An employer-sponsored 401(k) retirement plan is one of the best ways to save for retirement. They’re easy to set up, you can contribute directly from your paycheck and you receive significant tax benefits by participating. Your employer may even match your contributions up to a certain amount, which is free money!
But in certain situations you may need to move the money in your existing 401(k) to another plan, commonly known as a 401(k) rollover. The process is simpler than you might think, but there are important decisions to make before you determine the best way to roll over your funds.
Here’s how to roll over a 401(k).
What is a 401(k) rollover?
When you leave a job, you’re no longer allowed to make contributions to that employer’s 401(k) plan or take advantage of company matching. For this reason, people generally roll over a 401(k) when they change jobs or retire.
While there are many options for what to do with your existing 401(k), it often makes sense to roll it over for convenience, affordability or greater investment choices.
Moving your 401(k) into another plan could save you money in the long run or give you more freedom. Lower fees and a broader selection of investments in an independent retirement account or another employer-sponsored plan are two big motivators for a rollover, said Ryan Firth, certified public accountant and president at Mercer Street, a financial and tax services firm.
When you shouldn’t roll over your 401(k)
There are some reasons why you may choose not to roll over your 401(k):
- In some states, 401(k) plans are better protected against claims from creditors and bankruptcy than individual retirement accounts (IRAs).
- 401(k) plans don’t force you to take required minimum distributions (RMDs) at age 70 ½ if you are still working for your employer, while IRAs will require you to make withdrawals at age 70 ½.
- In some cases the fees and investment options in your existing 401(k) plan might be better than the options that are available to you via a rollover.
Understand all the options for your old 401(k)
Before you decide to roll over your 401(k), you should fully understand all the possibilities available to you. In some situations you have many options, while in others your choices may be limited.
Leave your 401(k) where it is
If you have over $5,000 in your 401(k) you can leave it where it is. You won’t be able to make contributions anymore, but your investments can continue to grow and you can start taking distributions once you’re eligible in retirement.
This is a good strategy if you don’t want to bother with a rollover and you like your existing 401(k). But keep in mind this could be more costly than rolling over into a more affordable plan, because of the fees associated with the account. Plus, you won’t have access to your old employer’s HR department or other resources that will help you manage your account.
Cash out your 401(k)
You also have the option to cash out your 401(k) and do what you please with the money, but this option is almost never a good idea. Unless you’re at least 59 ½ years old, cashing out is considered an early withdrawal and you’ll pay a 10% early withdrawal tax. Plus, your employer will withhold 20% of your withdrawal to prepare for the taxes you owe.
If your plan has under $1,000 in it, your old employer may force you to take a check and withhold the 20%. If it is between $1,000 and $5,000, your employer may still force you out of the plan but must help you roll it over into an IRA.
Roll over your 401(k) into your new employer’s plan
If you’re moving to a new employer, you may want to roll your old 401(k) into your new employer’s plan. Your investments can continue to grow in a tax-advantaged plan, your retirement plan won’t be split between multiple accounts and you can continue to make contributions as you always have.
Take a look at your new employer’s plan fees and investment options before you decide to roll over. If you don’t like your new employer’s plan, you may want to keep your old 401(k) where it is or look at alternative rollover options.
According to the IRS, your new retirement plan is not required to accept rollovers, so check with your plan administrator to find out if they’re allowed.
Roll over your 401(k) into an IRA
You can also roll your 401(k) balance into an IRA, a tax-advantaged savings plan that lets you contribute and invest funds on your own, outside of your employer. IRAs can be useful when you don’t have access to an employer-sponsored plan or you’re maxing out your 401(k) contributions and you want to save more. They also might have lower fees and greater investment options than a 401(k).
You can roll over your 401(k) into a traditional IRA, in which your contributions and earnings are tax-deferred until you make withdrawals in retirement, or a Roth IRA, in which your contributions are taxed at the normal rate but your earnings grow tax-free:
- Rolling over a traditional 401(k) into a traditional IRA is usually a seamless process.
- Rolling over a Roth 401(k) into a Roth IRA can be completed without any steps in between, but you need to be careful and check what happens with any employer contributions.
- Rolling over a traditional 401(k) into a Roth IRA will require you to make a stop in a traditional IRA before converting it.
“Traditional [IRAs] can be rolled into Roth, but then taxes will be owed on income. If Roth, make sure it isn't accidentally characterized as a traditional (i.e., deferred tax) account when rolled over,” said Firth.
You will need to open an IRA plan with a brokerage firm or financial institution on your own, as they are not sponsored by employers.
How to roll over your 401(k)
Whether you choose to move your current 401(k) into an IRA or a new employer plan, eventually it’s time to actually implement the rollover and transfer the money. You have two options: a direct rollover or an indirect rollover.
With a direct rollover, your current 401(k) plan administrator will simply cut a check directly to your new plan administrator instead of distributing the money to you. The money will transfer from your 401(k) to your new plan.
You will need to contact your 401(k) provider and ask for a direct rollover. The distribution may be issued as a check to the new account, and no taxes will be withheld from your transfer (unless you are transferring from a traditional plan to a Roth account).
With an indirect rollover, the distribution will be sent directly to you via check. You then have 60 days to deposit your distribution in a new plan before it becomes a taxable event and you’ll owe taxes on the entire distribution. Some people go this route to get a temporary loan before they eventually transfer the funds.
Think carefully before you choose an indirect rollover. Your employer will automatically withhold 20% for federal income taxes on the taxable portion of your distribution - which you will receive credit for if you deposit the full distribution within 60 days.
But this means you need to make up the 20% out of your own pocket when you deposit the rollover. If you don’t, the amount withheld will be considered a taxable deduction and subject to a 10% early withdrawal fee if you’re under age 59 ½.
For these reasons, it’s usually easier and safer to choose a direct rollover.
Some things to remember
When you change jobs, you have at least 30 days to decide what to do with your 401(k). If you miss the 30-day window, you may have to wait until the next enrollment period, which could be up to a year. Once the rollover is complete, you will need to choose the investments in your IRA or direct the investments in your 401(k).
There is no limit to how many times you can roll over a 401(k) in a single year. When rolling over an IRA, you are generally limited to one rollover per year.
According to the IRS, rollovers don’t count toward IRA contribution limits, so you can still contribute up to the annual limit on top of your rollover. Your same-year 401(k) contributions will count toward your annual 401(k) limit even after you roll over into a new employer plan, said Firth.
To help you learn more about retirement accounts and building your nest egg, here's some additional reading:
- Plan on opening an IRA? Check out our guide.
- Think you’re behind on retirement and what to make up? Here’s how.
- Here’s an explanation of the differences between a 401(k) and IRA.
- The IRS has a wealth of information on retirement plans, including how to choose a plan, contribution limits, calculating RMDs and much more.
Image: Bench Accounting