Pros and Cons of Rolling Your Pension 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 roll over your pension funds into a Roth individual retirement account (IRA). Discover the advantages and disadvantages of rolling over your pension into a Roth IRA.

Rolling a Pension Into 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 a traditional pension.

Defined-contribution Plan

With a defined-contribution plan, such as a 401(k) or a 403(b), you contribute money out of your paycheck, and your employer may match some portion of your contributions. With a defined-contribution plan, you get to decide how the money will be invested, within the range of choices offered by the plan.

Defined-benefit Plan

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

Leaving Your Job

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

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

If you’re leaving your job, you can often leave your pension behind with your employer and begin collecting monthly benefits after you reach retirement age, unless your employer terminates its pension plan.

In some cases, you’ll have no choice; if your pension is worth $5,000 or less, your employer is allowed to turn it over to you as a lump sum whether you want it that way or not. This is referred to as a cash-out.

Advantages of Rolling Your Pension Into a Roth IRA

Tax-Free Withdrawals

Once your money is in the Roth IRA, you’ll enjoy all of the tax benefits that a Roth provides. After you have 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 some flexible exceptions to those rules.

More Control Over Investments

With a Roth IRA, you’ll have control over how your money is invested while your employer makes those decisions with your pension. For example, you can invest more aggressively than your employer did, in hopes of a higher return, if you’re willing to take on the added risk.

Easier Access to Your Money

Due to its flexible exceptions for early withdrawals, you can take money out of the Roth at almost any time (though there may be taxes and penalties). With your pension, you must generally wait at least until age 59½ to receive anything. However, some defined-benefit plans allow for loans.

No Required Minimum Distributions (RMDs)

Non-Roth retirement accounts, such as traditional IRAs, are subject to required minimum distributions (RMDs) after you reach age 73 (for people born between 1951 and 1959) or age 75 (for those born in 1960 or later). Your employer’s defined-benefit pension may also require that you begin taking distributions at a certain point. In both cases, you’ll have to pay tax on the money that you receive.

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

Disadvantages of Rolling Your Pension Into a Roth IRA

You’ll Owe Taxes Up Front

If you decide to roll over your pension lump sum into a Roth IRA, you’ll owe income tax on the money just as you would with 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 meet the rules.

Responsibility for Investing

Rather than leaving the burden on your employer, you’ll be responsible for deciding how to invest the money in your IRA. You may see this as an advantage or a disadvantage, depending on how comfortable you are with managing investments.

No Guarantees

When your money is in a pension plan, your employer promises that you’ll receive benefits of a certain dollar amount in the future. While some employers fail to live up to their promises for one reason or another, your benefits may be insured by the federal Pension Benefit Guaranty Corp. However, Roth IRAs carry no such guarantees.

When a Pension-to-Roth IRA Rollover Makes Sense

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

Consider Your Tax Bracket

With a larger sum, you’ll want to be more careful. One consideration is your tax bracket. If you roll over your pension into a Roth, it can bump you up to a higher tax bracket for that tax year.

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

Roll Over Into a Traditional IRA

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

With a traditional IRA, you’ll owe no taxes on the rollover as long as you meet the rules for either a direct rollover or a 60-day rollover.

In a direct rollover, the administrator of your pension will transfer the money directly to the financial institution that will be holding your IRA or make out a check to that institution and give it to you to deposit. The pension administrator will make out the check to you, and you’ll have 60 days to deposit all or some of the money into the IRA; the trustee 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 close to retirement age, you might do better to either leave the pension money with your employer or simply roll it into a traditional IRA and not convert it to a Roth. Either way, you’ll end up paying tax on the distributions that you receive, but you may be in a lower tax bracket.

The Bottom Line

If you have a traditional pension at work, you may have the option of taking a lump sum when you change jobs or retire. You can then reinvest that money. If you roll it over into a traditional IRA, you 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 your future withdrawals can be tax-free. If you decide to go with the Roth, you can reduce the tax impact by depositing the money first in a traditional IRA and converting it into a Roth IRA over a series of years.