Pension rollover to a Roth IRA: How it works & when to consider it

If you're leaving a job where you've accumulated a pension, you'll want to manage that transition wisely so you can hold on to as much of your savings as possible. You'll be faced with several options that may include cashing out the pension or moving the funds into a retirement plan sponsored by your new employer.

A third option is rolling your pension assets into a Roth IRA. Let's weigh the pros and cons so you can decide if a pension rollover to a Roth IRA makes sense for you.

Yes, you can perform a lump-sum pension rollover into a Roth IRA. However, this option does come with a tax liability, which could substantially eat into your income.

Also, you'll need to meet a few requirements to convert your pension assets:

1. The employer offering the pension plan has to allow the lump-sum distribution.

2. The pension has to be classified as a "qualified employee plan" under IRS rules.

3. You need to qualify for a distribution from the pension (i.e., you are retiring or leaving the job). Your plan document will note the qualifications specific to your pension.

For some people, rolling over pension money to a Roth IRA can be an effective way to reduce future taxes and create financial security in retirement. You might consider it if:

When your money is in a pension plan, you don't have input over how that money is invested.

A Roth IRA, on the other hand, allows you to choose the stocks, bonds, mutual funds and other assets that best suit your financial needs. However, it also means there's more room for error and the potential to lose money in a down market.

If you retire and take a monthly distribution from your former employer's pension plan, they set the amount of your benefit. It's the same situation when an employer ends a pension plan. You're allowed to transfer your funds into an annuity that pays a regular monthly benefit.

A Roth IRA, by contrast, lets you make withdrawals from the contributions whenever you want, without an additional tax liability. Only earnings in your Roth IRA are subject to distribution rules.¹ The withdrawal flexibility of a Roth IRA means you can time distributions as part of your tax-planning strategy—and leave a legacy behind with the money you don't spend.

Converting your pension to a Roth account can provide long-term tax benefits, especially if you expect to be in a higher tax bracket during retirement. But be prepared for a significant tax hit in the year you make the conversion. If you don't have ready resources to pay that bill, a Roth IRA rollover likely isn't the best strategy.

There are multiple considerations to take into account when converting a pension to a Roth IRA. Here are three things to consider:

Because a pension uses pre-tax dollars and a Roth IRA uses after-tax dollars, you'll be expected to pay taxes on the full rollover amount. Some people may decide it's worth paying taxes now at today's tax rates to enjoy tax-free withdrawals from a Roth IRA later on. But if you've been working for the same employer for years, your tax bill could be hefty. Consult a tax professional before deciding if, and when, to roll over your retirement assets.

To roll your pension into a Roth IRA, you would need to take a lump-sum distribution from the plan. (This may happen automatically if the employer ends its plan.) This cash-out amount equals the current value of the projected monthly benefits you would receive in retirement. You'd get a smaller amount now to account for potential investment gains your money might accrue before you start making regular withdrawals.

If you request a cash-out of your pension, the administrator typically would disclose how much of the disbursement is eligible for a rollover. In some cases, you could transfer the entire lump sum. However, you can't roll over any amount that's subject to required minimum distributions, or RMDs.

When you have a defined benefit plan, the pension administrator assumes all the investment risk. They're promising to pay you the amount for which you're eligible, no matter what happens in the markets. But if you take those funds, convert them into a Roth IRA, and then invest that money within the IRA, you're on the hook for any losses you may incur during market downturns. The shorter the period of time between your rollover and when you start taking IRA distributions, the greater the risk.

If you do decide a rollover is in your best interest, you'll need to first open a Roth IRA, if you don't already have one. You'll then have to complete any required forms from your receiving IRA provider and from your pension plan, and submit them to the appropriate institution.

You can move your pension assets into a Roth IRA in one of two ways: a direct or indirect rollover.

With an indirect rollover, you personally receive a distribution from the pension administrator. You then have 60 days to deposit those funds into an IRA. If you leave your employer or it terminates its pension, the plan may send you a check by default if you choose to cash out your benefits.

When the administrator sends you money, they withhold 20% of the amount for taxes. Because you owe tax on pension funds that you roll into a Roth IRA anyway, this withholding represents a credit toward the total amount of tax you pay on the distribution. If you're younger than 59½, you'll need to use separate funds to make up for that withholding when doing your rollover—otherwise you may have to pay taxes and the 10% early withdrawal penalty on the difference.

You can simplify the process and avoid the 20% tax withholding, however, if you perform a direct rollover. In this case, the plan administrator sends the payment directly to your IRA provider, whether it's a brokerage firm, bank or insurance company. The rollover amount still counts as ordinary income in the year of the conversion, but no taxes are taken out by the pension administrator. If you experience a qualifying event and decide to perform a rollover, contact the administrator to see whether they can send the funds straight to your IRA.

Shifting your pension money into a Roth IRA calls for careful consideration. A Thrivent financial advisor can work alongside your tax professional to help you choose the strategy that makes the most sense for your family as you weigh your long-term personal and financial goals.