If you recently left your employer, you may have to decide whether or not your old 401(k) should come along for the trip. A 401(k) rollover can help you consolidate your retirement savings into fewer accounts, open up additional investment options, and even save you money in certain circumstances.

A dog rolling over in the sand.

This dog knows how to roll over. Do you? Image source: Getty Images

What is a 401(k) rollover?

A 401(k) rollover is when you transfer the account balance in your old 401(k) to a new or existing 401(k) or IRA. The IRS gives you a 60-day window once the transfer is initiated to complete it, and you're allowed to do one rollover every 12 months.

You'll usually face this decision when you leave an employer, but you might have an old 401(k) clanging around that you've forgotten about. It's never too late to examine your old plans and decide whether or not to roll it over into your current employer's 401(k) or an IRA.

You have four main options when considering a 401(k) rollover:

  • Rolling over the account into an IRA
  • Rolling over the account into your new employer's 401(k)
  • Cashing out the account
  • Leaving your old 401(k) account as-is

Direct rollover vs. indirect rollover

There are two ways of performing a 401(k) rollover: a direct rollover and an indirect rollover.

In a direct rollover, that money never passes through your accounts. Instead, you arrange for the rollover with the administrator of your old plan and ask them to execute a direct rollover. You'll either need to coordinate with the administrator of your new 401(k) plan or have the account details of your IRA ready.

Your old plan provider might cut and mail you a check made out to your IRA. In that case, you'll be responsible for mailing that check onward to the appropriate destination.

In an indirect rollover, you receive a cash distribution from the administrator of the former employer's plan, and it's your responsibility to ensure your retirement savings wind up in your new plan within 60 days. This approach leaves you vulnerable to a tax hit and penalties if you don't do so within a set amount of time. For this reason, a direct rollover is the safer option when it is available.

Under IRS rules, employers must withhold 20% of the taxable portion of that distribution -- just the earnings for a Roth 401(k) and all earnings and contributions for a traditional 401(k) -- in the event you don't deposit that cash in a new tax-advantaged retirement account within 60 days. Remember, traditional 401(k) contributions are made pre-tax.

If you do make that rollover within the 60-day window, that 20% withholding will be returned to you. If you don't make that 60-day window and you are younger than 59 1/2, you may also be subject to a 10% penalty.

To avoid tax consequences and penalties, you'll have to deposit funds into your new account equaling the amount in your old account before the 20% IRS withholding by your former employer is returned to you. This means you'll need to find another source of funds to make up for the IRS withholding.

For example, if you are indirectly rolling over $10,000 from your former employer's traditional 401(k) plan, you will only receive a check for $8,000. You must deposit the additional $2,000 yourself, out of pocket, within 60 days to avoid a 10% tax penalty. Once completed, that $2,000 initially withheld will be returned to you.

Rolling over your account to an IRA

Want to invest your retirement savings but don't like the investment options, fees, or other aspects of your employer's plan? You can choose to roll over your 401(k) into an IRA, another kind of tax-advantaged retirement account.

Before you take the plunge, however, be cautious: You should have an understanding of all the factors involved, including the fees associated with an IRA, and of all the potential tax consequences.

The nature of your old 401(k) determines what type of IRA you'll need to move your funds into. Converting a 401(k) into an IRA can be accomplished without paying new taxes if your IRA type matches your 401(k) -- that is, if you roll over a traditional 401(k) into a traditional IRA and a Roth 401(k) into a Roth IRA.

However, if moving funds between mismatching accounts, say, a traditional 401(k) into a Roth IRA, this is known as a Roth conversion and will be subject to taxes. 

In a Roth conversion, you pay taxes on your funds when you make the switch, but you eliminate federal income tax on future withdrawals. Whether this is a good idea for you or not depends on whether you expect your tax bracket at the time of the conversion to be higher or lower than when you start taking withdrawals. Make sure to check whether your 401(k) plan permits a Roth IRA rollover before setting your sights on this option.

Rolling over your account to your new employer

If you like the investment options in the 401(k) plan offered by your new employer and are comfortable with the fees that plan charges, you can roll over your old account to your new employer's plan -- if they allow rollovers into the plan.

This option can be especially useful if you need to keep pre-tax funds out of your IRA in order to execute the backdoor Roth. If your income puts you above the Roth IRA contribution limit, you can still move funds into a Roth IRA by first making an after-tax contribution to a traditional IRA and then converting it to a Roth IRA.

But if you have pre-tax funds in an IRA, even a separate account, it'll ruin the strategy, and you'll get an extra tax bill at the end of the year.

Cashing out

Deciding against a rollover and asking your 401(k) plan administrator to cut you a check is a common, but costly practice.

Doing so is the same as taking a distribution from your retirement account. That means, you'll have to pay all applicable income tax on the distribution, and if you're under age 59 1/2, you'll also owe a 10% penalty.

By law, your former employer will withhold 20% of your funds and apply them to taxes. And you might be subject to additional taxes on top of that 20% withholding depending on your tax bracket.

That means a significant portion of your 401(k) savings could evaporate -- and that fat check you thought you'd get might prove uncomfortably thin.

It's important to note that once you take a distribution, you won't be able to easily put that money back into your 401(k). Your contributions are capped each year, and once the year is over, you lose any leftover cap room. Taking a distribution check now means foregoing years of tax-free growth in your investments and likely paying higher taxes and penalties than necessary.

Don't change a thing

If you like your former employer's 401(k) plan, you may be able to keep your money parked there. But staying with the same plan will mean some changes.

As a former employee, you won't be able to make additional contributions to the account and you may also give up the option of taking a loan from the plan. And some companies will stop paying certain fees for former employees who remain in the plan, which might mean an extra cost to you.

Not all ex-employees are eligible to hang on to their old 401(k) accounts. If the value of your account is below certain thresholds, your former employer may require you to take a cash distribution or may automatically roll your savings into an IRA.

To avoid unexpected distributions or rollovers, be sure to check your former employer's rules regarding retirement savings accounts.