Final answer:
A 401(k) can be directly converted into a Roth IRA, through a process known as a conversion. This will subject the funds to ordinary income tax in the year of the conversion. It is useful for those anticipating a higher tax bracket in retirement, but advice from a financial advisor is recommended.
Step-by-step explanation:
Yes, you can convert a 401(k) directly into a Roth IRA. This process is commonly referred to as a "rollover" or "conversion". During a conversion, the funds in a traditional 401(k), which are pre-tax and subject to tax-deferred growth, are transferred to a Roth IRA. With a Roth IRA, contributions are made with after-tax dollars and qualify for tax-free growth and tax-free withdrawals in retirement, providing an advantage for those who expect to be in a higher tax bracket during retirement.
The funds rolled over from a 401(k) to a Roth IRA will be taxed as ordinary income in the year of the conversion. It is a strategic financial step that should be carefully considered as it could increase the individual's income tax for that year. It is important to note that tax laws change year to year; hence, individual circumstances and current tax laws should be reviewed with a tax professional or financial advisor before proceeding with the conversion.
Defined contribution plans like 401(k)s and 403(b)s are popular today as they allow for tax-deferred growth of investments and are portable when changing employers. These plans play a significant role in retirement planning and can be integrated into a strategy that includes Roth IRAs to potentially mitigate the impacts of inflation and future taxation.