AARP and Vanguard Say This Common 401(k) Move Could Trigger a Massive Tax Bill

Leaving a job or retiring comes with a deceptively simple question: What should you do with the money in your 401(k)? Rolling the balance into an IRA is often treated as the obvious answer. But the account you choose and the way the transfer is handled could produce very different tax results.

AARP, Vanguard, and the IRS have all highlighted traps that can turn an ordinary rollover into an expensive surprise. Before moving decades of savings, here are the surprising financial mistakes worth watching for.

Confusing a rollover with a Roth conversion

Not every transfer out of a 401(k) creates a tax bill. Moving money from a traditional 401(k) directly into a traditional IRA generally preserves its tax-deferred status. You typically do not owe income tax until you withdraw the money later.

Moving that same balance into a Roth IRA is different. It is a conversion, meaning the previously untaxed amount generally becomes taxable income for that year.

A large conversion could mean a large tax bill

Traditional 401(k) contributions are usually made with pre-tax dollars. Converting a $300,000 traditional balance to a Roth IRA could therefore add close to $300,000 to taxable income, depending on whether the account contains any money that has already been taxed.

AARP warns that although future qualified Roth withdrawals may be tax-free, the immediate cost can be substantial. The conversion could also push part of someone's income into a higher federal tax bracket.

The conversion could impact more than your taxes

The added income from a Roth can also ripple through other parts of a retiree's finances. A conversion raises adjusted gross income, potentially increasing the portion of Social Security benefits subject to federal income tax.

It could also trigger income-related Medicare premium surcharges in a later year. That means the real cost may extend beyond the tax shown on the conversion itself.

After-tax 401(k) money follows special rules

Some workplace plans allow traditional after-tax contributions, which are different from Roth 401(k) contributions. The employee has already paid income tax on this money, but any investment earnings attached to it generally remain pre-tax.

Savers sometimes assume they can withdraw only those after-tax contributions and move them to a Roth IRA. The IRS says a partial plan distribution must generally include a proportional share of both pre-tax and after-tax money.

There is a way to split the money correctly

The proportional rule does not necessarily mean the entire distribution must go into one type of IRA. When taking a full distribution, the IRS permits the pre-tax portion to be sent directly to a traditional IRA or another eligible retirement plan, while the after-tax contributions go to a Roth IRA.

This can prevent the already-taxed contributions from being taxed again. However, the plan must correctly process and document the transaction.

IRA conversions have another pro-rata trap

Once after-tax money is inside a traditional IRA, a different pro-rata rule can come into play. Vanguard explains that an IRA conversion's taxable and nontaxable portions are generally calculated across all of the owner's traditional, SEP, and SIMPLE IRAs rather than from one specially selected account.

Someone with large pre-tax IRA balances may therefore owe more tax on a Roth conversion than expected.

An indirect rollover creates a 20% problem

The simplest rollover is usually a direct one, with the money sent from the 401(k) plan to the receiving retirement account. No federal tax is generally withheld from a qualifying direct rollover.

When the distribution is instead paid to the account holder, the retirement plan generally must withhold 20% of the taxable amount, even when the person intends to complete a rollover within 60 days.

You may have to replace with withheld money yourself

Suppose someone requests a $100,000 distribution and receives $80,000 after the plan withholds $20,000. To roll over the full $100,000 and continue deferring tax on it, the account holder generally must deposit the $80,000 check plus another $20,000 from other funds within the 60-day window.

Otherwise, the missing amount may be treated as a taxable distribution and could face an additional 10% tax if the person is under 59 1/2 and no exception applies.

A Roth conversion may be difficult to undo

A poorly timed Roth conversion is not something savers should assume they can reverse after seeing the tax bill. Roth conversions completed after 2017 can no longer be recharacterized back into traditional IRAs.

That makes it especially important to estimate the federal and state tax consequences before authorizing the transaction rather than discovering them when preparing the next tax return.

Smaller conversion could reduce the damage

The choice does not always have to be between converting everything and converting nothing. Consider spreading Roth conversions over several years when the retirement plan and circumstances permit it.

Converting smaller amounts may help someone use lower tax brackets and limit secondary effects on Social Security taxation or Medicare premiums. A lower-income year between retirement and the start of required minimum distributions may offer a particularly useful planning window.

Bottom line

Rolling a 401(k) into an IRA is not automatically a taxable event, but choosing a Roth IRA, mishandling after-tax contributions, or accepting a check personally could create an unexpected bill. The safest approach is to confirm the destination, tax treatment, and rollover method before any money leaves the plan.

It may also help to keep enough cash outside the retirement account to cover conversion taxes. Using part of the converted balance to pay the bill reduces the amount left growing for retirement and could trigger an additional penalty for younger savers. Planning for that cost can help you stay on track for retirement before making an irreversible move.