Rollover IRA vs. 401(k): Which Should You Choose?

When you leave a job, you must decide what to do with your 401(k) funds. A rollover is the process of moving these retirement savings from your former employer’s plan into a different retirement account, which allows the savings to maintain their tax-deferred status. The primary choice is whether to move the money into a Rollover Individual Retirement Account (IRA) or transfer it to your new employer’s 401(k) plan. Each path has distinct features regarding investments, fees, and rules.

Comparing Your Rollover Destinations

Investment Choices

The range of available investments differs between an IRA and a 401(k). An IRA, opened with a brokerage firm, provides a vast universe of investment options, including individual stocks, bonds, mutual funds, and exchange-traded funds (ETFs). This gives you more control over your portfolio composition.

A 401(k) plan offers a limited menu of investment choices pre-selected by the employer. These consist of a small selection of mutual funds, target-date funds, and perhaps company stock, which restricts your ability to diversify beyond the provided options.

Fee Structures

With an IRA, you may encounter annual account maintenance fees, trading commissions, and the internal expense ratios of mutual funds or ETFs. Competition among brokerage firms has led many to eliminate trading commissions and annual fees.

Fees in a 401(k) plan can be less transparent. These plans charge administrative and record-keeping fees, which are passed on to participants. The mutual funds offered within the 401(k) also have their own expense ratios, which may be higher than similar funds available in an IRA.

Loan Provisions

The ability to borrow from your retirement savings is a feature exclusive to 401(k) plans. Many 401(k)s include a loan provision that allows you to borrow up to 50% of your vested account balance or $50,000, whichever is less. You must repay the loan with interest over a set period, usually five years.

IRAs do not permit loans; any attempt to borrow is treated as a taxable distribution and may be subject to a 10% early withdrawal penalty if you are under age 59½.

Creditor Protection

The level of protection your retirement assets receive from creditors varies. Funds in a 401(k) are governed by the Employee Retirement Income Security Act of 1974 (ERISA), which provides strong protection from seizure in lawsuits and bankruptcy proceedings nationwide.

IRA creditor protection depends on the type of legal claim. For general lawsuits, the rules are determined by state law. In bankruptcy, federal law provides uniform safeguards. Funds in a rollover IRA that originated in a 401(k) plan have unlimited federal protection, while contributory and Roth IRAs are protected up to an inflation-adjusted limit of $1,711,975.

Required Minimum Distributions (RMDs)

Both Traditional IRAs and 401(k)s require you to start taking Required Minimum Distributions (RMDs) once you reach a certain age. However, 401(k)s offer an exception. If you are still working for the company that sponsors your 401(k) plan when you reach RMD age (currently 73), you can delay taking RMDs from that plan until you retire.

This “still-working” exception does not apply to Traditional IRAs. You must begin taking withdrawals from all your Traditional IRAs once you reach RMD age, regardless of your employment status.

Information and Decisions for Initiating a Rollover

Required Account Information

Before starting the rollover, you need specific information. From your former employer’s 401(k), you will need the plan name, your account number, and the plan administrator’s contact information. For the destination account, whether an IRA or a new 401(k), you will need the financial institution’s name, your new account number, and the mailing address or electronic transfer details for receiving funds. It is a good practice to contact the receiving institution to confirm their requirements for accepting a rollover.

Choosing a Rollover Method

You must choose between a direct or an indirect rollover. A direct rollover is a trustee-to-trustee transfer where funds are sent from your old 401(k) plan to your new IRA or 401(k) provider. You never take possession of the money, and no taxes are withheld.

In an indirect rollover, the 401(k) administrator sends you a check for your account balance, minus a mandatory 20% federal tax withholding. You then have 60 calendar days to deposit the full original amount into a new retirement account. If you fail to meet the deadline or only deposit the 80% you received, the remainder is considered a taxable distribution and may incur a 10% penalty.

Required Forms

To authorize the transfer, you must complete a rollover distribution form from your old 401(k) plan administrator. This form is the official request to liquidate your investments and send the proceeds to your new account. You can find this document on the plan administrator’s website or request it from your former HR department.

The form will require you to provide the account information for both the distributing plan and the receiving account and to elect either a direct or indirect rollover.

Executing the Rollover

For a Direct Rollover

To execute a direct rollover, submit the completed distribution form to your old 401(k) plan administrator. The administrator will then process your request, sending a check or an electronic transfer to your new account provider. Your final step is to monitor your new account and confirm the funds have arrived and been properly invested.

For an Indirect Rollover

For an indirect rollover, your old plan administrator will mail you a check for 80% of your account balance. The 60-day period begins when you receive the funds. You must deposit the full, original 100% of your distribution into the new retirement account within that timeframe. This requires you to use your own money for the withheld 20%, which you can reclaim when you file your annual income tax return.

Tax Reporting for Your Rollover

Form 1099-R

After a rollover, your old 401(k) administrator will send you and the IRS a Form 1099-R. This form shows the gross amount of the distribution in Box 1. The code in Box 7 is important because it tells the IRS how to treat the distribution.

For a direct rollover, Box 7 will contain the code ‘G’, which confirms the event is not taxable. For an indirect rollover, the code might be ‘1’ or ‘7’, and you must properly report the rollover on your tax return to avoid taxation.

Form 5498

Your new account custodian will send you and the IRS a Form 5498, IRA Contribution Information, by late May of the year following the rollover. This form reports all contributions to your IRA, including rollover contributions in Box 2. Form 5498 verifies that the funds reported on Form 1099-R were successfully deposited into another retirement account, ensuring they retain their tax-deferred status.

Reporting on Your Tax Return

When filing your annual income tax return using Form 1040, you must report the rollover to ensure it is not counted as taxable income. You will report the total distribution amount from Form 1099-R on the line for IRA, pension, and annuity distributions. On the line for the taxable amount, you will enter “0” and write “ROLLOVER” next to it to signal to the IRS that the distribution was a non-taxable transfer.