401(k) Rollover: Transferring Your Retirement Savings to an IRA

Changing jobs is always a busy time. You need to tie up loose ends at your old job, learn the ropes at your new position, maintain your professional network, and a host of other activities. One thing you shouldn’t stress about is deciding what to do with your 401k plan.

Basically, it boils down to 3 primary options:

1. Cash it out,
2. Leave your funds in your old 401k plan if able, or
3. Roll it over into an IRA or another tax-deferred retirement plan.

The first option is rarely a good idea as you will have to pay taxes and possibly early withdrawal penalties.

The second option can be a decent idea if you are happy with your old plan and your former company allows you to maintain your assets in their 401k plan (keep in mind some plans charge former employees for the administration costs once they are no longer employed with the parent company, so you may be better off moving your investments).

Finally, the third option allows you to keep your investments in a tax-deferred plan and avoid taxes and early withdrawal penalties. You can transfer your old 401k plan into a new 401k plan at your new company, move it into an annuity, or you can roll your 401k plan assets into an IRA.

Should You Roll Over a 401k into an IRA?

We are going to make the assumption that you won’t cash out your plan, which leaves us with the choices of rolling your 401k into an IRA, leaving it with your former employer, or rolling it into your new 401k plan.

Because your assets stay in a tax-deferred retirement account, the tax rules are essentially the same for all three choices. The main differences boil down to the rules and investment choices of the plan you choose.

Rolling over your 401k into an IRA

Rolling your 401k into an IRA is usually the best option because you have total control over how and where your money is invested.

Advantages

• Total investment flexibility; you decide where and how to invest.
• Account consolidation (easier to maintain record keeping and balance assets).
• The option of moving your assets to a future employer’s plan.

Disadvantages

• You can’t borrow from your assets.
• Some investment options in a 401(k), such as company stock purchasing plans, may not be available in an IRA.

Where to open a Rollover IRA: Rolling over an IRA is very easy to do, and most providers will help you with the paperwork. Here are some of our recommended places to open an IRA.

Leave assets in your former employer-sponsored plan

This is usually the easiest option because it takes no effort on your part. Simply pack your bags and move on to your next place of employment. But just because it is easy doesn’t always mean it is the best decision.

Advantages

• You may have investment options in the plan that are not available to you outside the plan.
• No action is required on your part.

Disadvantages

• Possibly limited investment choices.
• Most likely cannot make future contributions.
• You usually need assets totaling $5,000 or more to remain in the former employer’s plan.
• May have to cover some or all of the administration fees.
• Having more retirement accounts can make account management and asset allocation more difficult.

Transfer to your new employer-sponsored plan

Most employer-sponsored plans will give you the option of transferring your assets from your former employer-sponsored plan when you enroll. You only have to fill out a form and the plan administrators will take care of the rest.

Advantages

• Account consolidation (easier to maintain record keeping and balance assets).
• Ability to borrow from your 401k.

Disadvantages

• Limited investment choices.
• May have to wait before you are eligible for the plan at your new company.

Rolling Over a 401k Plan into an IRA

We’re assuming you chose option #3 from the above options. Doing a 401k rollover into an IRA is easy, and is basically a three-step process:

1. Open an IRA,
2. Transfer your funds into an IRA via a trustee-to-trustee transfer or an indirect rollover,
3. Allocate your funds.

The second step is the most important because it can have an effect on your taxes.

Step 1. Opening an IRA

The first step is opening an IRA, which only takes a few minutes. All you need to do is open an account with the financial institution if you don’t already have one, sign a form, transfer some funds, then allocate them.

For more information regarding what to look for when opening an IRA, I recommend reading about how to start an IRA, and following that up with where to open an IRA for some great investment houses and brokerages.

Step 2. Roll Over Your 401k Assets into an IRA

There are two primary 401k rollover options to transfer your assets into an IRA – by a direct or indirect transfer. You can also transfer your money into a conduit IRA, which is a Traditional IRA set up to hold your old 401(k) assets until you move the money into another qualified retirement plan.

Indirect IRA rollover

With an indirect IRA rollover, you receive a check for the amount of your 401k plan assets. Sometimes the 401k custodian will automatically do a 20% tax withholding.

You then have up to 60 days to deposit the entire amount that was in your former plan into a tax-deferred retirement account. Otherwise, the amount you don’t deposit will be treated as a withdrawal for tax purposes and may be subject to income taxes and early withdrawal penalties.

That means you need to come up with 20% out of pocket to make up for the amount that was automatically withheld. You will receive a tax refund for the 20% when you file your taxes the following year, but you are on the hook in the meantime.

Thankfully, there is an easier way to rollover your 401k, which avoids any deductions or tax withholdings.

Trustee-to-Trustee Transfer of 401k plan assets

A trustee-to-trustee transfer, or direct transfer, moves your 401k plan assets to another qualified retirement plan without having to worry about cashing it out and having to pay taxes or early withdrawal penalties. This way you can safely and easily transfer the funds in your account and not worry about coming up with 20%, forgetting to deposit the assets, or making any other mistakes along the way.

The paperwork is easy to fill out, and most banks, brokerages, or investment houses will be happy to do the paperwork for you. Once the paperwork is filled out, your new brokerage will initiate the funds transfer from your old brokerage and the transfer is made.

Step 3. Allocate Your Funds According to Your Asset Allocation Plan

Most brokerages will allow you to select which funds you wish to invest in before you transfer your funds from your former 401k plan trustee to your IRA custodian. However, some IRA custodians may just place the money in a money market account or high yield savings account until the transfer has been completed; then you need to allocate the funds according to your risk tolerance and investment needs.

What to look for with a 401k Rollover into an IRA

• Rollover contributions do not count toward annual IRA contribution limits. You can still contribute up to the maximum amount allowed based on your age and income.
• Most Roth 401k plans will automatically roll over into a Roth IRA, and a Traditional 401k plan will roll into a Traditional IRA. You can transfer a traditional IRA into a Roth 401k, but you will need to pay taxes and meet certain income qualifications. Consult with your broker or a financial planner for more details.
• All 401k plans must allow you to transfer your funds via a trustee-to-trustee transfer.
• Verify transfer eligibility, fees, and/or tax considerations before transferring your 401k plan.
• You may wish to contact a financial planner if you have company stock in an old 401(k) plan.
• When in doubt, consult with your broker or a certified financial planner before making any financial decisions.

Keep Retirement Funds in a Tax-deferred Retirement Plan!

Whichever option you choose, try to keep your retirement funds in a retirement plan. Cashing out early will subject you to instant tax obligations and early withdrawal fees if you are under the minimum withdrawal age. The taxes and fees can easily destroy more than a third of your hard earned investments. In addition to taxes and fees, you will set yourself back in your retirement planning. Unless it is an emergency, leave it alone!