If you're considering leaving a job that has a 401(k), it's time to learn more about rollover plans.

Once you leave your employer, you can take advantage of several options, including rolling your funds into a traditional IRA, a Roth IRA, an individual retirement annuity, or a new employer’s 401(k) plan. Alternatively, you could just leave the money where it is or even cash it out.

Each of these options come with benefits and drawbacks. Factors such as your age, your income, and the size of your retirement nest egg all help determine the best choice for your family and your future income.

 Today, we want to dive deep into a popular rollover strategy — converting a 401(k) to a Roth IRA.

What Is a 401(k)?

Simply put, a 401(k) plan is an investment vehicle designed for retirement. It provides employees a tax-advantage way to save for retirement, that allows them to contribute directly out of their salaries. 401(k) plans debuted in the late 1970s, and today, 60 million Americans participate in 600,000 of these plans.

Collectively, 401(k) plans hold $3.7 trillion, or roughly 20% of Americans' retirement assets. How are these accounts generally invested? Well, About 66% of these investments are held in mutual funds, and the rest are divided among individual stocks, bonds, collective trusts, and other pooled products.

Why are 401(k) Plans so Popular?

Probably because they represent the easiest way to save and earn money on that savings. Automatic payroll deductions and dollar-for-dollar employer matches mean investors can sock away money without ever missing it and in some cases earn a 100% rate of return (thanks to the match) almost immediately.

401(k)s also offer lucrative tax benefits. The funds you invest in a 401(k) get withdrawn before you pay taxes. You might even drop into a lower tax bracket if you save enough. Consequently, you only pay taxes on your investments when you withdraw from your account after you retire.

Even though most 401(k) plans are attached to an employer, you can take the money with you if you decide to switch jobs.

What Is a Roth IRA?

A Roth IRA (Individual Retirement Account) is another popular investment vehicle in which participants deposit after-tax dollars. Established in 1997 and named after former Delaware senator William Roth, these accounts serve a specific investor profile.

 You can't put money in a Roth IRA if you earn above the income ceiling. In 2021, that ceiling was $140,000 for a single taxpayer. In 2022, it went up to $144,000. For married couples, the maximum earnings number stands at $208,000 in 2022. The maximum amount you can put into a Roth IRAfluctuates, but it's $6,000 a year for 2021 ($7,000 if you’re over the age of 50)

Approximately 37% of American adults own a Roth IRA. Another 29% own a traditional IRA — a similar vehicle but with a different tax structure. Six in ten of these IRAs were funded by rolling over 401(k) assets into IRAs.

When Would You Want to Convert Your 401(k) to a Roth IRA?

Since 2008, Americans have been able to directly convert their 401(k) plans to Roth IRAs. Why would you want to do that?

 Most frequently, people rollover their assets because they change jobs or get laid off. You must have separated from an employer to transfer your assets from a 401(k) to a Roth. The other primary reason for rolling overassets is simple — the investor retired.[CCWML1] 

 When a rollover happens, most people rollover all of their assets from one account to another, but some keep a small percentage in the first account. [CCWML2] 

Why Would You Choose a Roth over a Traditional IRA or an Annuity?

Generally, people choose to convert to a Roth when they believe they are headed into a higher tax bracket in the future. That's because you won't pay taxes on distributions from a Roth after retirement.

Another good reason for choosing a Roth is the belief that your income will increase. While current tax law does not restrict Roth conversions based on income, contributions to a Roth IRA are. Let's say you think you (or you and your spouse together) will earn more than the maximum allowable to contribute to a Roth in the future. You may want to invest in a Roth now and open a traditional account later so you can diversify your tax structure.

 Finally, you may choose to convert your 401(k) to a Roth if you wish to hold off on making withdrawals for as long as possible. Federal law requires investors to take withdrawals from traditional IRAs and some other vehicles beginning at age 72Roth IRAs do not contain this stipulation.

When Does Conversion Not Make Sense?

Is a 401(k)-to-Roth conversion always the best choice?

 No, it isn't. That's why it's important to consult with a tax expert and a wealth management advisor before making changes to your retirement accounts or other investments. If you believe you will need access to your retirement funds before age 59 ½, for example, you probably shouldn't convert them. You'll face penalties from withdrawing from a Roth that you may not have on a 401(k).

 In general, the best approach is to ask yourself: What will my tax bracket look like post-retirement?

 If you’re in a higher tax bracket before retirement, you likely won’t want to convert your 401(k) to a Roth.

 Keep in mind, current tax law contains a sunset clause for 2025, and all tax brackets will go back to what they were before the 2018 Tax Cuts and Jobs Act (TCJA). This means your current tax bracket is likely to increase slightly after 2025. The TCJA made many alterations to federal taxes, and future legislation could do the same. Again, always check with a professional before making money moves.

Taking Advantage of Wealth Management Advisors

Complex IRS rules, an array of investment choices, and the factors that determine the right approach to retirement planning all make choosing a conversion strategy challenging.

 At Cooke Wealth Management, our qualified financial advisors can sit down with you one-on-one to determine what approach is right for you and your family. We provide wealth management services in Orange County, CA 92612-92614 zip codes and beyond.

 Contact us today to learn more about rolling over your 401(k).

 [CCWML1]I think there might be some confusion between a “rollover” and a conversion…

The primary reason for converting assets is simple – tax advantages.

 [CCWML2]If we are talking about conversions here… I don’t know that this is the case. For someone to retire and convert their full 401k account would likely result in large tax consequences. Or at least this would be the case for our target audience.