Given the mobility of the modern-day workforce, it’s extremely common for someone to switch jobs. If your old employer offered a 401k and you participated in it, then you have an investment account that needs your attention. You have four choices.

One: Leave the money in your previous employer’s plan if they allow it.

Two: Rollover the 401k into your new employer’s 401k if they offer one and the option is available.

Three: Rollover the 401k into a traditional IRA at your brokerage of choice.

Four: Cash out the 401k, which will result in paying a 10% penalty and taxes unless you qualify for one of the very few exceptions.

Everyone’s situation is different, so there could be exceptions to this, but I’m generally not a fan of options one and two. Here’s why. 401k plans usually carry higher fees than IRAs. That’s because the government requires more administrative work and reporting to run them. Usually, the costs are passed along to plan participants. Though costs have come down toward approximately 1% to 1.5% annually, that’s still well above the ZERO fees you pay when investing in an IRA. In addition, you also have fewer investment choices in most 401k plans.

I hope it’s obvious why option 4 is a bad idea. The 10% penalty is vicious, and it’s easy to avoid. Just roll over the 401k into an IRA. Since you’re moving from one pre-tax account to another, there’s no tax consequence. To reiterate, option 3 eliminates 401k fees while opening the door to far more investment choices, including the broad array of options strategies.

Roth Conversion

Recall there is another type of IRA known as a “ROTH” IRA. These are funded with post-tax money and grow tax-free. In other words, you contribute money that has already been taxed into a Roth IRA. Most 401ks are funded with pre-tax money, so by default, they’re rolled into a pre-tax IRA (aka regular IRA or traditional IRA or plain ol’ IRA without the term Roth in front of it).

But could you convert your IRA into a ROTH IRA if you wanted to pay the taxes owed now and get future growth tax-free?

Sure.

Here are a few things to keep in mind. And let me preface all of this with the disclaimer that I’m not an accountant and tax laws change. Consult your own tax advisor on how these ideas may or may not apply to you.

First, it could be advantageous to carry pre-tax accounts and post-tax (ROTH) accounts into retirement. This allows for maximum flexibility in where you pull your money from for income. For instance, in years where you’re in a high tax bracket, you might prioritize pulling money from your Roth accounts. In low-income years when your tax burden is minimal, you could instead pull more funds from your pre-tax accounts.

If you only have ROTH money going into retirement, you limit your options. And you may end up having really low tax bracket years where you wouldn’t have had to pay that much tax on IRA distributions anyway!

Second, converting money from an IRA to a Roth IRA adds to your taxable income and can push you into a higher tax bracket. Here are the Federal tax brackets for 2023:

Imagine you have a 401k balance of $50,000 and roll the entire balance into an IRA. This year your taxable income is $79,450, and your file status is Married Filing Jointly, placing you in the 12% tax rate (blue box above). Not bad. Now, if you were to convert your entire $50k IRA into a Roth, it would bump your income up from $79,450 to $129,450. The first $10,000 of the conversion would be taxed at 12%, and the remaining $40,000 would be taxed at 22%. That’s a bummer, and it brings us to the next point.

Third, you don’t have to convert your entire IRA balance at once. Consider using the different tax brackets to strategize converting the optimal amount each year. In the previous example, your taxable income was $79,450, or $10,000 below the cap for the 12% bracket. Why not convert $10k of the IRA only? That way you’re only paying a 12% rate. Assuming your income and the tax brackets didn’t change, you could do another $10k the next year, so on and so forth.

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