If you’ve been contributing to a 401(k) or employer-sponsored retirement account for several years but are now leaving your job, you may be wondering what to do with your retirement account. Do you cash out your nest egg and let the money sit in a bank account until you retire?
It may be tempting to have unrestricted access to a lump sum of cash. But unfortunately, holding your retirement in a bank account could cost you a fortune. Furthermore, the small returns generated won’t keep up with inflation and your nest egg will actually lose value.
A more suitable option: a rollover IRA. Keep reading to learn how they work, along with key benefits and how to initiate an IRA rollover.
What is a Rollover IRA?
In a nutshell, a rollover IRA is an account that is designed specifically to hold funds transferred from employer-sponsored retirement plans, including 401(k), 403(b), profit-sharing and Keogh plans.
The purpose of a rollover IRA is to keep the tax-deferred status of those assets. Rollover IRAs also offer several distinct benefits.
What are the benefits of a Rollover IRA?
When you cash out or take distributions from retirement plans, two things happen. For starters, the funds are subject to taxation and the tax deferral benefit goes out the window. And if you haven’t yet reached 59 ½, you’ll also incur a 10% early withdrawal penalty.
However, an IRA rollover allows you to avoid taxation as long as you transfer the funds properly. Even better, you’ll also escape the 10% penalty.
Other benefits:
It’s free. You read that correctly. That are no fees to open a rollover IRA and transfer the funds from your 401(k) or other employer-sponsored plans into the new account.
Low fees. You may have to pay minimal fees to cover brokerage commissions and fund expenses associated with transactions. But there are financial entities, like Schwab, that offer rollover IRAs devoid of annual or maintenance fees.
No rollover limits. Fortunately, you’re allowed to roll over all the funds in your retirement account, regardless of the amount, without incurring a penalty.
Flexible investment options. Most 401(k) plans only allow you to select from a limited pool of assets, typically in the form of mutual funds, to build your portfolio. But with a rollover IRA, you’ll be afforded the opportunity to choose from an array of assets, including stocks, ETFs, and bonds, just to name a few.
Funds can be transferred to a new employer’s plan. If you find employment elsewhere, and they offer a qualifying retirement plan, you will be able to transfer the funds from the rollover IRA to their plan if you choose to. You also have the option to leave the funds where they are.
How to Roll Over a 401K to an IRA
Direct Rollover
To ensure the funds from your 401(k) or other employer-sponsored plan are moved seamlessly, a direct transfer is the preferred option. Selecting this option also minimizes the chances of an error occurring with the transfer. You’ll also avoid having to pay taxes on your nest egg and incurring early withdrawal penalties.
Even better, it’s easy to execute direct transfers. As all you need to do is contact your former employer and request that they transfer the funds to the entity that the rollover IRA will be housed. Expect to complete paperwork on both the sending and receiving end, but it shouldn’t take too much of your time. And once you’ve done your part, the direct transfer of funds will be completed in a brief window of time.
Indirect Rollover
If you prefer to set up the new account on your own, you have the option to do what’s referred to as an indirect rollover. Rather than having your former employer send the funds directly to the new entity that will manage the rollover IRA, you’ll need to obtain the funds via check and set up the account yourself.
Another important consideration: with direct transfers, your employer usually won’t deduct income tax before sending the funds to the company in charge of managing the rollover IRA. But if you take the indirect rollover route, there’s a chance they will, to the tune of 20%.
This means you could find yourself paying this amount out of pocket to avoid incurring additional penalties and fees when opening up a new account. Even worse, you won’t be eligible to recoup the funds until you file your annual tax return.
You should also know that you have 60 days to do so, or you’ll be on the hook for federal income tax and a 10% early withdrawal fee (if you aren’t yet 59 ½ years of age or older). To give yourself the best possible chance of avoiding any issues, promptly deposit the funds and notate your rollover IRA account number on the check.
Furthermore, follow up regularly until the funds are posted to your account, and you’ve confirmed the account is all set.
Other Important Considerations
Annual Rollover Limits: In most instances, you are limited to one rollover per year.
Roth IRAs: If you’re interested in a Roth IRA, you have the option to convert the proceeds from the rollover IRA. However, you will have to pay taxes right away, as Roth IRAs are comprised of post-tax contributions and distributions are tax-free.
See also: What’s the Difference Between a Traditional IRA & a Roth IRA?
Bottom Line
Rollover IRAs are an ideal way to avoid taxation and penalties when you leave your employer and are no longer eligible to participate in their retirement plan. But, if you’re uncertain if your plan is eligible for a rollover IRA, inquire with your plan administrator to determine what options are available to you. You can also view IRS Topic Number 413 for additional guidance.
Frequently Asked Questions
Why would I want to roll over my retirement account?
There are several reasons why you might want to roll over your retirement account. For example, you may want to move your money to a new IRA with lower fees, better investment options, or more flexibility.
Can I roll over any type of retirement account into a rollover IRA?
Yes, you can roll over most types of retirement accounts into a rollover IRA, including 401(k)s, 403(b)s, and traditional IRAs.
How do I choose the right rollover IRA provider?
When choosing a rollover IRA provider, you should consider factors such as fees, investment options, customer service, and the provider’s reputation. You may also want to consider whether the provider offers any additional services, such as financial planning or investment advice.
No matter what age you are, it’s never too soon to start thinking about — and actively saving for — your retirement. With reports coming out regularly about the severe retirement savings gap in the U.S., it seems as though the majority of Americans are vastly underprepared for this life event.
If your employer offers a 401(k) at your place of work, this is a great way to get started (or continue) saving for your golden years. Before you jump in, find out exactly what a 401(k) is and how it can help you prepare for retirement. If you already contribute to a 401(k) plan, make sure you know what to expect when it comes time to retire.
How does a 401(k) work?
A 401(k) plan helps you save while investing your contributions in various mutual funds. Employers offer this type of retirement plan, so you can’t sign up for one unless you go through your place of work.
As an incentive to save, you receive a tax break. Depending on the type of 401(k) you choose (or your company offers), you either receive that tax break when you make the contribution or when it comes time to withdrawal.
Employer 401(k) Matching
Many employers offer a match to any contribution you make. This usually happens in one of two ways: they’ll either match dollar for dollar up to a certain limit or up to a percentage of your salary.
The most common type of 401(k), the traditional 401(k), allows you to make any contribution tax-deductible each year. So if you contribute $6,000 a year, you get to knock that off your taxable income amount. If you’re on the edge of a tax bracket and make a sizeable 401(k) contribution, you might even be able to jump down into a different bracket with a lower tax rate.
401(k) Tax Rules
While your investments continue to grow each year, they remain temporarily protected from taxation. Unlike other types of investments, you don’t pay any annual tax on your 401(k) earnings until you start to make withdrawals. At that point, you’ll be subject to regular income tax when you take out money each month.
As you continue to make 401(k) contributions throughout your year, you can adjust your investments to become increasingly less volatile. The idea is that as you get closer to retirement age, you have less risk to ensure a solid nest egg when you need it.
The Benefits of a 401(k)
A 401(k) is a retirement savings plan sponsored by an employer. It allows employees to save and invest a portion of their paycheck before taxes are taken out. Contributions to a 401(k) are made with pretax dollars, which can lower your taxable income in the current year and potentially result in a lower tax bill.
Some other benefits of a 401(k) include:
Employer matching contributions: Many employers will match a portion of their employees’ 401(k) contributions, effectively giving you free money to save for retirement.
Tax-deferred growth: Any investment earnings on your 401(k) account grow tax-free until you withdraw the money in retirement.
Potential for tax credits: Depending on your income and participation in a 401(k) or other qualified retirement plan, you may be eligible for certain tax credits that can help reduce your tax liability.
Retirement income: A 401(k) can provide a source of income in retirement, which can help you maintain your standard of living when you are no longer working.
Convenience: Many 401(k) plans offer a range of investment options, and the contributions are automatically deducted from your paycheck, making it easy to save for the future.
The money you withdraw from a 401(k) in retirement is subject to income tax, and 401(k) plans have contribution limits. However, overall, a 401(k) can be a valuable tool for saving for the future and reducing your tax liability.
401(k) Contribution Limits
There are limits to your 401(k):
While it’s a great financial tool, you can only contribute up to $22,500 each year, amounting to $1,875 per month if you divide it out monthly. If you’re over the age of 50, you’re allowed to contribute up to $30,000 a year ($2,500 per month). These contribution limits are in place so that you can only benefit from so much tax savings each year.
Required Minimum Distributions
Another rule associated with a 401(k) is that you must start taking “required minimum distributions” at some point. That means once you hit a certain age, you must begin withdrawing funds from your 401(k) account — and paying taxes on them.
Currently, the requirement is that you start taking distributions the year after you turn 70 ½. Then you have to take out distributions by December 31 of each following year. Your minimum required amount is determined by the IRS based on your life expectancy. There’s nothing quite like a government tax agency predicting your lifespan, is there?
Still, this information helps you determine what kind of tax burden you can expect when you’ve finally retired. While your income may be lower, your deductions might be as well. After all, you probably don’t have kids left at home to claim as a deduction. And if you’ve paid off your mortgage, you won’t have that interest to deduct either.
It’s great not to have those expenses, but it can be helpful to talk to a tax professional to get a better idea of your taxes, especially in that first year of retirement or required minimum distributions. The more prepared you are, the more financial flexibility you can have!
401(K) Plan Types
There are two main types of 401(k) plans: traditional 401(k)s and Roth 401(k)s.
A traditional 401(k) allows you to contribute pretax dollars to your account. Your contributions and any investment earnings in the account are tax-deferred. This means you won’t have to pay taxes on them until you withdraw the money in retirement. When you withdraw the money in retirement, it is taxed as ordinary income.
A Roth 401(k) is similar to a traditional 401(k), but contributions are made with after-tax dollars. This means you won’t get an immediate tax break on your contributions, but qualified withdrawals from the account in retirement are tax-free.
Some 401(k) plans may offer both traditional and Roth options, allowing you the flexibility to choose the type of plan that best meets your needs.
There are also types of 401(k) plans that are designed for specific types of employers, such as safe harbor 401(k)s and SIMPLE 401(k)s. These plans may have different contribution limits and rules for employer matching contributions. So, it’s important to understand the details of the plan you are enrolled in.
What’s the difference between a traditional 401(k) and a Roth 401(k)?
While a traditional 401(k) offers upfront tax savings in return for taxes paid later during retirement, a Roth 401(k) flips the situation around. Instead, your contributions are made with your taxable income. In return, you don’t have to pay any taxes when you start withdrawing from your account during retirement.
While you miss out on tax savings upfront, you’re only paying on the original contribution amount. If you had to pay taxes when you withdraw, you’re also paying taxes on everything you’ve earned, which is hopefully a lot more money than you started with.
Roth 401(k) Requirements
There are requirements to qualify for the Roth 401(k) benefits:
First, your account must be open for at least five years. You also have to wait until you’re at least 59 ½ before you can start taking distributions, unless you’ve had a disability.
A Roth IRA is particularly useful if you’ve accumulated a lot in retirement savings and other investments. While many people have less income when they retire, that’s not always the case. You may have a comprehensive portfolio of investments, in which case you could be better served by not paying taxes on at least part of your withdrawals.
If you’re nearing retirement and expect to drop in your tax bracket soon, there may be no sense in using a Roth 401(k) now. A Roth 401(k) can be a great choice if you have a lower income now because you’re earlier in your career or have tons of tax deductions because of kids and a mortgage.
Like all retirement plans, there are better products for different points in your life. By constantly reassessing how you contribute to your retirement savings, you can maximize your tax benefits now and in the future.
See also: IRA vs. 401(k): Where Should You Invest Your Money?
Employer Contribution Match
An employer contribution match is a feature of some 401(k) plans in which the employer agrees to contribute a certain amount of money to an employee’s 401(k) account based on employee contributions.
For example, an employer might offer a 50% employer match on the first 6% of an employee’s salary that the employee contributes to their 401(k) account. In this case, if the employee contributes 6% of their salary to their 401(k), the employer would contribute an additional 3% (50% of the employee’s contribution).
Employer contributions are a way for employers to encourage their employees to save for retirement and to provide an additional source of retirement income for their employees. Employers may also use contribution matching as a way to attract and retain top talent.
Employer contribution matches may have certain rules and requirements, such as vesting periods, that determine when an employee becomes fully entitled to employer contributions. Make sure you understand the details of any employer contribution match offered by your employer to make the most of this benefit.
What happens if you leave your job?
Don’t worry. You don’t lose your 401(k) savings if you leave your current employer. You typically have a few different options available to you. First, you can leave it in the company plan if they allow it. You won’t be able to continue making contributions or any changes to your allocations. But you can access it when you’re ready to retire.
401(k) Rollover
Or you can do a rollover:
A rollover allows you to switch the funds to another retirement plan without paying any tax penalties. You can either do an IRA rollover or use a plan from your new employer. You do need to make sure your new employer’s plan allows for rollovers.
Then you can continue your contributions as normal, following the rules of the new account, whatever it may be. An IRA is always a viable option because you’re in control of how you invest. And while the annual contribution limit is $6,500 (or $7,500 if you’re 50 or older), it doesn’t count when you’re rolling over funds.
Your final option for handling your 401(k) when you leave your job is to cash it out. If you do this, you’ll be subject to all the relevant penalties. These include a 10% early withdrawal penalty and income taxes for both federal and state. The exception to the early withdrawal penalty is if you are at least 55 years old when you leave your employer.
How much should you contribute to your 401(k)?
How much you decide to contribute to your 401(k) should depend on numerous factors. At the very least, you should contribute the maximum amount allowed to receive a matching contribution from your employer. That essentially equals free money, which you should never pass up.
Next, think about your financial picture as a whole. What kind of debt do you have? If you have any high-interest credit card or loan balances, you may want to focus your efforts on paying those down before contributing more to your retirement plan. Lower interest debts, like a fixed student loan, may not be as pressing to repay.
Furthermore, consider these recommended saving strategies:
Emergency Fund
You’ll probably want a three to six-month emergency fund in case you lose your job or get a sudden illness or injury. Having a large chunk of money stashed away in an easy-to-access savings account can provide you with financial security here and now.
Roth IRA
Once you’ve got your overall savings plan in order, it’s time to start figuring out where else to invest for retirement. Before you max out your traditional 401(k), think about picking up a Roth IRA. This helps you diversify your retirement plans for tax purposes.
Like a Roth 401(k), a Roth IRA lets you pay taxes on your contributions now, so you don’t have to pay anything when you make withdrawals during retirement. It can certainly help you spread out your tax burdens over the course of your life.
Still have money left over to invest?
If you do, revisit your 401(k). Remember, you can contribute up to $22,500 so you can certainly divert more of your income towards that maximum.
How else should you prepare for retirement?
Preparing for retirement takes a constant reassessment of your current needs versus your future goals. As easy as it is to say, “You need to contribute this-many-thousands of dollars a year to survive retirement,” the reality is that it’s much harder to actually do that.
But saving for retirement is still a challenge worth conquering. Even if you’re in your 40s and haven’t started saving a dime, you can start today. Once you’ve got your current savings fund in place that you can use for emergencies, implement some of these easy tips to get ready for retirement.
For now, worry less about picking the perfect type of account and focus on the habit of retirement saving.
Here are some ideas to get you started:
How to Save Extra Money:
Downsize your living expenses, one step at a time.
Place your tax refund into a retirement account.
Stream television instead of paying for cable.
Cut back on eating out.
Stay healthy to reduce future healthcare costs.
Pay down high interest debt like credit cards.
Sell your stuff and put the money towards retirement.
How to Strategically Manage Your Retirement Accounts:
Create a retirement savings goal as a percentage of your income.
Pay yourself first by setting up auto direct deposit to your retirement account on payday.
Take advantage of higher IRA contribution limits when you’re 50+.
Audit your accounts every year.
Consolidate multiple accounts (like IRAs) to reduce fees.
Put your end-of-year bonus into a retirement account.
Bottom Line
Investing in your retirement is really investing in yourself. Taking advantage of your employer’s 401(k) is an important part of the equation. In addition to making regular contributions, be sure to explore all of your options for financing your retirement. A healthy portfolio mix isn’t difficult to develop, and there are plenty of resources available to help you get started.
The U.S. Bureau of Labor Statistics estimates that Americans change jobs about 10 times between the ages of 18 and 42. If job changers had a 401k account at just half of those positions, it would represent a significant money management challenge: multiple redundant investment portfolios and a mountain of account statements and investment documentation to sort through.
One flexible solution to simplify the task is to consolidate assets under a single account umbrella via a 401k rollover to IRA. Offered by many financial institutions, the rollover IRA can help you streamline your investments into a unified asset allocation plan. (Remember: In addition to 401k’s, this could also include 403b’s, 457’s, Pension Plans, Simple and SEP IRA’s)
If you enjoyed this article be sure to check out: How to Rollover Your 401k into a Roth IRA, Consolidate Retirement Assets with a Super IRA, How to do an In-Service 401k Distribution While You’re Still Working.
401k to Rollover IRAs Offer a Wide Range of Benefits
As compared with employer-sponsored retirement accounts, a rollover IRA can provide a broader range of investment choices and greater flexibility for distribution planning. Consider the following benefits rollover IRAs offer over employer-sponsored plans:
Simplified investment management. You can use a single rollover IRA to consolidate assets from more than one retirement plan. For example, if you still have money in several different retirement plans sponsored by several different employers, you can transfer all of those assets into one convenient rollover IRA.
More freedom of choice, control. Using a rollover IRA to manage retirement assets after leaving a job or retiring is a strategy that’s available to everyone. And depending on the financial institution that provides the rollover IRA, you could have a wide array of investment choices at your disposal to help meet your unique financial goals. As the IRA account owner, you develop the precise mix of investments that best reflects your own personal risk tolerance, investment philosophy and financial goals.
More flexible distribution provisions. While Internal Revenue Service distribution rules for IRAs generally require IRA account holders to wait until age 59½ to make penalty-free withdrawals, there are a variety of provisions to address special circumstances. These provisions are often broader and easier to exploit than employer plan 401k hardship withdrawal rules.
Valuable estate planning features. IRAs are more useful in estate planning than employer-sponsored plans. IRA assets can generally be divided among multiple beneficiaries, each of whom can make use of planning structures such as the stretch IRA concept to maintain tax-advantaged investment management during their lifetimes.In addition, IRS rules now allow individuals to roll assets from a company-sponsored retirement account into a Roth IRA, further enhancing the estate planning aspects of an IRA rollover. By comparison, beneficiary distributions from employer-sponsored plans are generally taken in lump sums as cash payments.
Efficient Rollovers Require Careful Planning
There are two ways to execute a 401k Rollover to IRA — directly or indirectly. It’s important you understand the difference between the two, because there could be some tax consequences and additional hurdles if you aren’t careful. With a direct rollover, the financial institution that runs your former employer’s retirement plan simply transfers the money straight into your new rollover IRA. There are no taxes, penalties or deadlines for you to worry about.
With an indirect rollover, you personally receive money from your old plan and assume responsibility for depositing that money from the 401k into a rollover IRA. In this instance, you would receive a check representing the value of the assets in your former employer’s plan, minus a mandatory 20% federal tax withholding. You can avoid paying taxes and any penalties on an indirect rollover if you deposit the money into a new rollover account within 60 days.
You’ll still have to pay the 20% withholding tax and potential penalties out of your own pocket, but the withholding tax will be credited when you file your regular income tax, and any excess amount will be refunded to you. If you owe more than 20%, you’ll need to come up with the additional payment when you file your tax return.
Potential Downsides of IRA Rollovers
While there are many advantages to consolidated IRA rollovers, there are some potential drawbacks to keep in mind. Assets greater than $1 million in an IRA may be taken to satisfy your debts in certain personal bankruptcy scenarios. Assets in an employer-sponsored plan cannot be readily taken in many circumstances.
Also, with a traditional IRA rollover, you must begin taking distributions by April 1 of the year after you reach 70½ whether or not you continue working, but employer-sponsored plans do not require distributions if you continue working past that age. (Roth IRAs do not require the owner to take distributions during his or her lifetime.)
Remember, the laws governing retirement assets and taxation are complex. In addition, there are many exceptions and limitations that may apply to your situation. Before making any decisions, consider talking to a financial advisor who has experience helping people structure retirement plans.
When you leave your job, either voluntary or not, you have to make an important decision regarding your 401(k). Many aren’t familiar with all their options on what they can do with their 401(k), but making the wrong choice could cost you. Most people are familiar with the 401(k) rollover concept but still need some help through the process. Here are your options if you are faced with this decision.
Cashing out is not the Best Option
What money you put it in yourself, you can cash out and take it with you. If your employer has a match, you maybe subject to some sort of vesting schedule. Many people choose to cash out their 401k’s. The most common reasoning I here, especially for 401k plans that have matching, is that it’s “The company’s money” not “theirs“. Wow! Isn’t that great reasoning?
By taking “The company’s money”, now that person is stuck with a 10% early withdrawal penalty plus ordinary income tax. Typically, when you cash directly from your 401k they will hold 20% standard plus the 10% early withdrawal penalty.
If you really need money, you could consider borrowing from your 401(k). The problem here is that most companies want the loan balance paid off when you leave – whether you leave work by choice or not.
Leave your 401k alone.
You always have the option to just leave the money with your old plan. The money will remain invested, and the financial firm handling your 401(k) will keep mailing you quarterly statements telling you how it is doing. Any future growth will be tax-deferred.
But this passive choice comes with an opportunity cost. If you just leave the 401(k) assets in the plan, you’re giving up control and flexibility. Your investment choices may be limited, the plan fees may be high, and you may not be able to quickly access your money or do what you want with it. If you have a trail of old 401(k)s left with a bunch of former employers, things can get really complicated when you retire – especially when you have to take Required Minimum Distributions (RMDs). Leaving the money in the plan may not be the wisest choice.
Transfer the 401k to a New Employer
Most people have the option to transfer their old 401k into their new 401k with the new employer. In the past, this used to be more difficult, but with recent government regulation changes, it’s much easier. While this could be a good decision, a lot depends on the new options that are in the new 401k.
You could roll your 401k into an IRA
This is the choice that usually makes the most sense. You can move the money into an IRA through a rollover or trustee-to-trustee transfer. Or, you could direct the money into a so-called “conduit IRA,” a traditional IRA created to hold your old 401(k) assets until you move the money into another qualified retirement plan.
There’s no tax penalty when you do an IRA rollover or trustee-to-trustee transfer. After you do it, you have total control of the money, continued tax-deferred growth, expanded investment choices, and possibly lower account management fees.
Rolling over the money into a Roth IRA might be a great move, provided you can meet two conditions. First, your adjusted gross income has to be less than $100,000 for the year in which you make the rollover. Second, you’ll have to pay taxes on the assets you convert. The upside is considerable: you get tax-free compounding, tax-free withdrawals if you are older than age 59½ and have owned your account for at least five years, and the potential to make contributions to your IRA after age 70½ without having to take RMDs. Contributions to a Roth IRA are not tax-deductible, but there are fewer restrictions on withdrawals.
In 2009, you can fund a Roth IRA with after-tax contributions to a 401(k), 403(b) or 457 retirement savings plan – you can take those contributions and convert them to a Roth IRA tax-free, provided your AGI is $100,000 or lower. There is no limit on the conversion amount. Incidentally, in 2010, anyone can convert a traditional IRA to a Roth IRA – the AGI restriction on such conversions disappears.
What if you have to shiver through a 401(k) freeze?
A “freeze” is when your employer reduces or suspends matching contributions to your retirement plan. FedEx, General Motors and Motorola have all recently chosen to do this. The answer: don’t let up on your personal contributions. If you can manage it, adjust your 401(k) contribution to a level where you effectively replace what your employer contributed. Saving for retirement should remain one of your highest priorities.
If you still need help with your 401(k) rollover, be sure to seek counsel from a Certified Financial Planner™ professional.
By Peter Anderson2 Comments – The content of this website often contains affiliate links and I may be compensated if you buy through those links (at no cost to you!). Learn more about how we make money. Last edited April 17, 2013.
If you’re leaving a job that you’ve been at for a while it can be tough to think about much else beyond trying to find a new job, or getting acclimated to your new one. There are resumes to brush up on, skill sets to improve and connections to make.
There are other things that you need to think about beyond a new job, however, that are important as well. Things like doing a 401k rollover from your old job’s plan to an IRA you’ve set up on your own.
So where do you start?
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What Are Your 401(k) Options When Leaving A Job
When you’re leaving a job, you have several different options of what to do when it comes to your 401(k).
Leave it in the current plan: You can just leave your 401(k) where it is and not touch it. If you’ve got a great plan that has good low cost investments and low fees, you may want to consider doing this. The thing is, usually you can do better to moving to your own IRA through a discount brokerage or mutual fund company.
Cash it out: You can choose to cash out your 401(k) plan when you leave the job. Honestly though I think this is an awful idea because if you’re not 59 1/2, you’ll be subject to a 10% early withdrawal penalty, along with your current combined state and federal tax rates. Assuming you have a combined rate of 35%, and a penalty of 10%, you’re only going to be left with 55% of your money. If you had $100,000 in the account, you’ll be left with $55,000 after penalties and taxes. Don’t lose out on all that money just by withdrawing it early.
Roll it over to an IRA: Rolling over your 401(k) to an IRA that you’ve set up at an external brokerage or company like Vanguard is probably the best option. It will allow you to have access to more and better funds, lower costs and more control.
Roll over to a new 401(k): If you already have a new job and 401(k), you may want to consider rolling the funds over if it’s a good plan. Typically you can do better rolling to an IRA, however.
So when it comes down to it, my suggestion is to roll the funds over to your own IRA at a company like Vanguard, or a discount brokerage.
Reasons To Rollover Your 401(k) To An IRA
There are a variety of reasons why you may want to rollover your 401(k) to your own IRA once you’ve left your old job. Here are a couple of the biggest:
Better investment options in an IRA: When you invest in your company sponsored 401(k) the plan that they have set up may not have that many investment options, or the ones that they do may not be the greatest. Many only offer one index fund, something like a S&P 500 index fund, and a few other low cost options. Rolling over your funds will give you more investment options in order to maximize your returns.
Lower fees in an IRA: Quite often a 401(k) through your company will have a bunch of pre-selected mutual funds that don’t have very good expense ratios. On top of that the plan may have an annual management fee or other miscellaneous fees. By moving to your own IRA you can select low cost mutual funds and index funds that will allow you to cut down on expenses.
It should be stated that there area few situations where you may not want to rollover your 401(k), but I won’t go over those here as they’re few and far between. Situations like if you’re retiring early, planning a roth conversion, or situations where you’re dealing with a large amount of company stock.
How To Rollover Your 401(k)
When you’ve decided to rollover your 401(k) to an IRA, there are a few steps you’ll need to go through.
Open an Individual Retirement Account (IRA): If you haven’t already, open an IRA at a discount brokerage, or mutual fund company. Here’s a post looking at how to choose a IRA custodian.
Contact your old 401(k) provider, get forms: You’ll want to contact the provider of your old 401(k) to verify that you don’t have any limitations on rolling over funds. Then request the forms you’ll need in order to initiate the process. Make sure to ask what information you’ll need from your new IRA plan.
Contact your new IRA provider, verify account setup: You’ll want to talk to your new plan administrator, whether it is a discount brokerage or company like Vanguard, and verify that your account is ready to receive transferred funds. Next, verify any information that you need for the old 401(k)’s transfer forms.
Fill out the forms, verify direct rollover of funds: When you have the forms, make sure that they are completely and correctly filled out to ensure no costly mistakes. Make sure that you’re asking for a trustee-to-trustee transfer or direct rollover of the funds. Have them send the check directly to your new IRA company. If your old company does an indirect rollover and cuts a check for the balance of your 401(k) in your name they will withhold 20% for taxes. You are then required to deposit the total amount of your balance (before 20% was deducted) into your new 401(k), or you could be subject to taxes and a 10% penalty for the amount under your total balance – a penalty for early withdrawal. For example, if you have $100,000 being rolled over, in an indirect rollover the company would cut a check for $80,000 and withhold $20,000 for taxes. Then you are required to take the $80,000 plus $20,000 of your own money and deposit it at your new IRA within 60 days, or be subject to taxes and penalties. The extra 20k that was withheld for federal taxes will be returned when you file your return as long as you deposit all 100k in your new plan.
401(k) To IRA Rollover Conclusion
Leaving an old job can be stressful, and sometimes it can be a pain to try and roll over on old 401(k) – but it’s an important thing to investigate.
Typically your best bet is going to be either to roll your funds over to an IRA with a discount brokerage or mutual fund company, and to do a direct rollover of funds so you don’t have hairy tax situations to mess with. There are other options to take, so make sure to investigate it for your own situation and proceed down the best path for you.
Typically, most people automatically assume they should roll over their old 401(k) into a traditional IRA. However, a lot of people have been asking about another option lately – and that’s whether you can roll your 401(k) over into a Roth IRA instead.
Fortunately, the definitive answer is “yes.” You can roll your existing 401(k) into a Roth IRA instead of a traditional IRA. Choosing to do so just adds a few additional steps to the process.
Whenever you leave your job, you have a decision to make with your 401k plan. Most people don’t want to let an old 401(k) sit idle with an old employer, and could benefit immensely by moving those funds somewhere that could benefit them more in the long run. Let’s see if I can help you make “cents” of the situation.
But first, let’s look at the rules behind the strategy of rolling over your 401k into a Roth IRA.
Table of Contents
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Roth IRA Rollover Rules From 401k
As a reminder, you must generally be separated from your employer to roll your 401k into a Roth IRA. However, some employers do permit an in-service rollover, where you can do the rollover while still employed. It’s permitted by the IRS, but not all employers participate.
Before January 1, 2008, you weren’t able to roll your 401(k) into a Roth IRA directly at all. If you wanted to do so you had to complete a two-step process. (Keep in mind that this would also apply to old Simple IRA’s, SEP IRA’s and 403b’s, 457, and qualified pensions, too)
Open a Traditional IRA.
Convert the Traditional IRA to a Roth IRA.
However, the law changed shortly after and this option became available. Still, just because the law has made this option available doesn’t mean you can definitely roll your old 401(k) into a Roth IRA no matter what. Unfortunately, it all depends on your plan administrator.
For example, recently I had two clients who intended to roll their old retirement plans into a Roth IRA.
One client had an old military retirement plan- Thrift Savings Plan (TSP) – and the other had an old state retirement plan. After helping each of them complete the required paperwork, I came across an interesting discovery.
The TSP rollover paperwork had a box you could mark if you wanted to roll over the plan into a Roth IRA (the instructions had been added to make sure you had a Roth IRA already established). However, the state retirement plan did not give that option.
The only option was to open a traditional IRA to accept the rollover and then immediately convert it to a Roth IRA. That certainly seemed like a hassle at the time, and it definitely was.
However, this man’s state retirement plan is not the only one I’ve encountered with these extra “rules.” Many 401(k)’s and 403(b)’s come with the same “No-Roth IRA Rollover” option. This option was supposed to be mandatory in 2010, but some still do it on a voluntary basis.
At the end of the day, this means you should explore this option thoroughly before automatically assuming it would work in your case. Ask questions, consult your financial advisor, and read through all of your rollover paperwork carefully before you begin moving in this direction.
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Recap on Roth IRA Conversion Rule
These days, nearly anyone can take all of their traditional IRAs and old retirement plans and convert them to a Roth IRA. The amount you convert will be taxed, but it still can be an attractive move for those that feel that taxes are going nowhere but up.
How Do I Rollover if I Receive the Check?
If you receive a distribution check from your 401(k) rollover to a Roth IRA, then chances are good they will hold around 20% for taxes. If you want a direct 401(k) rollover to a Roth IRA, you may want to send that check back to your employer 401(k) provider and ask to be sent all of your eligible retirement distribution directly to your new Rollover IRA account (not as a check, or they will just give you 80% again).
You have 60 days upon receiving the check to get the money into the Roth IRA- no exceptions! So don’t procrastinate on this one.
What About the Roth 401k?
If your employer offers a Roth 401k and you were savvy enough to take part, the path to a rollover will be much easier. When you’re converting one Roth product to another, there is simply no need for conversion. You would simply roll the Roth 401(k) directly into the Roth IRA with the help of your plan provider.
Roll Your 401(k) by Following These Steps
You have to have a Roth IRA open/established before you can do any of this.
Ask your plan provider about the paperwork required to roll your plan over, then complete the paperwork in a timely manner.
Enjoy the tax-free growth of your Roth IRA!
4 Signs It Makes Sense to Roll Your 401(k) into a Roth IRA
If you’re thinking of rolling your 401(k) into a Roth IRA instead of a traditional IRA, you have plenty of reasons to do so. Not only do Roth IRAs let you invest your dollars in the same investments as traditional IRAs, but they offer additional perks that can help you save money down the line. Here are four signs that a Roth IRA might actually be your best bet.
1. You expect to pay higher taxes in the future.
Since Roth IRAs use after-tax dollars, you’ll have to pay taxes upfront on any funds you roll over. However, you won’t have to pay taxes on your distributions, which could be extremely beneficial if you’re taxed at a higher rate when you reach retirement. You’ll pay taxes either way – now or later. But with a Roth IRA, you can rest assured your withdrawals will be tax-free.
2. You want to take withdrawals when you’re ready, and not a minute before.
While traditional IRAs force you to begin taking withdrawals at age 70 ½, Roth IRAs do not have this stipulation. Because of this, you can squirrel your Roth IRA funds away until you’re ready to use them.
3. You expect to earn more money in the future.
If you plan to earn lots of money in the future – or earn a high income now – you should consider rolling your funds into a Roth IRA instead of a traditional IRA. For single filers in 2023, the maximum income allowable for contributions to a Roth IRA starts at $138,000 and ends at $153,000. Learn more about Roth IRA rules and contribution limits here.
For married filers, on the other hand, the ability to contribute to a Roth IRA begins phasing out at $218,000 and halts completely at $228,000 for 2023. The more you earn in the future, the harder it will become to contribute to a Roth IRA and secure the benefits that come with it.
4. You want to increase your tax diversification.
Contributions to traditional IRAs are tax-advantaged, meaning you won’t pay taxes on your invested funds until you begin taking withdrawals at retirement. Roth IRAs, on the other hand, are taxed up front but offer tax-free withdrawals after age 59 ½.
If you’re unsure how your tax and income situation might pan out in the future, having both types of accounts – a traditional IRA and a Roth IRA – is a smart move in terms of diversifying your future tax exposure.
401k to Roth IRA Rollover Rules
Details
Eligibility
You can roll over a 401k to a Roth IRA if you have left the employer sponsoring the 401k and are no longer contributing to the plan. Some plans also allow in-service rollovers, but it’s best to check with your plan administrator for details.
Taxes
When you roll over a 401k to a Roth IRA, you will owe income taxes on the amount you convert. This is because contributions to a 401k are made with pre-tax dollars, while contributions to a Roth IRA are made with after-tax dollars.
Conversion Limitations
There is no limit on the amount you can convert from a 401k to a Roth IRA. However, the amount you convert will be added to your taxable income for the year in which you make the conversion, which could have tax implications.
Timing
You can convert a 401k to a Roth IRA at any time, but it’s important to consider the timing of the conversion carefully. If you convert when your income is higher, you will owe more in taxes.
Penalty-Free
If you are 59 ½ or older, you can convert a 401k to a Roth IRA penalty-free. If you are younger than 59 ½, you may be subject to a 10% early withdrawal penalty on the amount you convert.
The Bottom Line – Rolling Over 401k into a Roth IRA
Rolling your 401(k) into a Roth IRA is a smart decision for many investors, but it may not be right for everyone.
Some financial advisors may suggest rolling over your 401k into a Roth IRA to take advantage of the tax-free growth the account offers. While this can be a great option for some, it’s important to consider if you’ll be able to afford to pay the taxes on your contributions and earnings when you eventually withdraw them.
Before you pull the trigger, make sure to investigate all of your options and consider speaking with a tax professional. When it comes to complex investment vehicles and taxes, what you don’t know can hurt you
FAQs on Rollover 401k to Roth IRA
Can you roll over 401k to Roth IRA without penalty?
Yes, you can roll over funds from a 401(k) to a Roth IRA without incurring any penalties, but there are some important rules and restrictions to be aware of.
First, you’ll need to meet the eligibility requirements for a Roth IRA, which include having earned income and not exceeding certain income limits. If you’re eligible, you can roll over funds from your 401(k) to a Roth IRA by asking your 401(k) plan administrator to transfer the funds directly to your Roth IRA account. This is known as a “direct rollover” and it allows you to avoid paying any taxes or penalties on the funds.
However, there are limits on how much you can contribute to a Roth IRA each year, and there may be tax consequences if you exceed those limits. It’s important to consult with a financial advisor or tax professional before making any decisions about rolling over funds from a 401(k) to a Roth IRA. They can help you understand the rules and restrictions and determine if a rollover is the right move for your financial situation.
What are the disadvantages of rolling over a 401k to a Roth IRA?
There are a few potential disadvantages to rolling over funds from a 401(k) to a Roth IRA. These include:
1. Tax implications: When you roll over funds from a 401(k) to a Roth IRA, you’ll have to pay taxes on the amount you roll over. This can be a disadvantage if you’re in a high tax bracket and don’t have other funds available to pay the taxes.
2. Loss of employer matching: If your employer offers matching contributions to your 401(k), you’ll lose out on those contributions if you roll over your funds to a Roth IRA.
3. Loss of certain benefits: 401(k) plans may offer certain benefits, such as loan provisions and hardship withdrawals, that are not available with a Roth IRA. If you roll over your funds to a Roth IRA, you’ll lose access to these benefits.
Overall, rolling over funds from a 401(k) to a Roth IRA can be a good move for some people, but it’s important to carefully consider the potential disadvantages and consult with a financial advisor before making any decisions.
What is the tax penalty for rolling 401k to Roth IRA?
If you roll over funds from a 401(k) to a Roth IRA, you’ll have to pay taxes on the amount you roll over. This is because funds in a 401(k) are pre-tax, meaning you don’t have to pay taxes on them until you withdraw the funds. When you roll over the funds to a Roth IRA, you’re essentially withdrawing the funds and then depositing them into the Roth IRA, so you’ll have to claim that amount of reportable income.
Since you’re “rolling over” and not taking a distribution you won’t have to pay the 10% early withdrawal penalty if you’re under the age 59 1/2. If you do choose to this be prepared to pay the taxes on the rollover out of pocket. Otherwise if you use your 401k money to pay the taxes you will be penalized on that amount.
What is the Roth five year rule?
The Roth 5 year rule is a requirement for certain tax-free withdrawals from a Roth IRA. In order for a withdrawal from a Roth IRA to be tax-free, the account must have been open for at least 5 years and the withdrawal must be made after the age of 59 1/2. If these conditions are not met, the withdrawal may be subject to taxes and penalties.
The Roth 5 year rule applies to both contributions and earnings in a Roth IRA. For example, if you make a contribution to a Roth IRA and then withdraw it within 5 years, the withdrawal will be subject to taxes and penalties unless it meets one of the exceptions to the rule. The same is true for earnings on your contributions – if you withdraw earnings from a Roth IRA within 5 years, they will be subject to taxes and penalties unless an exception applies.
There are a few exceptions to the Roth 5 year rule, including:
-Withdrawals made to pay for qualified higher education expenses -Withdrawals made to pay for qualified first-time homebuyer expenses -Withdrawals made due to the account holder’s disability -Withdrawals made by a beneficiary of the account after the account holder’s death
It’s important to understand the Roth 5 year rule and the exceptions to it before making any withdrawals from a Roth IRA. If you’re not sure whether a withdrawal will be subject to taxes and penalties, it’s a good idea to consult with a tax professional.
By Peter Anderson2 Comments – The content of this website often contains affiliate links and I may be compensated if you buy through those links (at no cost to you!). Learn more about how we make money. Last edited April 17, 2013.
A couple of weeks ago I wrote a post talking about how a lot of folks forget to do a 401k to IRA rollover when they leave their old jobs. Instead, the money just sits in their old company’s 401(k) account, regardless of whether they can find a better plan with more available investments and lower plan costs. In the long run it can mean a difference of thousands of dollars by not switching to a lower cost plan. I’d highly recommend looking into doing a rollover as in many cases it will give you more flexibility and control – as well as saving you money.
One thing that I hadn’t realized was possible to do until I was researching that last post was the fact that in some cases you can do a direct 401(k) to Roth IRA rollover when moving on to another job. If you’re one of those folks who believe that the tax rates will be higher in retirement, it might make sense to look into doing one of these when you separate service with your current company.
401(k) to Roth IRA Rollover
A lot of people don’t realize that you can do a direct 401(k) to Roth IRA rollover. Up until a few years ago you actually couldn’t. You would have had to do a 401(k) to traditional IRA rollover first, and then convert that traditional IRA into a Roth IRA, paying taxes on the conversion in the process.
The Pension Protection Act of 2006 changed the two step process and made it possible for people who were separating service from one company to be able to do a direct rollover of company plan 401(k) funds to an existing Roth IRA account, without going through the extra step of rolling over to a traditional IRA.
So, as of the passage of the PPA, company retirement plan assets, including those from 401(k), 403(b) and 457(b) governmental plans, can now be converted directly to a Roth IRA.
401(k) to Roth IRA Rollover Rules
There are some things you need to remember when doing a direct rollover from a 401(k) to a Roth IRA.
To do a rollover from a 401(k) to a Roth IRA you must have left the job where you got the 401(k).
Funds that you’ve rolled over from the 401(k) that would have otherwise been taxed at retirement, must be included as income for the year of the conversion. In other words, you’ll need to pay taxes on those rolled over funds as income since the Roth isn’t taxed at retirement.
If you’re rolling over to a Roth IRA and will have taxes due – you must pay the taxes with funds from outside of the account. Otherwise, if you’re younger than 59 1/2, you’ll be subject to penalties for early withdrawal.
Make sure to do a direct trustee to trustee transfer to ensure no funds are withheld for taxes, as is done with a 60 day rollover where 20% is withheld, and you receive a check to do the transfer yourself.
It should be noted that the owner of a Roth IRA must have had the account for 5 years, and be at least 59 1/2 in order for tax free withdrawals to be made.
Not All Company Plans Have 401(k) to Roth IRA Option
One thing to note is that unfortunately not all company plans allow or have a provision for a direct 401(k) to Roth IRA rollover. If that is the case with your company plan, you’ll have to go the extra mile and roll the 401(k) over to a Traditional IRA first, and then convert it to a Roth IRA afterwards.
It should be noted that any Roth 401(k) funds, since they are contributed after taxes have been levied, would be able to transfer directly over to a Roth IRA regardless.
Who Does A 401(k) To Roth IRA Rollover Make Sense For?
Typically doing a rollover from a 401(k) to a Roth IRA would make the most sense for someone who has a longer time horizon in order to invest, and for those who anticipate seeing a higher tax rate in retirement. It also makes more sense for those who actually have the cash on hand to be able to pay the extra tax bill that will be associated with adding the converted funds to the AGI when figuring taxes. Make sure to talk with a financial professional before heading down this road in order to fully understand the consequences for your taxes. Have you done a direct 401(k) to Roth IRA rollover, or are you considering doing one when leaving a job? Tell us your thoughts in the comments.
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