A 401(k) rollover involves transferring funds from your 401(k) to another tax-advantaged retirement account. Typically, individuals choose to roll their 401(k) into an Individual Retirement Account (IRA). There’s also the option to transfer to another 401(k) if it's allowable. You have a 60-day window from receiving the funds to reinvest them in another retirement plan. A direct rollover, where funds move directly into the new account, is usually recommended.
Routes to Roll Over Your 401(k)
Upon leaving a job, you have four primary routes for your 401(k): roll it into an IRA, move it into a new 401(k), leave it where it is, or cash it out. Each has unique tax and financial implications.
Rollover to an IRA
Rolling your 401(k) into an IRA can offer more investment choices and potentially lower fees. There are three main types:
- Traditional 401(k) to Traditional IRA: Taxes on rolled funds and earnings are deferred until retirement distributions, avoiding immediate tax implications.
- Traditional 401(k) to Roth IRA: As 401(k) contributions are pre-tax and Roth IRAs are after-tax, taxes are due in the year of rollover. This benefits future tax-free qualified distributions.
- Roth 401(k) to Roth IRA: Since both are post-tax accounts, there are no immediate taxes due on the rollover.
Transferring to a New Employer
If permissible by your new employer, transferring your 401(k) to their plan consolidates your retirement assets, simplifying performance tracking. This doesn't incur tax penalties if done directly.
Leaving Your 401(k) with a Former Employer
Leaving your funds in your former employer's plan can be advantageous if the plan offers solid investment options and reasonable fees. However, ex-employees might face higher fees, less direct support, and the inability to make additional contributions. Employers also have the right to transfer small balances into an IRA or issue a check.
Cashing Out Your 401(k)
Cashing out is often the costliest option due to potential tax penalties and early distribution fines unless the distribution qualifies as a penalty-free scenario. Employers might withhold 20% for taxes, and the IRS may impose an additional 10% early withdrawal penalty.
Why Direct 401(k) Rollovers Matter
A direct rollover ensures that the 401(k) plan transfers money directly to your new retirement account, avoiding penalties and tax withholdings that occur with indirect rollovers. In an indirect rollover, any withheld amount must be re-deposited to avoid penalties and full tax liabilities.
Weighing the Benefits and Drawbacks of a 401(k)-to-IRA Transfer
Pros:
- No immediate taxes or penalties: A direct 401(k) to IRA rollover continues tax deferral.
- Broader investment choices: Access a wider array of investments, including stocks, bonds, mutual funds, ETFs, and more.
- Potential lower costs: Many IRAs have lower fees than 401(k) plans, especially those with no maintenance fees.
- Robo-advisors: Low-cost automated investment management solutions are available.
Cons:
- Limited creditor protection: While 401(k)s offer robust protections, IRA protections vary by state and can be less comprehensive.
- Access limitations: Withdrawals from IRAs are generally restricted until age 59½, unlike the earlier access available with 401(k)s under certain circumstances.
- Tax considerations on company stock: Rolling company stock into a taxable brokerage account might be preferable, necessitating professional tax advice.
Carefully considering these factors will help ensure you make the best decision regarding your 401(k) funds when changing jobs or nearing retirement.
