Guide to 401(k) Rollovers
Understanding 401(k) Rollovers
In essence, rollovers are your method of taking advantage of the portability of your 401(k). Typically, a rollover refers to moving 401(k) assets into an IRA (Individual Retirement Account). Most individuals process a 401(k) rollover when they change employers or retire. While 401(k)’s provide significant tax benefits during your career, the investment capabilities are limited. Therefore, transferring these funds to an IRA at separation from the employer and/or retirement typically provides for greater investment options and subsequent portfolio growth. There are many options available for individuals when they are no longer an active participant in the company 401(k), each having unique advantages and disadvantages. The implications of each should be understood fully so you are able to decide which particular option helps you reach your desired goals.
What Is an IRA?
An Individual Retirement Account is an investment account in which one may save for retirement with tax-free growth or tax-deferred basis. There are a variety of different types of IRA’s, each with unique tax advantages to encourage you to save for retirement.
Is Rolling Over to an IRA My Only Option?
Not at all. While this is definitely the most common, there are other options available. Some choose to take an immediate lump sum (cash-out), while other choose to leave the assets in the former employer’s plan or moving them into their new employer’s plan. The rationale for each is different and the tax and investment implications should be understood completely before taking action.
401k Rollover Options
Rollover to Traditional IRA
With this option, assets placed from 401(k) into the IRA will remain tax-deferred. Additional funding is an available option, and your assets will continue to grow tax-deferred until the account becomes subject to withdrawal.
Rollover to Roth IRA
A rollover to a Roth IRA is a similar move to the Traditional IRA, with a few major differences. First, only after-tax contributions to a company 401(k) are eligible to be rolled over to a Roth IRA. Pre-tax employee deferrals (most common contribution method) are only able to transfer into a traditional IRA. Next, subsequent contributions to Roth IRA’s are made with after-tax dollars. These contributions along with the initial rollover grow tax-free and withdrawals are not subject to income tax in retirement. Contributions to Roth IRA’s are not tax-deductible.
Leave It in Employer’s Plan
Leaving your 401(k) in your former employer’s plan is the default option for individuals. Until a rollover is initiated by the individual, the 401k account will remain on its current platform. The plan will continue to operate as though you were still employed, with few to no changes whatsoever. This option is often chosen by those who are unaware of the investment benefits of a rollover to an IRA or are content managing the account on their own.
Rolling Into Current Employer 401(k)
If the 401(k) offered by a new employer offers desirable benefits, it is possible to consolidate your old plan and assets into your new employer’s plan, where its tax-deferred status remains. Not all plans allow for this, so do be aware that this option is not always available. However, as mentioned previously, 401(k)’s offer limited investment options so long-term growth may be hindered by voluntarily limiting the scope of investments to another company retirement plan.
Choosing to cash out provides an immediate lump sum to the individual. However, this option is often chosen by the hasty as there are significant tax implications in doing so. Withdrawals are subject to both federal and state income tax. In addition, if under the age of 59.5, a 10% penalty is assessed as well. Depending on your tax bracket at the time of withdrawal, you could end up playing close to 50% in taxes and penalties upon withdrawal from a 401(k).
The Advantages & Disadvantages of Rolling Over to an IRA
- More control for avid and active investors. Choosing an IRA places your assets firmly in your control, with no outside influence.
- Investment versatility. IRAs, both Traditional and Roth, are open to far more options when it comes to investing.
- Rolling into unified, consolidated accounts. If you have multiple floating 401(k) accounts, or currently are holding an IRA account, you stand to simplify your investments considerably by rolling them into a single account.
- Potentially higher fees and lost opportunities. In some cases, additional fees or higher investment costs may make choosing an IRA the less desirable option. However, these added fees are typically for the active management by an investment advisor.
- Potential opening to risks. Employer-held 401(k) accounts mean a planned fiduciary, who can be trusted to act in safe, controlled interests. To many, this security is welcome. Registered Investment Advisors (RIA) act as a fiduciary for their clients, so this only applies to advisors that are broker-dealers.
WHAT’S THE DIFFERENCE BETWEEN A ROLLOVER AND AN ASSET TRANSFER?
The main difference between a rollover and an asset transfer is that a transfer can only be done between two accounts with the same registration (Roth IRA to Roth IRA). A rollover can be from different registrations, such as from a 401(k), 403(b) or 457 into an IRA.
WILL I OWE TAXES ON MY ROLLOVER?
No taxes are owed on a direct rollover from like registered accounts. Also, no taxes are incurred on a direct rollover from a retirement plan (401(k), 403(b), 457) to an IRA. Taxes are only owed if a “distribution” from a retirement plan occurs.
WHAT HAPPENS IF I ALREADY TOOK THE CASH FROM MY ACCOUNT? CAN I STILL ROLL OVER TO AN IRA OR TO A NEW PLAN?
If a cash distribution from an IRA or 401(k) has taken place, you have 60 days to place into another IRA or 401(k) plan. Otherwise, taxes and penalties (if applicable) will be owed.
CAN I MOVE MY ASSETS FROM ONE TYPE OF PLAN TO ANOTHER, FOR EXAMPLE, FROM A 403(B) TO A 401(K)?
Yes, assets can be transferred between retirement plans such as a 403(b) into a 401(k).
CAN I ROLLOVER AN OLD 401(K) THAT HAS BOTH PRE-TAX AND AFTER-TAX MONEY IN IT?
Yes, old 401(k)’s that contain pre and after-tax money can be transferred to an IRA’s. However, the funds will be split between two IRA’s, a traditional and a Roth. The pre-tax dollars will be rolled into a traditional IRA, whereas the after-tax dollars will fund the Roth IRA.
CAN I LEAVE A PORTION OF MY 401(K) IN AN OLD EMPLOYER’S PLAN AND ROLL THE REMAINING AMOUNT TO AN IRA?
Rolling over only a portion of your 401(K) to an IRA is an option from a tax perspective. However, some plans may not allow for partial rollovers. You must confirm with your plan administrator.