What is a 401k rollover?
If you lose or leave your job, your 401k retirement savings can come with you. When this happens there are options for your 401k funds and one is to conduct a rollover into an Individual Retirement Account (IRA). The IRS allows you to direct the rollover to another plan or IRA. Having a financial advisor to assist you in clarifying your options and in the decision making is sometimes helpful.
Know your options
When you leave a job, there are four options for your retirement plan account. You can:
- Keep your money in the current plan if your employer allows it (some don't, especially for accounts with low balances).
- Move it to your new employer's retirement plan (if available).
- Roll it over into an IRA account.
- Take the cash. You may want to consult with your tax adviser before doing it. By taking the cash, you may have to pay tax on the distribution, including a 10% tax penalty if you are younger than age 55, and it may reduce your retirement savings. When you take the cash directly, the IRS only allows you 60 days from the date of receipt of the funds to rollover the funds to another plan or IRA.
If you leave your money in your current employer's plan or move it to a new employer plan, you will be limited to the rules of that plan and the options they offer. You can generally withdraw funds without a 10% early withdrawal penalty from a 401k if you leave your employer at age 55 or older. With an IRA you generally have to wait until you are age 59 1/2 to withdraw funds in order to avoid a 10% early withdrawal penalty. Plus, if you leave your money in the current plan, you'll no longer be able to make contributions or take a loan, in most cases. And you may have to pay extra service or administrative fees, along with the possibility of having transaction limits imposed.
Depending on your circumstances, keeping the funds with your previous employer might be a good idea.
Rollover to an IRA can mean tax-deferred growth
If you rollover to an IRA you may have a wide choice of investment options, including choices that employers might not offer, such as mutual funds, annuities and bank CDs. This option allows your funds to continue growing tax-deferred. And you can simplify your financial life by moving the account to a company where you already have funds or even into an existing IRA.
If you choose a Traditional IRA, you won't pay any taxes when you conduct a rollover. If you roll money into a Roth IRA, you'll be taxed on the money going into the account, but pay no federal income taxes when you withdraw the money (after you're age 59 1/2 and have had the account open for five or more years). Money from a Roth 401k can be rolled into a Roth IRA tax-free.
When rolling over a 401k balance into an IRA it's important to do a full comparison on the differences in the guarantees and protections offered by each respective type of account as well as the differences in liquidity/loans, types of investments, fees and any potential penalties.
Steps to roll over 401k to IRA
The process is simple:
- Find an IRA investment appropriate for you (such as an annuity, a bank CD, or a mutual fund). You will have to do some research or talk to someone in the financial industries to find out which options are right for you.
- Contact the administrator of your former employer's plan and arrange the direct rollover to the custodian of your new IRA. The exact procedure may vary a little from company to company, but don't worry - they've all dealt with this request before.
- Sign documents to directly rollover funds to your new account. The funds will then arrive in your IRA for investment as you chose in step 1.
Take caution with indirect rollovers
Rollovers may be done as direct or indirect, but they are not managed the same.
Direct - A direct rollover is where the funds are transferred directly from one retirement account to another; as the owner you never touch the funds. Doing a direct rollover avoids this negative consequence that may come with an indirect rollover.
Indirect – As the owner you can receive a distribution of your account balance from the plan instead of arranging for a direct rollover. This might not be the best idea. If you take a distribution, the plan administrator typically withholds 20% of the distributable amount for federal income taxes. The 20% is returned in the form of a tax credit in the year the rollover process was completed. When you do this indirect rollover, you can increase the rollover amount, from your own funds, equal to the 20% withholding amount. If you roll over the amount of the check you receive without adding that 20% back, then the amount withheld will be treated as a taxable distribution. You will generally have to pay income taxes on that amount as well as a 10% penalty tax if you are younger than 59 1/2. Also, when you take the cash directly, the IRS only allows you 60 days from the date of receipt of the funds to rollover the funds to another plan or IRA.
Additional rollover caveats
- Only one indirect rollover is permitted in a 12-month period (not calendar year).
- Transfer must be from one account to another, not multiple accounts.
Visit the IRS website or talk to your tax advisor for more information. Helpful tools can also be found on the Social Security Administration’s website, ssa.gov. You can see a detailed comparison of your retirement benefits at different ages. A qualified financial advisor can help you gain a clear understanding of your financial options.