Should You Always Rollover Your 401k?

A 401(k) is an employer-sponsored retirement savings plan allowing employees to contribute a portion of their salary on a pre-tax or Roth basis, with investments growing tax-deferred. When leaving an employer, deciding what to do with your accumulated 401(k) savings is a significant financial decision. This choice affects your retirement security, tax obligations, and access to funds. Whether to roll over your 401(k) requires careful consideration of your personal financial situation.

Options for Your Old 401(k)

Upon separating from an employer, you generally have four primary choices for your old 401(k) plan. You can leave funds in the former employer’s plan, often permissible if your balance exceeds $5,000. Some plans allow balances as low as $1,000, but amounts below this may be automatically cashed out or rolled into an employer-chosen IRA. This option means you cannot make new contributions and may face limitations on investment choices or withdrawal flexibility.

Another common choice is to roll over your 401(k) into your new employer’s 401(k) plan, if it accepts rollovers. This simplifies your financial life by consolidating retirement savings in one place, allowing your money to continue growing with potential tax advantages within an employer-sponsored structure.

Many individuals also roll over their old 401(k) into an Individual Retirement Account (IRA). This can be a traditional IRA, maintaining tax-deferred status, or a Roth IRA, where qualified withdrawals are tax-free. Converting pre-tax 401(k) funds to a Roth IRA is a taxable event. An IRA rollover offers greater control and potentially broader investment opportunities than employer-sponsored plans.

The final option, cashing out your 401(k), generally involves immediate and significant financial consequences. If you are under age 59½, distributions are typically subject to ordinary income tax and an additional 10% early withdrawal penalty. For example, cashing out $5,000 might leave you with only $3,400 after federal taxes and penalties, and state taxes could further reduce the amount. This action significantly diminishes your long-term retirement savings potential.

Key Considerations for Your Decision

Several factors can influence the optimal decision for your old 401(k). Understanding these considerations can help you make an informed choice that aligns with your financial goals.

Fees and expenses

Fees and expenses are important to evaluate across different retirement vehicles. Employer-sponsored 401(k) plans and IRAs can have varying administrative fees, record-keeping charges, and investment management fees. While some larger 401(k)s may offer institutionally priced, lower-cost investment options, others, particularly smaller plans, might have higher expense ratios that can erode returns over time. IRAs can also have fees depending on the custodian and chosen investments, but often provide access to lower-cost index funds or exchange-traded funds.

Investment options

The breadth and quality of investment options available in each account type are significant. Employer 401(k) plans typically offer a curated selection of mutual funds or other investments chosen by the plan administrator. An IRA, by contrast, generally provides a much wider universe of investment choices, including individual stocks, bonds, mutual funds, and exchange-traded funds, allowing for greater portfolio customization. This expanded access can be beneficial if you seek specific investment strategies or lower-cost investment vehicles not available in your old 401(k).

Access to funds

Access to funds can differ considerably between 401(k)s and IRAs, particularly before age 59½. The “Rule of 55” allows penalty-free withdrawals from the 401(k) of the employer you just left if you separate from service in or after the year you turn 55. This rule applies only to the plan of the employer from whom you separated and does not extend to IRAs or other 401(k)s. IRAs generally impose a 10% penalty on withdrawals before age 59½, unless a specific IRS exception applies, such as for higher education expenses or a first-time home purchase.

Creditor protection

Creditor protection is another factor. ERISA-qualified 401(k) plans typically offer robust protection from creditors and legal judgments under federal law. Funds in a 401(k) are generally shielded from creditors, including in bankruptcy proceedings. While IRAs do receive some federal creditor protection in bankruptcy, the extent of protection outside of bankruptcy can vary significantly by state law and may not be as comprehensive as that for 401(k)s.

Required Minimum Distributions (RMDs)

Required Minimum Distributions (RMDs) are rules dictating when you must begin withdrawing money from your retirement accounts. For traditional 401(k)s and IRAs, RMDs generally start at age 73. However, if you are still working past this age, you might be able to delay RMDs from your current employer’s 401(k) until you retire, a flexibility not typically available for IRAs or previous employer 401(k)s. RMD rules also differ in how they are calculated and withdrawn across multiple accounts, with IRAs allowing aggregation of RMDs across all accounts, while 401(k)s require separate RMDs from each plan. Roth IRAs are exempt from RMDs during the owner’s lifetime.

Estate planning considerations

Estate planning considerations involve how your retirement assets are distributed to beneficiaries upon your death. While rules vary by plan, some 401(k)s may default to a lump-sum distribution to beneficiaries, which could have immediate tax implications. IRAs often provide more flexibility in beneficiary designations and payout options, allowing for strategies like “stretch IRAs” (though recent legislation has limited this for many beneficiaries). Consolidating accounts into an IRA can also simplify reviewing and updating beneficiary information.

Simplicity and convenience

The simplicity and convenience of managing your retirement savings can also play a role. Consolidating multiple old 401(k) accounts into a single IRA or your new employer’s 401(k) can streamline record-keeping and reduce the number of financial institutions you need to monitor. This consolidation can make it easier to track your overall retirement portfolio and adjust your investment strategy.

Executing a Rollover

Once a decision is made to perform a rollover, understanding the procedural aspects is essential to avoid unnecessary taxes and penalties. The two primary methods are a direct rollover and an indirect rollover.

Direct rollover

A direct rollover involves funds being transferred directly from your old plan administrator to your new retirement account, whether it’s a new 401(k) or an IRA. This method is generally preferred because the money never passes through your hands, meaning there is no mandatory 20% federal tax withholding and no risk of missing the 60-day deadline. The old plan administrator typically sends a check made payable to the new financial institution or wires the funds directly.

Indirect rollover

In contrast, an indirect rollover means you receive a check made out to you personally from your old plan. Your old plan administrator is required to withhold 20% of the distribution for federal income tax. You then have 60 days from the date you receive the funds to deposit the entire amount, including the 20% that was withheld, into your new qualified retirement account. If you fail to redeposit the full amount within this 60-day window, the unrolled portion is treated as a taxable distribution and, if you are under age 59½, may also incur the 10% early withdrawal penalty.

Executing a direct rollover

To execute a direct rollover, contact your former employer’s plan administrator. Provide them with the account information for your new receiving institution, such as the account number and the institution’s name and address. The plan administrator handles the transfer of funds directly to the new account. Confirm any specific paperwork requirements, such as a letter of acceptance from the new institution, which can often be generated online.

Incorrect execution of a rollover

Incorrect execution of a rollover, particularly with an indirect rollover, can lead to significant tax implications. If the full amount is not redeposited within the 60-day limit, the distribution becomes taxable income. This could push you into a higher tax bracket, increasing your tax liability. If you are under age 59½, the 10% early withdrawal penalty will apply to the unrolled portion, in addition to income tax. Direct rollovers are generally recommended to ensure the tax-deferred status of your retirement savings is maintained without procedural risks.