Should I Roll Over My 401(k)?

A 401(k) retirement plan is a valuable savings vehicle offered by many employers, allowing individuals to contribute a portion of their income on a tax-advantaged basis. When transitioning between jobs or entering retirement, a common decision arises regarding the future of these accumulated funds. A 401(k) rollover involves moving money from an existing 401(k) plan into another qualified retirement account, such as a new employer’s plan or an Individual Retirement Account (IRA). This strategic move helps maintain the tax-deferred or tax-free growth of retirement savings, preventing premature distributions that could trigger taxes and penalties.

Exploring Your 401(k) Options

Upon leaving an employer, individuals generally have several choices for their 401(k) funds. One option is to leave the funds within the former employer’s 401(k) plan. This choice can be suitable if you are comfortable with the plan’s investment options and fee structure, or if you prefer to defer making an immediate decision. While no new contributions can be made to the old plan, the funds will continue to grow on a tax-deferred basis. Some plans might automatically roll over or cash out accounts with low balances.

Another pathway involves rolling over the funds into a new employer’s 401(k) plan, if the new plan accepts such rollovers. This can simplify retirement planning by consolidating all savings into a single account. The new plan’s rules, investment choices, and fee structure should be reviewed to ensure this option aligns with your financial strategy.

Individuals may also choose to roll over their 401(k) into an Individual Retirement Account (IRA). A rollover into a Traditional IRA keeps the funds tax-deferred, similar to a traditional 401(k). This option often provides a broader selection of investment choices, which might not be available in an employer-sponsored plan. It can also offer the potential for lower administrative or investment management fees.

Alternatively, a rollover from a traditional 401(k) into a Roth IRA is possible, but this is considered a Roth conversion. The amount rolled over from a pre-tax traditional 401(k) to a Roth IRA becomes taxable income in the year of the conversion. However, if the funds originate from a Roth 401(k), the rollover to a Roth IRA is generally tax-free, as contributions were made with after-tax dollars. A Roth IRA offers tax-free withdrawals in retirement, provided certain conditions are met, such as being at least age 59½ and having the account open for five years.

Cashing out the 401(k) by taking a direct distribution is generally not recommended. Any amount received from a pre-tax 401(k) is subject to ordinary income tax. If you are under age 59½, a 10% early withdrawal penalty typically applies to the distributed amount, in addition to the income tax. Federal law also mandates a 20% tax withholding on such distributions.

Making Your Rollover Decision

Deciding the optimal destination for your 401(k) requires careful consideration of several factors.

Investment Options

Employer-sponsored 401(k) plans typically offer a curated selection of investment vehicles. Conversely, Individual Retirement Accounts (IRAs) generally provide access to a much broader universe of investment choices, including individual stocks, bonds, mutual funds, and Exchange Traded Funds (ETFs).

Fees and Expenses

Fees and expenses associated with retirement accounts can impact long-term growth. 401(k) plans may involve various fees, such as administrative fees, recordkeeping fees, and investment management fees. Similarly, IRAs are not without fees, but the investor often has more control over selecting a provider with a competitive fee structure and choosing lower-cost investment options.

Creditor Protection

Funds held in 401(k) plans generally receive robust protection from creditors under the Employee Retirement Income Security Act (ERISA). For IRAs, creditor protection can vary more widely, depending on federal and state laws, and may be subject to certain limits.

Required Minimum Distributions (RMDs)

RMDs from traditional pre-tax retirement accounts, including 401(k)s and IRAs, must begin once the account holder reaches age 73. A notable exception for 401(k)s allows individuals to delay RMDs past age 73 if they are still employed by the company sponsoring the plan and are not a 5% owner of the business. This “still employed” exception does not apply to IRAs. Roth IRAs do not have RMDs during the original owner’s lifetime. If you hold multiple 401(k)s, RMDs must be calculated and taken separately from each plan, whereas RMDs from multiple IRAs can be aggregated.

Access to Funds Before Retirement Age

While IRAs generally do not permit loans, some 401(k) plans allow participants to take loans from their vested balance. These loans must be repaid with interest, usually within five years. For early withdrawals without penalty, the “Rule of 55” applies exclusively to 401(k) plans. This rule permits penalty-free withdrawals from a 401(k) if an employee leaves their job in or after the year they turn age 55. This exception applies only to the plan of the employer from whom you separated and does not extend to IRAs.

Another method for penalty-free early access is through Substantially Equal Periodic Payments (SEPPs), also known as 72(t) distributions. This strategy allows individuals to take a series of fixed payments from IRAs or 401(k)s at any age without the 10% early withdrawal penalty. The payments are calculated based on IRS-approved methods and must continue for at least five years or until age 59½, whichever is longer. Strict adherence to the payment schedule is crucial. Other penalty exceptions for early withdrawals from both 401(k)s and IRAs include distributions for unreimbursed medical expenses, qualified higher education expenses, and up to $10,000 for a first-time home purchase from an IRA.

Tax Considerations

If converting a traditional 401(k) to a Roth IRA, the converted amount is added to your taxable income in the year of conversion, potentially pushing you into a higher tax bracket. It is important to have funds outside of your retirement account to cover this tax liability.

Steps for a 401(k) Rollover

Executing a 401(k) rollover involves several practical steps. Begin by contacting the administrator of your former employer’s 401(k) plan and the financial institution that will receive the funds. Clearly communicate your intention to perform a rollover and specify the type of account the funds should be transferred into, such as a Traditional IRA or a Roth IRA.

The method of transferring funds is important, with direct rollovers being the recommended approach. In a direct rollover, the funds move directly from your old 401(k) plan to the new retirement account. This method avoids any tax withholding and is not subject to the 60-day rule, ensuring a seamless and tax-compliant transfer.

An indirect rollover involves the 401(k) funds being distributed directly to you. If you choose this method, you have 60 days from the date you receive the funds to deposit them into another qualified retirement account. A significant drawback of an indirect rollover from a pre-tax 401(k) is the mandatory 20% federal income tax withholding by the plan administrator. To roll over the full amount, you must deposit the entire original amount within the 60-day window, often requiring you to make up the 20% from other personal funds. Failing to complete the deposit within 60 days means the distribution becomes fully taxable income, and if you are under age 59½, it will also be subject to the 10% early withdrawal penalty.

Both the old 401(k) plan administrator and the new receiving institution will require specific information and forms to process the rollover. You will need to provide account numbers for both the old and new accounts. Each institution will provide their own specific rollover forms that must be completed accurately.

Monitor the transfer of funds by tracking the progress with both the sending and receiving institutions. Confirm the funds have successfully moved from your old 401(k) account and have been received and properly allocated into your new retirement account.

For tax reporting purposes, the administrator of your former 401(k) plan will issue Form 1099-R in January of the year following the distribution. This form will indicate the amount of the distribution and typically include a code in Box 7, such as ‘G’ for a direct rollover, signifying a non-taxable event. The financial institution receiving the rollover may also issue Form 5498 to report the rollover contribution. Retain these forms and report the rollover correctly on your tax return to avoid misunderstandings or unintended tax liabilities.