Do I Need to Rollover My 401k? Here Are Your Options

When an individual changes jobs, a common financial decision arises regarding their 401(k) retirement savings from a previous employer. A 401(k) rollover involves moving these funds from one qualified retirement plan to another, or into an Individual Retirement Account (IRA). This process allows savings to continue growing on a tax-deferred or tax-free basis, without incurring immediate taxes or penalties. It enables individuals to consolidate their retirement assets.

Understanding Your 401(k) Rollover Options

Upon leaving an employer, individuals have several choices for their existing 401(k) funds. Each option carries distinct implications concerning access, fees, and tax treatment. Understanding these paths helps in making an informed decision.

One option is to leave funds within the former employer’s 401(k) plan. This can be suitable if the old plan offers low fees or unique investment options like stable value funds. However, if the account balance is small, under $5,000 or $7,000, the employer may automatically distribute funds, often by rolling them into an IRA or cashing them out. A drawback is becoming disconnected from the account, making management harder.

Another choice involves rolling the 401(k) into a new employer’s 401(k) plan. This promotes consolidation, simplifying retirement savings management. It also allows for continued pre-tax growth and retains creditor protections offered by employer-sponsored plans under federal law. Additionally, this option may preserve the ability to take a loan from the plan, a feature not available with IRAs.

Alternatively, rolling the 401(k) into an Individual Retirement Account (IRA) provides greater control and a broader selection of investment options. If you roll a traditional 401(k) into a Traditional IRA, earnings continue to grow tax-deferred, with taxes paid upon withdrawal in retirement. Rolling into a Roth IRA is a Roth conversion and a taxable event. However, future qualified withdrawals from the Roth IRA will be tax-free, and Roth IRAs are not subject to required minimum distributions for the original owner.

Cashing out the 401(k) is not recommended due to financial penalties. If you withdraw funds before age 59½, you will owe ordinary income tax on the distribution and a 10% early withdrawal penalty. This option diminishes your retirement savings and should only be considered in financial hardship.

Key Considerations for Your Decision

Deciding the path for your 401(k) requires evaluating several factors based on your financial situation and retirement goals. This helps determine which rollover option aligns best with your needs, ensuring your retirement savings continue to grow.

Investment options and flexibility vary between 401(k)s and IRAs. While 401(k) plans offer a limited list of investment choices, IRAs provide access to a wider array of vehicles, including stocks, bonds, mutual funds, and exchange-traded funds (ETFs). This broader selection allows for more customized portfolio allocation and diversification.

Fees and expenses can impact your retirement savings growth. 401(k) fees can range from 0.2% to 5% of assets, with an average around 0.49% to 1%, encompassing administrative and investment management costs. IRA fees tend to be lower with online brokerages offering accounts with no annual maintenance fees or charging $25 to $50 annually, though transaction fees and mutual fund expense ratios still apply. Compare the fee structures of your old 401(k), new 401(k), and prospective IRA.

Required Minimum Distributions (RMDs) are another consideration. RMDs from traditional 401(k)s and traditional IRAs must begin by age 73. However, if you are still working for the employer sponsoring your 401(k) plan, you may be able to delay RMDs from that plan past age 73, a flexibility not available with IRAs. Roth IRAs are exempt from RMDs for the original owner.

Creditor protection differs between plan types. Funds held in 401(k)s receive protection from creditors under the Employee Retirement Income Security Act (ERISA). While IRAs also offer some creditor protection, its extent can vary by state law and may not be as comprehensive as 401(k)s.

Access to loans is a feature of 401(k) plans. Many 401(k) plans permit participants to borrow from their accounts, up to 50% of their vested balance or $50,000. These loans must be repaid with interest within five years. IRAs do not allow loans, which is a factor for those needing short-term liquidity from savings.

The choice between a Traditional IRA rollover and a Roth IRA rollover involves tax implications. Rolling a pre-tax 401(k) into a Traditional IRA maintains its tax-deferred status, with withdrawals taxed as ordinary income in retirement. Converting a traditional 401(k) to a Roth IRA requires paying income tax on the converted amount. This strategy is considered if you anticipate being in a higher tax bracket in retirement or desire tax-free withdrawals in the future.

Net Unrealized Appreciation (NUA) applies to employer stock in a 401(k), representing its increase in value. While normal distributions tax the entire amount as ordinary income, NUA allows only the original cost basis to be taxed as ordinary income if distributed as a lump sum. The appreciation is then taxed at long-term capital gains rates when sold, offering tax savings. This strategy requires careful planning and a full distribution of the company stock from the plan within a single tax year.

Steps to Complete a 401(k) Rollover

Once you decide where to roll over your 401(k), the next phase involves steps to complete the transfer. The process aims to move funds from your old plan to your new account without incurring taxes or penalties.

The first step is to contact your old 401(k) administrator to initiate the rollover. You can do this via phone or their online portal. Inform them of your intent to roll over your funds.

A direct rollover is a method where your former employer’s plan administrator sends funds directly to the custodian of your new 401(k) or IRA. This method avoids tax withholding and prevents penalties. Funds might be transferred electronically or via a check made payable directly to the new institution.

An indirect rollover, or 60-day rollover, is a method where funds are paid directly to you. If you choose this option, the plan administrator will withhold 20% of the distribution for federal taxes. You then have a 60-day deadline from the date you receive the funds to deposit the full amount into a new qualified retirement account. Failing to redeposit the entire amount or missing the deadline makes the distribution taxable income, and if under age 59½, subject to a 10% early withdrawal penalty.

Both the old plan administrator and the new custodian will require documentation and forms to process the rollover. This includes a rollover request form from your old plan and a new account application for the receiving institution. These forms help ensure the transfer is correctly processed.

After initiating the rollover, track the transfer until funds are deposited into your new account. Confirm the transfer with both the old and new custodians. Retain all records related to the rollover, including confirmation statements and any tax forms. This helps ensure proper reporting for tax purposes.