Your Guide to 401(k) and IRA Rollovers

When you leave a job, you need to decide what to do with the money in your 401(k) plan. You have four options. Choose one of these:

1. Roll over the assets into an individual retirement account (IRA)
2. Roll over your 401(k) into a new employer’s 401(k) plan
3. Keep your 401(k) with your former employer
4. Cash out your 401(k)

Each of these options comes with its own rules that you need to follow to make the most of your retirement savings going forward.

1. Rolling Over Your 401(k) to an IRA

Whether or not you’re moving to a new employer and a new 401(k) plan, you might consider moving the assets in your old plan into an individual retirement account (IRA). Available through most banks, brokerages, and investment companies, an IRA gives you the most control over your money and the greatest number of options for investing.

Many company 401(k) plans have only a half dozen mutual funds to choose from. Others are funded with variable annuity contracts, which provide insurance protection for assets in the plan but can cost participants as much as 3.9% annually in fees.

IRA fees tend to be lower, depending on which custodian and which investments you choose. And, with a small handful of exceptions, IRAs allow for virtually any asset, including:

If you want to set up a self-directed IRA, you can even purchase some alternative investments like oil and gas leases, physical property, and commodities.

Once you decide on the assets you want to have in your portfolio, you’ll have to figure out which kind of IRA you want: a traditional IRA or a Roth IRA. The main difference between the two is the choice between paying income taxes now (Roth) or later (traditional).

Traditional IRA

If you are transferring a traditional 401(k) account, the simplest move is a transfer to a traditional IRA.

The main benefit of a traditional IRA is that your investment has lowered your taxable income by the amount of your contributions, up to annual limits set by the Internal Revenue Service (IRS).

You must pay taxes on the assets and their earnings later when you withdraw the funds. And you are required to start withdrawing them from an IRA at age 73, whether you’re still working or not. This is the tax rule known as required minimum distributions (RMDs). (There is an exception: if you’re still working at age 73, you don’t have to take RMDs from the retirement plan offered by your current employer. You must take RMDs from all of your other plans, however.)

Roth IRA

Another option for handling your 401(k) balance is to convert it to a Roth IRA.

If you opt for a Roth IRA conversion (turning your traditional account into a Roth one), the entire balance will be taxable income for that year. However, you won’t owe any taxes on the amount you withdraw after age 59½, as long as it’s been five years since you first contributed to the account.

But the upfront hit could be considerable. If the conversion is part of a job change, you might need to increase your payroll withholding or file a quarterly tax return to account for the liability.

There are no lifetime distribution requirements for Roth IRAs, so the funds can stay in the account and continue to grow on a tax-free basis. You can even leave this tax-free nest egg to your heirs, although they must draw down the account within 10 years of receiving the inheritance.

How to Convert to a Roth IRA

If your 401(k) plan was a Roth 401(k), it can only be rolled over to a Roth IRA. This is because you already paid taxes on the funds you contributed to the designated Roth account. If that’s the case, you don’t pay any tax on the rollover to the Roth IRA.

Doing a conversion from a traditional 401(k) to a Roth IRA is a two-step process. First, you roll the money over to an IRA, then you convert it to a Roth IRA.

How to Choose Between a Roth or Traditional IRA

Where are you now financially compared to where you think you’ll be when you tap into the funds (typically retirement)? Answering this question can help you decide which rollover to use.

If you’re in a high tax bracket now and expect to need the funds in less than five years, a Roth IRA may not make sense. You’ll pay a high tax bill upfront and then lose the anticipated benefit from tax-free growth that won’t materialize.

If you’re in a modest tax bracket now but expect to be in a higher one in the future, the tax cost now may be small compared with the tax savings down the road. That is, assuming you can afford to pay taxes on the rollover now.

Bear in mind that all withdrawals from a traditional IRA are subject to regular income tax plus a 10% early withdrawal penalty if you’re under age 59½. But withdrawals from a Roth IRA of your after-tax contributions (the money you already paid taxes on) are never taxed. You’ll only be taxed if you withdraw earnings on the contributions before you’ve held the account for five years. These may be subject to a 10% penalty as well if you’re under 59½ and you don’t qualify for a hardship exception.

It’s not all or nothing, though. You can split your distribution between a traditional and a Roth IRA. You can choose any split that works for you, such as 75% from a traditional IRA and 25% from a Roth IRA.

2. Rolling Over Your 401(k) to a New 401(k)

If your new employer allows immediate rollovers into its 401(k) plan, this move has its advantages. You may like the ease of having a plan administrator manage your money and the discipline of automatic payroll contributions.

Another reason to take this step: If you plan to continue to work after age 73, you should be able to delay taking RMDs on funds that are in your current employer’s 401(k) plan, which would include money rolled over from your previous account.

You will also be able to make further investments in the new plan and receive any company matches in your new job.

Make sure your new plan is excellent. If the investment options are limited or have high fees, or there’s no company match, the new 401(k) may not be the best move.

If your new employer is a small business or a startup, the company may offer a Simplified Employee Pension (SEP) IRA or a SIMPLE IRA. These are qualified workplace plans that are geared toward small businesses and are easier and cheaper to administer than 401(k) plans.

The Internal Revenue Service (IRS) allows rollovers of 401(k)s to these, but there may be waiting periods and other conditions.

3. Keeping Your 401(k) Where It Is

If your former employer allows you to keep your funds in its 401(k) after you leave, this can be a good option in certain situations. The best reason would be if your new employer doesn’t offer a 401(k) or offers one that’s substantially less advantageous. For example, the old plan might have investment choices you can’t get through the new plan.

Other advantages to keeping your 401(k) with your former employer include:

• Performance: If your 401(k) plan account has done well for you, substantially outperforming the markets over time, stick with a winner. The funds are obviously doing something right.
• Special Tax Advantages: If you leave your job in or after the year you reach age 55 and think you’ll start withdrawing funds before turning 59½; the withdrawals will be penalty-free.
• Legal protection: In case of bankruptcy or lawsuits, 401(k)s are subject to protection from creditors by federal law. IRAs are less well-shielded, though this depends on state laws.

You may want to stick to the old plan if you’re becoming self-employed. It’s certainly the path of least resistance. But bear in mind, that your investment options with the 401(k) are more limited than in an IRA.

Some things to consider when leaving a 401(k) at a previous employer:

• Keeping track of several different accounts can be cumbersome, says Scott Rain, manager of Consulting Services at Schneider Downs Wealth Management in Pittsburgh, Pennsylvania. “If you leave your 401(k) at each job, it gets really tough trying to keep track of all of that. It’s much easier to consolidate into one 401(k) or into an IRA.”
• You will no longer be able to contribute to the old plan or receive company matches, one of the big advantages of a 401(k), and, in some cases, may no longer be able to take a loan from the plan.
• You may not be able to make partial withdrawals, as you may be limited to a lump-sum distribution down the road.

Bear in mind that, if your assets in the plan are less than $5,000, you may have to notify your plan administrator or former employer of your intent to stay in the plan. If you don’t, they may automatically distribute the funds to you or to a rollover IRA.

If the account has less than $1,000, you may not have a choice, as many 401(k)s at that level are automatically cashed out.

4. Cashing Out Your 401(k)

Cashing out your 401(k) is almost always a mistake. First, you will be taxed on the money as ordinary income at your current tax rate. In addition, if you’re no longer going to be working, you need to be at least 55 years old to avoid paying a 10% penalty as well. If you’re still working, you need to be at least 59½. 

So aim to avoid this option except in true emergencies. If you are short of money (for example, because you were laid off), withdraw only what you need.

Don’t Roll Over Employer Stock

There is one big exception to all of this. If you hold your former company’s stock in your 401(k), it may make sense to not roll over this portion of the account.

The reason is net unrealized appreciation (NUA), which is the difference between the value of the stock when it went into your account and its value when you take the distribution.

You’re only taxed on the NUA when you take a distribution of the stock and opt to not defer the NUA. By paying tax on the NUA now, it becomes your tax basis in the stock, so when you sell it (immediately or in the future), your taxable gain is the increase over this amount.

Any increase in value over the NUA becomes a capital gain. You can even sell the stock immediately and get capital gains treatment. The usual more-than-one-year holding period requirement for capital gains treatment does not apply if you don’t defer tax on the NUA when the stock is distributed to you.

In contrast, if you roll over the stock to a traditional IRA, you won’t pay tax on the NUA now, but all of the stock’s value to date, plus appreciation, will be treated as ordinary income when distributions are taken.

How to Do a Rollover

The mechanics of rolling over a 401(k) plan to an IRA are straightforward. You pick a financial institution, such as a bank, brokerage, or online investing platform, to open an IRA with them. Let your 401(k) plan administrator know where you have opened the account.

To roll over a 401(k) to another 401(k), contact the plan administrator affiliated with your new employer.

There are two types of rollovers: direct and indirect. We explain how both work below.

How a Direct Rollover Works

A direct rollover is an electronic transfer from your old account to your new account, or a check made out to your new account. The money is not paid directly to you, so it cannot be counted as taxable income for the year.

The direct rollover (no check) is the safest approach. You’re shifting assets directly from one custodian to another, without selling anything.

The direct rollover is also known as a trustee-to-trustee rollover or an in-kind transfer.

How an Indirect Rollover Works

In an indirect rollover, the funds are paid to you and you deposit them in your account. You only have 60 days to deposit the funds into a new plan. If you miss the deadline, you will be subject to income taxes and a 10% early withdrawal penalty if you are under age 59½.

Some people do an indirect rollover if they want to take a 60-day loan from their retirement account.

If you take an indirect rollover, the IRS requires that your previous employer withhold 20% of your funds. Meanwhile, you’ll need to come up with that 20% to roll over the full amount of your distribution within 60 days.

The Bottom Line

When you leave a job, you can leave your 401(k) where it is, roll it over into your new employer’s 401(k) plan, roll it over into an IRA, or cash it out. To decide which is right for you, consider any associated penalties, fees, and taxes as well as the range of investment opportunities associated with each choice.

A rollover doesn’t typically trigger tax complications, as long as you move a traditional 401(k) into a traditional IRA or another traditional 401(k) or a Roth 401(k) into a Roth IRA or another Roth 401(k).