Should You Rollover Your 401(k)? Key Factors to Decide

A 401(k) rollover involves moving funds from an employer-sponsored retirement plan into another qualified retirement account. This decision often arises when individuals change jobs, retire, or seek more control over their investments.

Choices for Your Old 401(k)

When leaving an employer, individuals typically have several options for their existing 401(k) account. One choice is to leave the funds within the former employer’s plan, which may be suitable if the plan offers desirable investment options and low fees. However, some plans may have minimum balance requirements or limit investment flexibility for former employees.

Another option is to cash out the 401(k), which involves taking a direct distribution of the funds. This action generally results in immediate tax consequences, as the entire distribution is typically treated as ordinary income. Additionally, if the account holder is under age 59½, a 10% early withdrawal penalty usually applies, significantly reducing the amount received. Due to these substantial tax and penalty implications, cashing out is generally not recommended for long-term retirement savings.

A common path is to roll over the funds into an Individual Retirement Account (IRA). This option offers a wide array of investment choices and providers, giving the account holder greater control. The transfer maintains the tax-deferred status of the retirement savings, avoiding immediate tax liabilities or penalties.

Alternatively, the funds can be rolled over into a new employer’s 401(k) plan, if the new plan accepts such transfers. Consolidating retirement savings into one account can simplify financial management. This choice allows for continued contributions and potentially provides access to institutional-class investments.

Key Factors When Deciding on a Rollover

Evaluating investment options and flexibility is a key factor when considering a 401(k) rollover. IRAs often provide access to a broader range of investment products, including individual stocks, bonds, mutual funds, and exchange-traded funds, compared to the more limited selections within employer-sponsored 401(k) plans. A new 401(k) might offer a curated list of funds, while an IRA allows for greater personalization of a portfolio.

Fees and expenses associated with retirement accounts can significantly impact long-term growth. Compare administrative fees, investment management fees, and other potential charges between the old 401(k), a new 401(k), and various IRA providers. Some employer plans may offer lower-cost institutional funds not available to individual IRA investors.

Creditor protection is another factor to consider for retirement assets. Employer-sponsored 401(k) plans generally receive strong federal protection from creditors under the Employee Retirement Income Security Act (ERISA), regardless of the account balance. IRAs also have federal protection in bankruptcy up to a certain amount, and rollover IRAs generally receive unlimited protection in bankruptcy. Outside of bankruptcy, IRA protection varies by state law, which may offer different levels of security against creditors.

Required Minimum Distributions (RMDs) are mandatory withdrawals from retirement accounts that typically begin at age 73, though this age will increase to 75 for those turning 73 after December 31, 2032. While IRA holders generally must begin RMDs at this age regardless of employment status, participants in a 401(k) plan can delay RMDs from their current employer’s plan until they retire, unless they own more than 5% of the business. This “still working” exception provides flexibility for those who continue to be employed past the RMD age.

Access to funds before traditional retirement age also differs between account types. The “Rule of 55” allows individuals who separate from service in the year they turn 55 or later to take penalty-free withdrawals from their current employer’s 401(k) plan. This specific rule does not apply to IRAs, where penalty-free withdrawals typically begin at age 59½, unless another IRS exception is met. Funds rolled into an IRA from a 401(k) lose this Rule of 55 provision.

Consider the implications of pre-tax IRA balances for future “backdoor Roth” conversions. The IRS’s pro-rata rule mandates that any Roth conversion from an IRA that holds both pre-tax and after-tax contributions will be partially taxable. Rolling pre-tax 401(k) funds into a new employer’s 401(k) can help avoid commingling pre-tax and after-tax money in IRAs, simplifying future backdoor Roth conversions and potentially reducing their taxable component.

Executing a 401(k) Rollover

Initiating a 401(k) rollover involves contacting the administrator of the old 401(k) plan and the receiving institution, such as a new 401(k) plan administrator or an IRA custodian. Both institutions will provide the necessary forms and instructions to facilitate the transfer.

The preferred and most common method for a 401(k) rollover is a direct rollover, also known as a trustee-to-trustee transfer. In this method, the funds are sent directly from the old 401(k) plan administrator to the new account custodian. This direct transfer ensures that the money never passes through the account holder’s hands, thereby avoiding any potential tax withholding or early withdrawal penalties.

An alternative, though less recommended, method is an indirect rollover, sometimes called a 60-day rollover. With this option, a check for the 401(k) balance is issued directly to the account holder. The Internal Revenue Service (IRS) mandates that the funds must then be deposited into a new qualified retirement account within 60 days of receipt to maintain their tax-deferred status and avoid penalties.

A significant drawback of the indirect rollover is the mandatory 20% federal income tax withholding applied to the distribution. While this amount is withheld, it is not a permanent tax if the full amount, including the 20% withheld, is rolled over within the 60-day window. The account holder would then need to cover the 20% from other sources to complete the full rollover and later reclaim the withheld amount as a tax credit when filing their annual tax return.

The old 401(k) administrator will require specific documentation and information about the receiving account. The process typically takes a few weeks to complete, with both institutions providing confirmations once the transfer is finalized. Monitor the transfer’s progress to confirm funds have successfully moved.