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401(k) Rollover to IRA: what you need to know

An IRA offers more investment choices and often lower fees than a 401(k).

Financial Planning & Investments ServicesKey takeaways:

  • Have you left a 401(k) behind at an old employer? Rolling over your old 401(K) to an IRA gives you more investment choices and typically saves money in fees.
  • A financial professional can help you customize your IRA to meet your retirement goals; you typically don’t have the ability to do this within a 401(k).

Most of us change or leave jobs multiple times over the course of our careers. Recent events have forced these transitions for some of us. But one thing that often gets forgotten is the 401(k). Have you left a trail of old 401(k)s at former employers? You’d be surprised how many people do.

When you change jobs or leave a company, you have options. You can:

  1. Leave your money in the old 401(k)
  2. Roll it over to your new employer’s 401(k)
  3. Rollover the 401(k) to an IRA (individual retirement account)
  4. Cash it out (but this is a bad idea, keep reading to learn why)

There are pros and cons to each, but first, make sure you understand the differences between these types of retirement savings options. And before you decide what to do with your 401(k), be sure to discuss your options with a financial professional who can help you avoid the common pitfalls of a 401(k) rollover.

 

What’s the difference between a 401(k) and an IRA?

While they’re all retirement savings plans, there are important distinctions between them.

A 401(k) is an employer-sponsored retirement account. When you work for a company that offers a 401(k), you can contribute money and your employer often makes matching contributions, up to a certain amount, which helps your 401(k) grow even faster.

There are two types of 401(k)s:

  • Traditional 401(k): With this plan, your contributions are made pre-tax, which reduces your taxable income and lowers the income tax you pay. Then when you take distributions during retirement, the money is taxed as income.
  • Roth 401(k): This is the reverse of the traditional 401(k). You make your contributions with after-tax dollars, but the distributions are tax-free.

An IRA is an individual retirement account. You can open an IRA with the help of a financial professional. The IRA can be invested in mutual funds, stocks, bonds, or other options. Your financial professional will work with you to identify your financial goals and assess your risk tolerance when choosing these investments.

There are two common types of IRAs:

  • Traditional IRA: Like the traditional 401(k), your contributions to a traditional IRA are tax-free; the money is taxed only when you withdraw it during retirement.
  • Roth IRA: Here, your contributions are taxed but your distributions are tax-free, regardless of your income or tax bracket at the time you begin taking them. Unlike a traditional IRA, though, only people with certain income limits qualify for a Roth IRA.

 

Why roll over your 401(k) to an IRA?

Both IRAs and 401(k)s are convenient ways to save for retirement. But if you’ve left a company and are no longer contributing to their 401(k), there are a lot of good reasons to roll that money into an IRA. It’s all about choice.

The investment options you have within a 401(k) are determined by your employer. Some offer a wider variety of fund options than others, but they’re always limited. In comparison, you have almost unlimited choices in how you can invest the money in your IRA. In fact, having better investment choice is the biggest reason people choose to roll over their 401(k) to an IRA.

 

401(k) Rollover to IRA: what are your options?

A retirement plan rollover is a transaction where you transfer your investment savings from one plan, such as a 401(k), to another, such as an IRA. When you transfer directly from a traditional 401(k) to a traditional IRA, or from a Roth 401(k) to a Roth IRA, you will pay no tax. Plus, there's no limit on how much money you can roll from a 401(k) into an IRA.

 

Direct vs. indirect rollover

With a direct rollover, your money is transferred from one account to the other; you never touch it. This process is tax-free and requires no withholding. You can do a direct rollover at any time for any amount, and there is no limit to the number of direct rollovers you can do in a year.

Indirect rollovers require more work. With this option, the 401(k) administrator from your old employer will send you a check made payable to you, and you are then responsible for making sure the money gets deposited into your new IRA within 60 days.

In addition, with an indirect rollover, you will be subject to withholding. Typically, your old 401(k) will withhold 20 percent when you ask for an indirect rollover. You can get that back in the form of a tax credit when you file your tax return, but in the meantime, you must come up with the remaining 20 percent yourself and deposit it into the IRA within 60 days if you want to avoid any taxes or penalties. If you don’t complete the full deposit within 60 days, you will owe tax on the amount that was not deposited into your IRA. You are limited to just one indirect rollover per year. Because they are tricky and potentially costly, think twice before choosing an indirect rollover.

 

What are the alternatives to a rollover?

1. You can keep the money invested in your current 401(k)

Once you leave a company, most 401(k) plan administrators allow you to leave your money in the plan if the balance is above a minimum, usually $5,000. If your 401(k) totals less than $1,000, though, the plan administrator will typically write you a check and close your 401(k).

If your old plan has low fees, and if you like the investment options that are available to you, you may want to keep your money where it is. However, be sure to compare the fees to those of an IRA, which are typically low.

Leaving your 401(k) where it is also takes more coordination in the long run. If you get married or move, or if you need to make a change in your beneficiaries, you’re responsible for notifying the plan administrator. You’ll also need to check your investment allocations regularly, to make sure they continue to meet your overall financial goals.

If your 401(k) includes company stock from your former employer that has appreciated over time, you may want to consider leaving the 401(k) as is, due to a rule regarding something called net unrealized appreciation (NUA). NUA situations qualify for special tax treatment, depending on how long you’ve owned the stock. However, these NUA benefits cannot be applied if you roll the stock over to an IRA or another 401(k).

 

2. You can roll over your old 401(k) to your new employer’s 401(k)

If your new employer allows rollovers, and if the new 401(k) has low fees and investment options that work for you, you may want to consider rolling your old 401(k) into the new one. But again, an IRA typically has lower fees and almost unlimited investment options, so make sure a rollover to your new employer’s 401(k) meets your needs.

A direct rollover from one 401(k) to another can also take weeks, so you’ll need to track the status of the transfer. And some employers require a waiting period before you’re eligible for this option.

 

3. You can cash out your 401(k) (but this is rarely a good idea)

This should be a last resort, used only if you're facing severe financial hardship. You will be taxed on the money you take out, and you will also be charged an early withdrawal fee. Altogether, you could lose as much as 40 percent of your fund because of taxes and fees.

If you need money, check to see if your existing 401(k) plan allows you to borrow against the fund instead or consider other options such as a home equity loan or a mortgage refinance.

 

7 Reasons to rollover your 401(k) to an IRA

  1. An IRA offers more investment choices. You can typically choose from stocks, bonds, mutual funds, exchange-traded funds (ETFs), real estate investment trusts (REITs), annuities, and more.
  2. You can buy and sell your investments anytime you want within the IRA, which is particularly helpful if you need to change your asset allocation.
  3. An IRA has fees, but they are typically lower than those of a 401(k).
  4. Upon your death, a 401(k) is paid as a lump sum to your heirs. But IRAs have more flexibility, and Inherited IRAs give your beneficiaries choices in terms of how and when they can take a distribution. Roth IRAs can be left intact and passed on to your heirs with no distribution required.
  5. Once you leave a company, you can no longer contribute to your 401(k). However, you can continue to contribute to a Roth IRA for as long as you like, even after age 70.
  6. You can work with a financial professional to fully customize the way in which the money is invested in your IRA. A 401(k) rarely allows this type of customization.
  7. It’s easier to manage your portfolio and keep track of your overall asset allocation when you don’t have multiple retirement accounts scattered about.

 

Pitfalls to avoid when rolling your 401(k) to an IRA

While there are many good reasons to roll over your 401(k) to an IRA, there are a few important things to consider.

  • If you have a traditional 401(k), you will be taxed if you roll it into a Roth IRA.
  • Traditional IRAs have distribution requirements, while Roth IRAs do not. This means if you plan to leave an IRA to your heirs, you may be better with a Roth.
  • If you think you might need to borrow against your retirement savings, leave your money in the 401(k). You cannot borrow against an IRA, but many 401(k)s have an option that allows you to borrow without penalty.
  • Don’t lose out on the opportunity to continue contributing to your IRA. Just because you rolled over a 401(k) to an IRA, it doesn’t mean that you can’t also make your annual maximum contribution to a separate IRA. As of 2022, you can invest up to $6,000 per year in an IRA ($7,000 for those age 50 or older). You’re allowed to set aside up to $20,500 per year in a 401(k) ($27,000 for ages 50 and up). And yes, you can contribute the maximum amount to both!
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Trying to decide whether to rollover?

There are a lot of good reasons to roll over your old 401(k) to an IRA. But is this the best choice for you? That’s where we can help.

An Alaska USA Financial Planning and Investment Services Professional can help you evaluate your options, and if it makes sense, help you roll over your 401(k) and develop a customized investment plan that will put your IRA money to work for you. Schedule a complimentary, no-obligation consultation today.

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