This article was updated on April 5, 2017, and originally published on August 7, 2016.
If you leave a job, or retire, you'll have a decision to make in regards to your 401(k). You can leave your account alone, transfer it to your new employer, cash it out, or roll it over into an IRA. Here's what rolling over your 401(k) could do for your retirement planning, and whether or not it could be the best move for you.
What does it mean to roll over your 401(k)?
In a nutshell, rolling over your 401(k) means moving your retirement assets into another account, typically a traditional IRA. You can roll over your 401(k) into a Roth IRA, but unless the contributions were originally made on an after-tax basis, doing so can result in a pretty hefty tax bill.
A 401(k) and traditional rollover IRA have some similar features. For example, contributions are made on a tax-deferred basis, which means that you won't have to worry about capital gains or dividend taxes on every year -- you simply count your withdrawals as taxable income. And, with both account types, you can take money out penalty-free after you turn 59-1/2 years old.
There are a few advantages to rolling over that you should be aware of. Perhaps the most significant is the increase in available investment choices. While most 401(k) plans have a selection of investment funds to choose from -- perhaps a dozen or two -- with a rollover IRA you can choose to invest in any mutual funds, stocks, or bonds you want. If you want to put some of your retirement savings in say, Apple stock, you are free to do just that. Or, if you want to continue to invest in funds and leave your retirement saving on auto-pilot, you can do that too. Plus, you can shop around for funds and might even be able to find lower-cost options to invest in.
Additionally, IRAs have some different ways than 401(k)s to use your money earlier without paying the IRS a penalty. Most notably, you can use up to $10,000 for a first-time home purchase or any amount for college expenses at any time, regardless of your age.
Now that we've seen an overview of what it means to roll over your 401(k), let's take a look at the other three options available.
1. Cash it out -- This is rarely, if ever, a good idea. Unless you're suffering an extreme financial hardship and have no other options, it's not a good idea to withdraw your retirement savings. For one thing, you'll have to pay taxes and penalties, which depending on your tax bracket can easily take 35% or more of your money. And, you'll effectively be robbing your future self. Just as an example, if you're 35 years old and have $25,000 in your 401(k), cashing it out would give you $16,250 assuming you're in the 25% tax bracket. On the other hand, leaving that amount invested until you're 65 could result in an account value of more than $190,000, based on 7% annualized returns. That seems like a no-brainer to me.
2. Leave it alone -- As long as your account's value is greater than a certain threshold, you're allowed to leave your money invested in your former employer's plan. And, if you're happy with your 401(k)'s performance and investment options, there's nothing wrong with doing this.
I'd suggest at least comparing the fees charged by your plan's fund options with some alternatives, but this is a completely valid option. It's also worth mentioning that there are some advantages to a 401(k) over an IRA, such as the ability to borrow money from your account and the ability to get penalty-free withdrawals after age 55 if you're no longer working, as opposed to waiting until 59-1/2 with an IRA.
3. Combine it with your new employer's plan -- If your new employer offers a 401(k), chances are good that you have the ability to move your old 401(k) into your new plan. Doing so can make perfect sense, as it can be convenient to keep all of your retirement savings in the same place. Before doing so, compare the fees charged by your new plan's fund options with your old ones. If your old plan is cheaper, it's probably best not to transfer the funds.
Who should roll over?
Simply put, you should consider rolling over your 401(k) if the benefits of an IRA outweigh those of a 401(k) for your personal situation.
Specifically, if the idea of researching, choosing, and managing your own investments appeals to you, or if you'd like to use some of the money to pay for your first house or send your kids to college, a rollover IRA could be the best option for you.
On the other hand, if you don't have the time or desire to invest your retirement savings, or prefer some of the advantages of 401(k) plans I mentioned, there's nothing wrong with leaving your account alone or moving it into your new employer's plan. The most important point is to leave it invested. Whatever you do, don't cash out unless you have no other alternative.