.

Frequently Asked Questions

Do I have to move my 401(k) when I leave my job?

No. You can usually leave it in your old plan. The exception is small balances, which the plan may cash out or move to an IRA for you.

Is rolling a 401(k) into an IRA taxable?

No, not if you use a direct rollover and keep the money in the same tax bucket: pre-tax into a Traditional IRA, Roth into a Roth IRA. Rolling pre-tax money into a Roth IRA is a Roth conversion, so it’s taxable in the year you do it.

Does a 401(k) rollover count toward the once-a-year IRA rollover limit?

No. The one-rollover-per-year limit applies to IRA-to-IRA rollovers, not rollovers from an employer plan to an IRA.

Can I roll my 401(k) into a self-directed IRA?

Yes. A self-directed IRA isn’t a separate type of IRA under the tax code. It’s a Traditional or Roth IRA held with a custodian that allows alternative investments, so an old 401(k) can roll into it like any other IRA.

What if I already got a check made out to me?

You have 60 days from the day you received it to deposit it into an IRA. To roll over the full amount, add back the 20% that was withheld. The IRS can waive the 60-day deadline in some situations outside your control.

Key Takeaways

  • ✓Check your vested balance first. Make sure you know how much of your 401(k) you actually own.
  • ✓Leaving your 401(k) at your old employer is usually a bad idea – High fees and limited investment options make it less appealing.
  • ✓Rolling your 401(k) into your new employer’s plan may not be the best move – You’ll still be stuck with high fees and limited investment options.
  • ✓Cashing out your 401(k) is a terrible idea for most people under 59½ – Taxes and penalties could take 40% or more of your money.
  • ✓Rolling over to an IRA is the best option for most people – It gives you lower fees, more investment options, and complete control over your retirement funds.
  • ✓Use a direct rollover to avoid taxes and penalties – Never take a check in your name unless it’s your only option, and if you do, you must redeposit the same amount into an IRA within 60 days.

FREE ROLLOVER GUIDE

Learn how to move an old 401(k) or IRA into a self-directed IRA, tax-free.

Get the Free Transfers & Rollovers Guide

Prefer to talk it through? Book a call with a Directed IRA specialist

Self-Directed IRA Versus Solo 401(k)

by | Oct 6, 2022 | Retirement & IRAs, Uncategorized

Many self-directed investors have the option of choosing between a self-directed IRA or a self-directed solo 401k. Both accounts can be self-directed so that you can invest in any investment allowed by law such as real estate, LLCs, precious metals, or private company stock. However, depending on your situation, you may choose one account type over the other. What are the differences? When should you choose one over the other?

We’ve been advising clients for over a decade on self-directed IRAs and solo 401(k)s and what we’ve learned is that there is no universal answer to the question. Instead, you need to learn what is best based on your personal situation and investment objectives. Do you even qualify for a solo(k)? What investments do you plan to make and does one account type make a difference for your investments? The good news is that either way you go, we can help with a self-directed IRA at Directed IRA, where we are a licensed trust company and can serve as custodian of your IRA. Or, we can set-up a solo(k) at KKOS Lawyers using our pre-approved plan documents.

Infographic: how a self-directed IRA and a solo 401(k) compare on eligibility, contributions, Roth options, set-up, control, and leveraged real estate
Infographic: how a self-directed IRA and a solo 401(k) compare on eligibility, contributions, Roth options, set-up, control, and leveraged real estate

Comparing the Two Accounts

IRA Solo 401K
Qualification Must be an individual with earned income or funds in a retirement account to roll over. Must be self-employed with no other employees besides the business owner and family/partners.
Contribution Max $6,000 max annual contribution. Additional $1,000 if over 50. $61,000 max annual contribution (it takes $140K of wage/se income to max out). Contributions are employee and employer.
Traditional & Roth You can have a Roth IRA and/or a Traditional IRA. The amount you contribute to each is added together in determining total contributions. A solo 401(k) can have a traditional account and a Roth account within the same plan. You can convert traditional sums over to Roth as well.
Cost and Set-Up You will work with a self-directed IRA custodian who will receive the IRA contributions in an SDIRA account. You must use an IRS pre-approved document when establishing a solo 401k. This adds additional cost over an IRA.
Custodian Requirement An IRA must have a third-party custodian involved in the account (e.g. bank, credit union, trust company) who is the trustee of the IRA. Of course we recommend our company, www.directedira.com. A 401(k) can be self-trustee’d, meaning the business owner can be the trustee of the 401(k). This provides for greater control but also greater responsibility.
Investment Details A self-directed IRA is invested through the self-directed IRA custodian. A self-directed IRA can be subject to a tax called UDFI/UBIT on income from debt leveraged real estate. A Solo 401(k) is invested by the trustee of the 401(k) which could be the business owner. A solo 401(k) is exempt from UDFI/UBIT on income from debt leveraged real estate.

UPDATE (NOV 2026)

This table uses 2022 limits. For 2026, the IRA limit is $7,500, plus $1,100 if you’re 50 or older, and the Solo 401(k) total limit is $72,000, plus catch-up contributions ($8,000 at age 50+). (Source: IRS)

Keep in mind that the solo 401(k) is only available to self-employed persons while the self-directed IRA is available to everyone who has earned income or who has funds in an existing retirement account that can be rolled over to an IRA.

Conclusion

Based on the differences outlined above, a solo 401(k) is generally a better option for someone who is self-employed and is still trying to maximize contributions as the solo 401(k) has much higher contribution amounts. On the other hand, a self-directed IRA is a better option for someone who has already saved for retirement and who has enough funds in their retirement accounts that can be rolled over and invested via a self-directed IRA as the self-directed IRA is easier and cheaper to establish.

Another major consideration in deciding between a solo 401(k) and a self-directed IRA is whether there will be debt on real estate investments. If there is debt and if the account owner is self-employed, they are much better off choosing a solo 401(k) over an IRA as solo 401(k)s are exempt from UDFI tax on leveraged real estate.

Choosing between a self-directed IRA and a solo 401(k) is a critical decision when you start self-directing your retirement. Make sure you consider all of the differences before you establish your new account.

FREE SOLO 401(K) GUIDE

Self-employed? Learn how a self-directed Solo 401(k) works and how much you can contribute.

Get the Free Solo 401(k) Guide

Prefer to talk it through? Book a call with a Directed IRA specialist

Mat Sorensen

Mat has been at the forefront of the self-directed IRA industry since 2006. He is the CEO of Directed IRA & Directed Trust Company where they handle all types of self-directed accounts (IRAs, Roth IRAs, HSAs, Coverdell ESA, Solo Ks, and Custodial Accounts) which are typically invested into real estate, private company/private equity, IRA/LLCs, notes, precious metals, and cryptocurrency. Mat is also a partner at KKOS Lawyers and serves clients nationwide from its Phoenix, AZ office.

He is published regularly on retirement, tax, and business topics, and is a VIP Contributor at Entrepreneur.com. Mat is the best-selling author of the most widely used book in the self-directed IRA industry, The Self-Directed IRA Handbook: An Authoritative Guide for Self-Directed Retirement Plan Investors and Their Advisors.

Stuck With a 401K Loan and Leaving Your Job

by | Oct 3, 2022 | Retirement & IRAs

Have you taken a loan from your employer 401(k) plan and plan on leaving? Unfortunately, most company plans will require you to repay the loan within 60 days, or they will distribute the amount outstanding on the loan from your 401(k) account. It’s one of the ways they try to keep their employees from leaving. “Don’t leave or we’ll distribute your 401(k) loan that you took from your money in your 401(k) account.”

Infographic: leaving your job with a 401(k) loan. Repay the outstanding loan amount to an IRA by your tax return deadline, including extensions, to avoid taxes and penalties
Infographic: leaving your job with a 401(k) loan. Repay the outstanding loan amount to an IRA by your tax return deadline, including extensions, to avoid taxes and penalties

How to Buy Yourself More Time & Avoid the Distribution

The good news is that following the Tax Cuts and Jobs Act (TCJA) you now have the option to re-pay the loan to an IRA to avoid the distribution and you have until your personal tax return deadline of the following year (including extensions) to contribute that re-payment amount to an IRA. By re-paying the amount outstanding on the loan to an IRA, you will avoid taxes and penalties that would otherwise arise from distribution of a participant 401(k) loan.

How It Works In Practice

EXAMPLE

Let’s say you left employment from your employer in February 2026 and that you had a 401(k) loan that was distributed by your employer’s plan following your termination of employment. You will have until October 15th of 2027 (if you extend your personal return, 6 month extension from April 15th) to make re-payment of the amount that was outstanding on the loan to an IRA. These funds are then treated as a rollover to your IRA from the 401(k) plan and your distribution and 1099-R will be reported on your federal tax return as a rollover and will not be subject to tax and penalty. While it’s not perfect it’s far greater time than was previously allowed. Traditionally, you had 30 or 60 days at most to make re-payment.

Limitations

The ability to rollover an outstanding 401(k) loan amount to an IRA is only available when you have left an employer (for any reason). It does not apply in instances where you are still employed and have simply failed to re-pay the loan or to make timely payments.

FREE ROLLOVER GUIDE

Learn how to move an old 401(k) or IRA into a self-directed IRA, tax-free.

Get the Free Transfers & Rollovers Guide

Prefer to talk it through? Book a call with a Directed IRA specialist

Mat Sorensen

Mat has been at the forefront of the self-directed IRA industry since 2006. He is the CEO of Directed IRA & Directed Trust Company where they handle all types of self-directed accounts (IRAs, Roth IRAs, HSAs, Coverdell ESA, Solo Ks, and Custodial Accounts) which are typically invested into real estate, private company/private equity, IRA/LLCs, notes, precious metals, and cryptocurrency. Mat is also a partner at KKOS Lawyers and serves clients nationwide from its Phoenix, AZ office.

He is published regularly on retirement, tax, and business topics, and is a VIP Contributor at Entrepreneur.com. Mat is the best-selling author of the most widely used book in the self-directed IRA industry, The Self-Directed IRA Handbook: An Authoritative Guide for Self-Directed Retirement Plan Investors and Their Advisors.

Solo 401K Form 5500 Tax Filing and Five-Point Compliance Checklist

by | Jun 22, 2022 | Real Estate & Alternative Asset Investing 

Solo 401(k)s have become a popular retirement plan option for self-employed persons. These plans put the business owner in control of the plan but with that control also comes responsibility. Unfortunately, many solo 401(k) plans are not properly maintained and are at the risk of significant penalty and/or plan termination. If you have a solo 401(k), you need to ensure that the 401(k) is being properly maintained. Here’s a quick checklist to make sure your plan is on track:

Infographic: five-point Solo 401(k) compliance checklist covering Form 5500-EZ filing, plan updates, tracking and separating funds, and reporting contributions and rollovers
Infographic: five-point Solo 401(k) compliance checklist covering Form 5500-EZ filing, plan updates, tracking and separating funds, and reporting contributions and rollovers

1. Does your Solo 401(k) need to file a Form 5500-EZ?

There are two primary situations where you are required to file a Form 5500 for your Solo 401(k).

  1. 1If your Solo 401(k) has more than $250,000 in assets, and
  2. 2If the Solo 401(k) plan is terminated (regardless of total asset amount).

If either of these instances occurs, then the Solo 401(k) must file a Form 5500 to the IRS annually. Form 5500 is due by July 31st of each year for the prior year’s plan activity. Solo 401(k)s can file what is known as a 5500-EZ. The 5500-EZ is a shortened version of the Standard Form 5500. Unfortunately, Form 5500-EZ cannot be filed electronically and must be filed by mail. Solo 401(k) owners have the option of filing a Form 5500-SF online through the DOL. Online filing is preferred as it can immediately be filed and tracked by the plan owner. In fact, if you qualify to file a 5500-EZ, the IRS and DOL allow you to file the Form 5500-SF online, but you can skip certain questions so that you only end up answering what is on the shorter Form 5500-EZ.

UPDATE (NOV 2026)

Form 5500-EZ can now be filed electronically through the Department of Labor’s EFAST2 system (for plan years beginning after 2019) or on paper with the IRS. The late-filing penalty is now $250 per day, up to $150,000 per return. (Source: DOL; IRS)

2. Is the plan up-to-date?

The IRS requires all 401(k) plans, including Solo 401(k)s, to be amended at least once every six years. If you’ve had your plan for over six years and you’ve never restated the plan or adopted amendments, it is not compliant and upon audit, you will be subject to fines and possible plan termination (IRS Rev Proc 2016-37). If your plan is out of date, your best option is to restate your plan to make sure it is compliant with current law. On average, most plan documents we see updated every two to three years as the laws affecting the plan documents change. We’ve had two different plan amendments to our IRS pre-approved plan in the past six years.

3. Are you properly tracking your plan funds?

Your Solo 401(k) plan funds need to be properly tracked and they must identify the different sources for each participant. For example, if two spouses are contributing Roth 401(k) employee contributions and the company is matching employer Traditional 401(k) dollars, then you need to be tracking these four different sources of funds, and you must have a written accounting record documenting these different fund types.

4. Plan funds must be separated by source and participant

You must maintain separate bank accounts for the different participants’ funds (e.g. spouses or partners in a Solo K), and you must also separate traditional funds from Roth funds. In addition, you must properly track and document investments from these different fund sources so that returns to the Solo 401(k) are properly credited to the proper investing account.

5. Are you properly reporting contributions and rollovers?

If you’ve rolled over funds from an IRA or other 401(k) to your Solo 401(k), you should have indicated that the rollover or transfer was to another retirement account. So long as you did this, the company rolling over the funds will issue a 1099-R to you, but will include a code on the 1099-R (code G in box 7) indicating that the funds were transferred to another retirement account, and that the amount on the 1099-R is not subject to tax.  If you’re making new contributions to the Solo 401(k), those contributions should be properly tracked on your personal and business tax returns. If you are an S-Corp, your employee contributions should show up on your W-2 (traditional and roth), and your employer contributions will show up on line 17 of your 1120S S-Corp tax return. If you are a Sole Prop, your contributions will typically show up on your personal 1040 on Schedule 1, line 16.

WATCH OUT

Make sure you are complying with these rules on an annual basis. If your Solo 401(k) retirement plan is out of compliance, get with your attorney or CPA immediately to make sure it is up-to-date. Failure to properly file Form 5500 runs at a rate of $250 a day up to a maximum penalty of $150,000 per return not properly filed. You don’t want to get stung for failing to file a relatively simple form. The good news is there are correction programs offered for some plan failures. But, don’t get sloppy, or you’ll run the risk of losing your hard-earned retirement dollars.

Check out the latest Directed IRA, Ep 62: Solo 401(k) Required Filings and Avoiding Common Mistakes. In this episode Mark and I outline common mistakes made in solo 401(k)s (aka, QRPs) when it comes to creation, documentation, contributions, handling of funds, and filings. They cover plan documents and update requirements (required every 6 years) as well as 5500-EZ solo 401(k) tax return filings.

FREE SOLO 401(K) GUIDE

Self-employed? Learn how a self-directed Solo 401(k) works and how much you can contribute.

Get the Free Solo 401(k) Guide

Prefer to talk it through? Book a call with a Directed IRA specialist

Roth Conversions: When You Should Convert Your IRA or 401(k) to Roth?

by | Apr 24, 2020 | Real Estate & Alternative Asset Investing , Retirement & IRAs

Many Americans convert traditional dollars to Roth when account values are down or when they’re in a lower tax bracket than usual. If you have a traditional IRA or 401(k), then that money grows tax-deferred, BUT you pay tax on the money as it is drawn out at retirement. And that’s a big BUT. On the other hand, you get zero tax deduction on Roth IRA and Roth 401(k) contributions but they grow and come out tax-free at retirement. What’s better? Well, in the end the Roth account is a much better deal as you’re pulling out what you put in AND the growth of the account after years of investing and saving. That’s likely a larger amount than what you put in so you’d typically be better paying tax on what you put in (or convert) rather than paying tax on the larger sum that you will take out later. The trade-off of course, is you’re playing the long game. You’re skipping a tax deduction or paying tax now to convert in return for tax-free growth and tax-free distributions at retirement. The Roth seems to be the better deal. Yet, most Americans have been sucked into traditional IRAs and 401(k)s because we get a tax deduction when we put the money in a traditional account, saving us money on taxes now.

Infographic: the Roth conversion trade-off (pay tax now, grow tax-free later), the three times to definitely convert (big upside, low-income year, possible need for the money), and what to know before you convert
Infographic: the Roth conversion trade-off (pay tax now, grow tax-free later), the three times to definitely convert (big upside, low-income year, possible need for the money), and what to know before you convert

For more on the differences between Roth IRA and Roth 401(k), take a look at the video from my Partner Mark J. Kohler:

How a Roth Conversion Is Taxed

The good news is that you can convert your traditional IRA to a Roth IRA, or your traditional 401(k) to a Roth 401(k). The price to make that conversion is including the amount you convert to Roth as taxable income for the year in which you make the conversion. So, if I convert $100K from my traditional IRA to a Roth IRA in 2026, I will take that $100K as income on my 2026 tax return, then pay any federal and state taxes on that income depending on my 2026 tax bracket. Many retirement account owners want to move their traditional funds to Roth, but don’t like the idea of paying additional taxes to do so. It can be a big tax hit when you do your taxes. I get it. Nobody likes paying more taxes now, even if it clearly saves you more as your account grows and the entire growth comes out tax-free.

Chunking Conversions

One way to soften the tax blow of the Roth conversion is to chunk the amount you want to convert over two or more years. For example, if it’s November 2026 and you want to convert $100K to Roth, you could convert $50K by December 31, 2026, and the remaining $50K in January 2027. That spreads the tax over two years. You could also convert about $33K a year over three years.

When You Should Definitely Convert

The following are three cut-and-dry situations of when you should definitely convert your traditional IRA or 401(k) funds to Roth:

1. Up-Side Investment Opportunity – I’ve had numerous clients over the years convert their traditional funds to Roth before investing their account into a certain investment. They’ve done this because they’ve had a tremendous investment opportunity arise where they expect significant returns. They’d rather pay the tax on the smaller investment amounts now, so that the returns will go back into their Roth IRA or 401(k), where it can grow to an unlimited amount and come out tax-free. These clients have invested in real estate deals, start-ups, pre-IPOs, and other potentially lucrative investments. So, if you have an investment that you really believe in and will likely result in significant returns, then you’re far better off paying a little tax on the amount being invested before the account grows and returns a large profit. That way, the profit goes back into the Roth and the money becomes tax-free.

2. Low-Income Year – Another situation where you should convert traditional funds to Roth is when you have a low-income tax-year. Since the pain of the conversion is that you have to pay tax on the amount that you convert, you should convert when you are in a lower tax bracket to lessen the blow. For example, if you’re married with $40,000 of taxable income and you convert $50,000 to Roth, the entire conversion falls in the 12% federal bracket, for about $6,000 in federal tax. If you instead convert in a year when you have $250,000 of taxable income, the same $50,000 conversion is taxed at 24%, or about $12,000. That’s twice the tax. Keep in mind that you also pay state tax on the amount that you convert (if your state has state income tax), and most states have stepped brackets where you pay tax at a lower rate when you have lower income. Now, you may not have taxable income fluctuations. But, for those who are self-employed, change jobs and have a loss of income, or have investment losses where taxable income is lower than normal for a year, you should think about converting your retirement funds to Roth. You may not have a more affordable time to make the Roth conversion.

3. Potential Need for a Distribution After Five Years – One of the perks of Roth accounts is access. Your Roth contributions can come out anytime, tax- and penalty-free. Converted amounts aren’t taxed again when you take them out. But if you’re under 59 1/2, each conversion has its own five-year clock for the 10% early withdrawal penalty, starting January 1 of the year you convert. So if you convert in November 2026, you can take out the converted amount penalty-free starting January 1, 2031. (For more, see The Roth IRA 5-Year Rule Everyone Gets Wrong.) If you try to access funds in your traditional IRA or 401(k) before you are 59 1/2, then you will pay tax and a 10% early withdrawal penalty even if the amounts you distribute are only the contributions you put in, not the investment gains. Clearly, the Roth account is much more accessible in the event you need personal funds. Keep in mind, you don’t get this perk immediately: You have to wait 5 years from the tax year in which you converted before you can take out the converted amount penalty-free.

WATCH OUT

One final thought to consider when converting to a Roth is that there are no do-overs. You used to be able to do what was called a Roth re-characterization where you could undo a Roth conversion but the ability to undo a Roth conversion was eliminated in 2018 forward. As a result, make sure you’re committed before you convert as there are no mulligans, do-overs, or re-characterizations anymore. Also, if you want the conversion to fall onto your current year tax return, then make sure you convert those sums by December 31. For the most common ways conversions go wrong, see Roth Conversion Mistakes That Could Wreck Your Retirement Plan.

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Mat Sorensen

Mat has been at the forefront of the self-directed IRA industry since 2006. He is the CEO of Directed IRA & Directed Trust Company where they handle all types of self-directed accounts (IRAs, Roth IRAs, HSAs, Coverdell ESA, Solo Ks, and Custodial Accounts) which are typically invested into real estate, private company/private equity, IRA/LLCs, notes, precious metals, and cryptocurrency. Mat is also a partner at KKOS Lawyers and serves clients nationwide from its Phoenix, AZ office.

He is published regularly on retirement, tax, and business topics, and is a VIP Contributor at Entrepreneur.com. Mat is the best-selling author of the most widely used book in the self-directed IRA industry, The Self-Directed IRA Handbook: An Authoritative Guide for Self-Directed Retirement Plan Investors and Their Advisors.