Do I Need to Roll Over My 401k? Your Options Explained

A 401(k) is a retirement savings plan sponsored by an employer, allowing employees to save and invest a portion of their paycheck before taxes are withheld. These contributions often receive a matching contribution from the employer, further boosting retirement savings. The funds within a 401(k) grow tax-deferred, meaning taxes are not paid until the money is withdrawn in retirement. When individuals change jobs or retire, they often face a decision about what to do with their accumulated 401(k) savings, which commonly involves considering a “rollover” to another retirement account.

Scenarios for 401(k) Rollover Decisions

Several common life events prompt individuals to consider what to do with their existing 401(k) account. The most frequent scenario arises when an employee leaves their job. Upon departure, the former employer’s 401(k) plan administrator will communicate the available options.

Retirement also represents a trigger, as individuals transition from active employment to drawing down their savings. The focus shifts from accumulating wealth to managing distributions and fund accessibility.

In some cases, the death of a 401(k) account holder necessitates action by beneficiaries. Surviving spouses or other designated heirs must decide how to manage inherited funds, which can involve specific rollover rules and distribution options. Each situation requires a careful evaluation of the available choices.

Options for Your Old 401(k) Account

When faced with a decision about an old 401(k) account, individuals have several choices:

Leave the money in the former employer’s plan, if allowed by plan rules and the account balance exceeds a minimum. Some plans may automatically roll over smaller balances into an IRA if no election is made.
Cash out the account by taking a lump-sum distribution. This incurs immediate income tax liability on the entire amount, along with potential penalties. This option is discouraged due to its financial drawbacks.
Roll over the funds into a new employer’s 401(k) plan, if offered and accepted. This keeps the money within a qualified employer-sponsored retirement plan. The new 401(k) plan might have different investment options and fee structures.
Roll over the funds into an Individual Retirement Account (IRA). This can be either a traditional IRA or a Roth IRA, depending on the individual’s tax situation and original 401(k) contributions. Rolling into an IRA provides greater control over investment choices and potentially lower fees.

Factors to Consider for Each Option

When deciding on the best course of action for an old 401(k), several factors warrant consideration.

Tax Implications

Cashing out a 401(k) before age 59½ results in the entire distribution being subject to ordinary income tax, plus an additional 10% early withdrawal penalty. Rolling over funds to a traditional IRA or a new employer’s 401(k) maintains tax-deferred status. Converting a traditional 401(k) to a Roth IRA requires paying income tax on the converted amount in the year of conversion. This allows future qualified Roth IRA withdrawals to be tax-free, assuming the account meets age and holding period requirements.

Fees and Expenses

All retirement accounts, including 401(k)s and IRAs, have varying fee structures, such as administrative fees, investment management fees, and fund expense ratios. Comparing these costs is important for maximizing net returns.

Investment Options

Investment options and flexibility vary between different retirement vehicles. Employer-sponsored 401(k) plans offer a limited menu of investment choices. IRAs provide a broader range of investment opportunities, including stocks, bonds, and funds, offering greater control.

Creditor Protection

Creditor protection differs between 401(k) plans and IRAs under federal law. 401(k)s and similar employer-sponsored plans receive unlimited creditor protection under the Employee Retirement Income Security Act (ERISA). IRAs also receive federal bankruptcy protection, though it may be less comprehensive than for 401(k)s in non-bankruptcy situations.

Required Minimum Distributions (RMDs)

RMDs dictate when individuals must begin withdrawing funds from their retirement accounts. RMDs typically begin at age 73 for most accounts. However, 401(k) participants still employed by the plan sponsor can delay RMDs from that 401(k) until retirement. This exception does not apply to IRAs or 401(k)s from former employers.

Access to Funds

Access to funds before retirement, including rules for loans and early withdrawals, also varies. Some 401(k) plans permit loans against the vested balance, which are not taxable if repaid. IRAs do not allow loans. Early withdrawals from both 401(k)s and IRAs before age 59½ are subject to income tax and a 10% penalty.

Executing a Rollover

Once a decision has been made to roll over a 401(k), understanding the procedural aspects is important. Two primary methods exist for executing a rollover: a direct rollover and an indirect rollover.

Direct Rollover

A direct rollover involves the funds being transferred directly from the old 401(k) plan administrator to the new account custodian, whether it’s a new 401(k) plan or an IRA. This is the preferred method because it avoids any tax withholding and the risk of missing a deadline.

Indirect Rollover

An indirect rollover occurs when the funds are first distributed to the account holder, who then has 60 days from the date of receipt to deposit the money into a new qualified retirement account. During an indirect rollover, the old 401(k) plan administrator is required to withhold 20% of the distribution for federal income taxes. If the full amount, including the 20% withheld, is not rolled over within the 60-day period, the unrolled portion becomes taxable income and may be subject to the 10% early withdrawal penalty if the individual is under age 59½.

Steps to Initiate

To initiate a rollover, contact the administrator of the old 401(k) plan. They will provide the necessary forms and instructions. Simultaneously, if rolling into a new IRA, open an IRA account with a chosen custodian, such as a bank or brokerage firm.

The new IRA custodian or new 401(k) plan administrator will also have specific forms to accept the incoming funds. Clearly specify whether the rollover is direct or indirect on all paperwork. Once forms are submitted to both the old plan administrator and the new account custodian, the transfer process begins.

After initiating the rollover, track the transfer of funds to ensure successful completion. This can involve monitoring account statements or contacting the financial institutions involved to confirm the funds have been received and properly allocated.

Citations

Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions.
U.S. Department of Labor. ERISA Retirement Plans.
Internal Revenue Service. Retirement Topics – Required Minimum Distributions (RMDs).
Internal Revenue Service. Retirement Plans FAQs regarding IRAs – Rollovers.