Good for you if you're considering rolling over your 401(k) into a retirement account such as a Rollover IRA when leaving your job. It's a penalty-free strategy that can be a powerful boost to your retirement savings. Cashing out your 401(k) can result in an early withdrawal penalty -- and paltry retirement savings.
Here's a closer look at how you can roll over a 401(k) account, along with some persuasive reasons for doing so.
Defining terms: What's a 401(k)?
A 401(k) plan is a retirement plan typically sponsored by an employer, permitting workers to sock away a portion of their earnings into a tax-advantaged retirement account. The traditional form of the 401(k) works much like a traditional IRA: Your contributions within a given year reduce your taxable income for that year. In a simplified example, if you earn $75,000 and contribute $10,000, your earnings fall to $65,000, saving you tax dollars up front. (Your withdrawals will eventually be taxed, though.)
A newer form of 401(k) plans is the Roth 401(k), which shares some features of Roth IRAs. For example, like a Roth IRA, you fund it with post-tax contributions. So if you earn $75,000 and contribute $10,000, your earnings remain at $75,000. While there's no up-front tax break, your withdrawals in retirement can be entirely tax-free.
401(k)s differ in a few meaningful ways from IRAs:
- Contribution limits: 401(k)s have much higher contribution limits. The IRA contribution limit for 2019 is $6,000, plus another $1,000 for those 50 and older, while the 401(k) 2019 limit is a whopping $18,000, plus $6,000 for those 50 and up, totaling $24,000 for many people.
- Investment options: 401(k)s typically offer a more limited menu of investment options for your contributions, such as perhaps a dozen assorted mutual funds. In an IRA opened at a major brokerage, you can invest in just about any stock or exchange-traded fund (ETF), and often any of hundreds of mutual funds, too.
- Matching funds: You're on your own with IRAs, but 401(k) plans tend to feature matching contributions from employers -- which is essentially free money. A typical employer match might be 50% of worker contributions up to 6% of pay, resulting in employers contributing a maximum of 3% of worker pay.
Leaving your job: It's decision time
You may not have changed your job that often in your work life so far, but many people routinely do. The Bureau of Labor Statistics noted in 2015 that workers born between 1957 and 1965 held an average of 11.7 jobs between ages 18 and 48 -- changing jobs, on average, about every 2 1/2 years. Each time someone with a 401(k) changes a job, they need to decide what to do with their existing account -- and there are roughly 15 million 401(k) participants changing jobs each year, per the Employee Benefit Research Institute.
These folks have three main options when leaving a job that has sponsored a 401(k) account for them:
- Cash out the account
- Leave it in place, if that's allowed
- Roll over the account to a new one
A closer look at each of these options is coming up, but there's an important detail to be aware of as soon as possible: 60 days. That's how long you have to transfer those funds, once you withdraw them, if you want to roll over your account.
Also, know that you might even be able to do two or more of the above. For example, you might leave your account in place, and then, later, transfer just some of its value to an IRA.
Cash out your 401(k)
For most people in most situations, the answer to the question above is no -- don't cash out your 401(k). Many do -- about 1 in 3 people cashed out their 401(k)s before reaching age 59 1/2 (typically because of leaving a job), per data from Fidelity Investments -- but it's not a smart move, as it shortchanges your future.
Remember that a 401(k) account is not meant to be a short-term savings account, but a long-term vehicle to help fund your retirement. With many people not staying at jobs for very long, their 401(k) accounts will often have relatively little money in them, making it not seem worth rolling over. Even if you only have $20,000 in your account, if that sum can remain invested for another 25 years and grows by an average of 8% annually, it will end up worth almost $137,000. That can be very helpful in retirement. Indeed, if you withdraw 4% per year in retirement, it will give you more than $5,000 per year, or around $450 per month.
Here's another incentive to not cash out: If you're withdrawing funds from your 401(k) before age 59 1/2, you'll have to fork over a 10% penalty, not to mention having to pay taxes on the withdrawal, too.
Leave your 401(k) in place
Some workers leaving a job with a 401(k) account may be allowed to leave their account in place. So you might move from you job at Company A to a job at Company B and keep a 401(k) account at Company A.
The main upside of this move is that it's very easy. It also lets you decide, in the future, to roll over the account into another one. But there are some downsides, too. You won't be an employee at the company any more, so you won't be receiving any more matching contributions, and you can't add any more money into the account on your own, either. Your investment options will remain limited to those offered by the plan. The plan may charge fees, which might be higher than the fees in your new employer's 401(k) or in an IRA. And perhaps most important, this strategy, if you do it repeatedly when leaving multiple jobs, can have your financial life getting progressively more complicated, with lots of retirement accounts to keep track of.
If you don't leave your account in place and you don't cash it out, you'll likely be rolling it over into a new account. That can take several forms, though. You might roll it over into a new employer's plan, a traditional IRA, or a Roth IRA. Here's a closer look at each of the three options above.
Roll over your 401(k) to a new employer's 401(k) plan
If you're moving to a job with a company that has a 401(k) plan of its own, you may be able to roll over your 401(k) account into an account in that plan. This is especially smart if the new 401(k) plan is a good 401(k) plan -- perhaps with particularly appealing investment options and/or low fees.
One upside is that you'll continue to enjoy tax-deferred growth in the account -- as you would if you rolled over your 401(k) into a traditional IRA. But unlike a traditional IRA that requires you to start taking required minimum distributions (RMDs) beginning at age 70 1/2, you can postpone starting to take them if you're still working.
You may also be able to take distributions penalty-free beginning at age 55, if you leave your job between the ages of 55 and 59 1/2. With IRAs, you face penalties for withdrawals before age 59 1/2. (This is allowed only for a 401(k) sponsored by the employer at the current job you're leaving, not for any old 401(k) account held at a former employer.) The 401(k) plan at your new employer might also permit loans to be taken from accounts, which may be handy on occasion -- though it's generally not an advisable move.
This kind of consolidation can also help simplify your financial life, as you combine what might otherwise be two accounts into one. And here's one last upside: 401(k) accounts are also generally protected from any claims by creditors. That's not the case with IRAs.
A disadvantage of rolling over a 401(k) into a new employer's plan is that the money remains in a 401(k), which will offer far fewer investment choices than an IRA, through which you can invest in just about any stock, possibly hundreds or even thousands of mutual funds, and other securities. And many 401(k) plans charge more in fees than you'd face elsewhere.
One more consideration is that upon your death, the entire value of your 401(k) account might be paid to your beneficiary, possibly triggering a major tax headache. (If you have a surviving spouse, he or she can roll over the sum into an IRA without triggering taxes.) You'll likely have more options with an IRA, but if this is a concern, look into the rules governing the new 401(k) plan -- as plan rules can vary from company to company.
Perhaps the biggest caveat regarding a rollover from one 401(k) plan to another 401(k) plan (or an IRA) is if you're transferring any company stock that you received. If your 401(k) plan has some company stock in it, and especially if it has a lot of company stock in it, take some time to read up on an "NUA strategy," which could save you thousands or tens of thousands of dollars -- or more.
Roll over your 401(k) to a traditional IRA or Roth IRA
If your new employer doesn't offer a 401(k) plan or it simply isn't a very appealing plan, consider rolling over your 401(k) into an IRA. Remember that there are two kinds of IRAs -- traditional and Roth -- with the former accepting pre-tax contributions and letting you defer taxation until withdrawals that typically occur in retirement and the latter accepting post-tax dollars and letting you eventually make tax-free withdrawals. Each has its pros and cons.
Funds transferred into either a traditional or Roth IRA can be invested in a very wide range of stocks, ETFs, mutual funds, and other securities, and they will grow in a tax-advantaged way. If you've rolled over those assets into an IRA at a good brokerage that offers many handy services, such as financial advising or Wall Street research reports, you can take advantage of those, too.
Drawbacks for rolling over a 401(k) account into an IRA include the fact that IRAs don't let you borrow against them the way that 401(k)s do, and assets held in an IRA are generally not protected from creditors who may come calling -- unless you've filed for bankruptcy protection.
A potentially big drawback if you're rolling over a 401(k) to an IRA will materialize if you're transferring any company stock that you received. If you've received company stock from the employer you are leaving or have just left and it's in your 401(k) account, be sure to read up on an "NUA strategy" that could save you a lot of money.
A last consideration when rolling over a 401(k) into an IRA is whether you should do so to a traditional or Roth IRA. With traditional IRAs, know that you'll have to start taking required minimum distributions once you turn 70 1/2. With Roth IRAs, you can leave the money in the account for as long as you live, if you want.
You can easily transfer assets from a Roth 401(k) into a Roth IRA, but if you're transferring from a traditional 401(k) into a Roth IRA, you'll be taxed on the value of the assets. That's because a traditional 401(k) will have been funded with pre-tax dollars, unlike Roth IRAs, which get funded with post-tax dollars in order to qualify for eventual tax-free withdrawals.
Now that you have an idea of how you want to proceed with your 401(k) rollover, you need to know exactly how to do it. Read on.
How to roll over your 401(k) into your new employer's 401(k) plan
Before taking this action, be sure to review your new employer's plan, and make sure it's a good 401(k) plan. Sites such as brightscope.com can help -- and can allow you to compare the new plan with the old one. Next, assuming you want to proceed, contact the 401(k) plan administrator at your new employer. You'll need an "address" for their plan, so that your current plan administrator can direct the funds to your account. A common format for this address might be something like "NewEmployerName 401(k) Plan FBO [for the benefit of] YourName." After that, the funds will either be sent directly to your new account or will be sent to you via a check that's made out to that account address. Both of these ways count as "direct" rollovers and are the easiest options.
A less simple way is the "indirect" rollover, which involves your former employer simply sending you a check for the contents of your 401(k) account, made out to you -- less 20% which is withheld for taxes, in case the transaction ends up being a cash-out of the account. Meanwhile, you have 60 days in which to complete your rollover, giving your new employer's 401(k) administrator that sum of money. If you don't follow the rules, you may end up facing a 10% early withdrawal penalty.
Once you're all set with your new and funded 401(k) account, be sure to have those assets invested effectively and to continue contributing to the account. Don't make common 401(k) mistakes, such as being too conservative, not aiming to increase your contributions over time, and not grabbing all available matching funds. Simply keeping much of your money in one or more low-fee index funds is a sound investment strategy.
How to roll over your 401(k) into an IRA
A simple way to roll over your 401(k) account into an IRA is to do so through a brokerage. Take a little time to review good brokerages and to choose which one will serve you best. (If you already have one or more accounts with a particular brokerage and you're satisfied with it, you might just stick with that one.)
Here are some factors to consider when assessing brokerage contenders:
- Costs: Ideally, focus on brokerages that charge little per trade. Many good ones charge $10 or $7 or less per trade. This factor isn't as critical if you don't trade frequently, though. Look into any other fees that might charged, too, such as IRA custodian fees, account inactivity fees, paper statement fees, annual fees, and so on.
- Research: Many brokerages offer free company research reports and tools such as stock screeners. If this is valuable to you, see what each of your contenders offers.
- Mutual funds: Some brokerages offer hundreds of funds in which you can invest, while others offer thousands. If you're interested in any particular funds, see whether they're available.
- Non-stock offerings: If you're interested in investing in bonds or CDs in your IRA, for example, see whether they're offered.
- Usability: Look into how easy to use each brokerage's online trading system is and how user-friendly its website is.
- Customer service: Ask some questions of the customer service department to see how responsive it is.
- Convenience: Would you rather place trade orders through an actual person, your phone, or online? See which brokerages offer what you want. Some have brick-and-mortar locations, for instance, while others are only available online.
Once you've settled on the brokerage, contact both the brokerage and your 401(k) plan's administrator to ask how they do such transfers and what information they may need you to provide. For example, you may need to set up an IRA account at the brokerage first and then have your company wire the funds to that account. Or you may be given a check, made out to the brokerage, which needs to be deposited relatively soon. (Remember that 60-day rule!) It's important to follow the rules and procedures of your IRA provider, so that the transfer takes place smoothly, without triggering any headaches such as taxes or penalties.
Again, as with money moved to a new 401(k) plan, be sure to invest those assets effectively and to continue contributing to the account. Don't make common IRA mistakes, such as forgetting required minimum distributions, not designating beneficiaries, and trading too often in the account. Consider just keeping much of your money in one or more low-fee index funds -- which is what Warren Buffett has recommended for most people. If you're near or in retirement now and aren't too focused on growing your assets and you want to minimize volatility, you might keep a meaningful chunk of your assets in lower-risk places, such as CDs or bonds.