Should You Rollover Your 401k? Weighing Your Options
Make confident decisions about your old 401k. This guide offers clarity on managing your retirement savings through various pathways and their financial impacts.
When changing jobs or approaching retirement, individuals often consider what to do with their existing 401k balance. This employer-sponsored account is a significant part of long-term savings, and its future requires careful consideration to maintain financial security and optimize tax benefits. This article explores the options for managing an old 401k to help you make an informed choice.
Understanding Your 401k Options
Upon separating from an employer, individuals have several choices for their 401k funds, each with unique implications for management and accessibility. One option is to leave funds in the former employer’s 401k plan, if allowed. This is common for balances over $5,000, as smaller amounts might be subject to automatic cash-outs.
Another option is to roll over funds into a new employer’s 401k plan, if available and permitted. This consolidates assets, simplifying management. Eligibility depends on the new plan’s rules.
An alternative is to roll over the 401k balance into an Individual Retirement Account (IRA). This transfers funds from the employer plan into a personal IRA, which can be Traditional or, in some cases, Roth. An IRA offers a broad range of investment choices and greater control.
The final option is to cash out the 401k, taking a direct taxable distribution. While providing immediate access, this significantly diminishes savings due to substantial taxes and penalties.
Tax Implications of Each Option
Each decision regarding an existing 401k balance carries specific tax consequences. Leaving funds in a former employer’s 401k or rolling them into a new employer’s 401k allows for continued tax-deferred growth. Earnings and contributions are not taxed until withdrawn in retirement, preserving compounding potential. There are no immediate tax implications when transferring funds directly between qualified employer plans.
Rolling over funds into a Traditional IRA also maintains tax-deferred status, with taxes paid upon withdrawal in retirement. A direct rollover to a Traditional IRA does not trigger immediate tax consequences. However, converting a Traditional 401k balance to a Roth IRA is a taxable event, added to your gross income and taxed at your ordinary rate.
If an indirect rollover occurs, funds are distributed to the individual before being redeposited into a new retirement account. Funds must be redeposited within 60 days to avoid being a taxable distribution. Failure to do so means the entire amount is subject to ordinary income tax. If under age 59½, an additional 10% early withdrawal penalty may apply.
Cashing out a 401k results in the entire amount being taxed as ordinary income in the year of withdrawal. For individuals under age 59½, this distribution is also subject to a 10% early withdrawal penalty, in addition to regular income taxes. There are limited exceptions to this penalty, such as:
- Distributions due to disability
- Certain unreimbursed medical expenses
- Qualified domestic relations orders (QDROs)
- Substantially equal periodic payments (SEPPs)
- Qualified higher education expenses
- Up to $10,000 for a first-time home purchase
Key Considerations for Your Decision
Making an informed decision about your 401k requires evaluating several factors beyond tax implications. A primary consideration is comparing fees and expenses. Different 401k plans and IRA providers charge varying administrative fees. Investment management fees, like expense ratios for mutual funds or ETFs, also differ and impact net returns.
The breadth and quality of investment options available are also important. Employer-sponsored 401k plans may offer a limited selection of mutual funds, while IRAs provide access to a wider array of investments, including individual stocks, bonds, and various funds. Evaluate which option better serves your investment preferences and long-term strategy.
Required Minimum Distribution (RMD) rules vary between 401ks and IRAs, especially as you approach retirement age. RMDs generally begin at age 73 for both. However, for 401k plans, if you are still working for the employer, you may delay RMDs from that 401k until retirement. This “still working” exception does not apply to IRAs, where RMDs begin at age 73 even if employed.
The level of creditor protection also differs. ERISA-qualified 401k plans generally receive strong federal creditor protection. IRAs offer some protection, but its extent varies by state law and circumstances, potentially offering less robust safeguards than 401k plans.
Access to loan provisions is another consideration. Many 401k plans permit borrowing against vested account balances, typically up to $50,000 or 50% of the vested balance. These loans must generally be repaid with interest within five years, though longer terms may be allowed for home purchases. IRAs do not allow loans; any access to funds before retirement is a distribution subject to taxes and penalties.
Rules for accessing funds before age 59½ for non-penalty purposes can differ. The “Rule of 55” allows individuals leaving a job at age 55 or later to take penalty-free withdrawals from that 401k. IRAs have different exceptions for penalty-free withdrawals, such as for higher education expenses or a first-time home purchase, which are generally not available from 401k plans.
Steps to Initiate a Rollover
Once you decide to proceed with a rollover, the process involves several steps to ensure a smooth transfer. First, contact your former employer’s 401k plan administrator, either through HR or the plan’s recordkeeper/custodian (info on statements). Clearly state your intention to initiate a direct rollover.
Request the necessary distribution or rollover forms. These forms authorize the transfer of funds and specify the destination. The plan administrator will provide specific instructions and forms, such as a “Direct Rollover Request Form” or a “Distribution Request Form,” detailing required information.
The forms will ask for specific information about the receiving account (new employer’s 401k or IRA), including the name of the new plan or IRA custodian, account number, and routing instructions. Ensure all information is accurate and complete to avoid delays. Determine if you want a direct or indirect rollover.
A direct rollover is the preferred method; funds are sent directly from your old 401k to your new account without passing through your hands. This avoids immediate tax withholding and minimizes the risk of missing the 60-day rollover window. The plan administrator will issue a check payable directly to the new plan or IRA custodian, ensuring tax-deferred status.
In contrast, an indirect rollover distributes funds to you personally. You have 60 days from receipt to deposit them into a new qualified retirement account. The former 401k plan administrator must withhold 20% for federal taxes, even if you intend an indirect rollover. To avoid this 20% being a taxable distribution, you must deposit the full original amount into the new account, making up the 20% from other personal funds if necessary.
After initiating the rollover, follow up to confirm the successful transfer. Contact the new plan or IRA custodian to verify receipt. Regularly check your new account statements to ensure the process was completed correctly.