According to the Bureau of Labor Statistics, the average Baby Boomer will have held 12 jobs between the ages of 18 and 52. Over the next several years, millions of Americans will change jobs or retire. Many have company-sponsored retirement accounts like 401(k)s and 403(b)s.
Rolling over your 401(k) money offers you three key benefits—choice, control, and convenience.
- Choice. By rolling your money into an IRA, you have a wider array of investments from which to choose.
- Control. Your IRA isn’t subject to your former employer’s 401(k) rules and restrictions. You’ll enjoy more control over how and where you invest your money.
- Convenience. An IRA rollover gives you the chance to streamline the various retirement assets that you’ve accumulated over time. It’s easier to track and manage your retirement finances after consolidating your assets into a single IRA.
An IRA rollover is an effective way to maintain the tax-sheltered status of your retirement nest egg. While there are some considerations to make before initiating your IRA rollover, the process is simpler than it sounds. We can help you execute your retirement plan rollover in the most tax-friendly way possible.
It’s best to be informed of the basics before determining whether an IRA rollover is right for you. Let’s dive into all the most common questions about IRA rollovers.
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I’m switching jobs. What should I do with my old 401(k)?
The most common rollover is from a 401(k) to an IRA, and the most common reason for a 401(k)-to-IRA rollover is a job change.
You generally have four options for what you want to do with your old 401(k):
- You can leave your retirement funds in your old employer’s plan (if allowed).
- You can roll your retirement funds into a new employer’s plan (if allowed).
- You can cash out your retirement savings.
- You can roll your retirement funds to an IRA.
Option #1: Leave your retirement funds in your old employer’s plan (if allowed)
- Investment options. You can take a relatively hands-off approach to choosing investment options, which are selected and monitored by your 401(k) plan’s Fiduciary.
- Fees. Your employer may cover some administrative costs, like those associated with 401(k) plan administration. The Employee Retirement Income Security Act (ERISA) requires your company to administer the plan in compliance with various laws & regulations.
- Creditor protection. ERISA contains a special clause, known as the anti-alienation provision, which blocks your 401(k) money from the hands of most creditors.
- Tax benefits. Your contributions are made on a pre-tax basis, which lowers your taxable income for the year. Only your distributions are taxable.
- Investments. Your plan Fiduciary creates your 401(k)’s menu of investments. In general, you’ll have fewer investments to choose from than an IRA.
- Plan administration. As a former employee, your old employer can charge additional administrative fees—ones that current employees don’t have to pay.
- No employer match. You won’t be able to contribute to your old plan and receive an employer match, which is one of the big advantages of a 401(k). In some cases, you may not be able to borrow from your plan.
- Distributions. Each 401(k) plan defines “retirement” a little differently; your old employer’s plan can call for required minimum distributions (RMDs) to begin earlier than the tax code does. Remember that the penalty for not taking is RMD is 50% of your RMD, in addition to the income tax due on the distribution! Moreover, you may face limitations in taking a stream of retirement income payments (i.e., “installment payments”) or in implementing estate planning strategies.
- Loans. Some plans require loan repayments to be made through wage withholding. As a former employee, you’ll have limited loan access.
- Extra features. Many 401(k)s don’t offer additional investments that provide for long-term retirement income, such as annuities.
- Extra administrative load. If you’ve held jobs with several employers throughout your career, you probably have several different retirement plans. If you leave your 401(k) at each job, it becomes complicated to keep track of all your retirement funds. It’s much easier to consolidate your assets into one retirement account. As a bonus, you can avoid higher fees from several smaller accounts.
Option #2: Roll your retirement funds into your new employer’s plan (if allowed)
In general, the benefits of doing a roll-in are similar to leaving your retirement funds in your old employer’s plan.
- Simplicity. By consolidating your retirement funds, you can simplify your retirement savings management. This can help reduce your paperwork.
- Make sure your new retirement plan is excellent. Always compare investment options, plan features, and services in your new employer’s plan against your old employer’s plan. If there are limited or expensive investment options, or if there’s no employer match, the new 401(k) may not be the best move.
Option #3: Cash out your retirement savings
Cashing out your 401(k) is a tempting way to solve a short-term cash flow problem, but you could potentially stunt your retirement. In general, cashing out is not the optimal option. You’ll have to pay fees and penalties for withdrawing the funds before age 59 ½, miss out on the future growth of the money you withdraw, and potentially impact your future retirement lifestyle. Before deciding to cash out your 401(k), arm yourself with the facts.
- Investments. You have the freedom to invest in whatever you’d like, and to change your investments at any time.
- No retirement plan rules. You don’t have to follow the yearly contribution or income limitation rules that employer plans & IRAs are subjected to.
- Distributions & loans. You can dip into your assets at any time, and you don’t have to take RMDs. You get to choose the timing and amount of your distributions, and you have more flexibility for non-traditional retirement income & estate planning strategies.
- Tax benefits. There are potential tax diversification benefits, as assets won’t be taxed again in retirement years—although future investment earnings will typically be taxable in the year they are earned.
- Investments. You’re responsible for selecting & monitoring your own investments.
- Plan administration. You’re responsible for overseeing investments and analyzing the tax impact of distributions.
- Creditor protection. In general, non-retirement assets don’t benefit from creditor protection.
- Tax penalties. Your cash-out is considered income. If you’re under age 59 ½, you’ll have to pay local, state, and federal taxes on your distributions. If you don’t roll over your payment, it will be taxable subject to a 20 percent mandatory income tax withholding.
- Less money for your future. If you choose to spend your withdrawals, you risk depleting your retirement savings and missing out on tax-sheltered returns. This is especially true if the market is down when you make the early withdrawal. If you cash out, it can severely impact your ability to participate in a rebound, which offsets your entire retirement plan.
Cashing out is usually a bad move; try to avoid this option except in true emergencies. If you need quick cash, take out the bare minimum and transfer the remaining funds to an IRA.
Option #4: Roll your retirement funds into an IRA
By rolling your retirement funds into an IRA, you become the owner of your retirement savings, rather than a participant in an employer plan. The biggest draw to investing through an IRA over a 401(k) is access to a wider range of investment options. You may also be able to consider annuities or other investments with guaranteed retirement income options.
- Investments. You have the most control and the most choice as an IRA owner. IRAs are completely self-directed; you retain control over all investment activities. Unless you work for a big Fortune 500 firm, IRAs typically offer a much wider array of investment options than 401(k)s. You can change your investments at any time, subject to your IRA provider’s rules.
- Tax advantage. Similar to a 401(k), your contributions are tax-deductible. Your rollover is even simpler if you’re rolling over between accounts that are taxed in similar ways (e.g., a traditional 401(k) to a traditional IRA, or a Roth 401(k) to a Roth IRA).
- Fees & fee disclosures. Like your old employer’s Summary Plan Description, your IRA provider is required to provide a disclosure statement explaining your IRA features.
- Plan administration & other services. Your IRA trustee or custodian handles contribution and distribution reporting and will help you with your age 70 ½ RMD calculations.
- Distributions. You generally have more leeway with IRA withdrawals versus employer plan withdrawals. There are certain exceptions to the 10 percent early distribution tax levied on IRA distributions (e.g., for certain education expenses or for purchasing your first home). Finally, you enjoy more flexibility in when and how much you plan to distribute, which can support retirement income & estate planning objectives.
- Creditor protection. The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) of 2005 provides federal bankruptcy protection for IRAs; in 2020, traditional and Roth IRAs are protected up to a value of $1.36 million. SEP IRAs, SIMPLE IRAs, and most rollover IRAs are fully protected from creditors in a bankruptcy, regardless of the dollar value.
- Choose when to pay taxes. You can decide when to pay taxes on IRA assets with flexible conversion & re-characterization options. IRAs are great wealth transfer vehicles that offer flexible estate planning options (e.g., stretch IRAs).
- Investments. Unless you have a Fiduciary Financial Advisor on your team, you’re responsible for selecting & monitoring investments. This can have a huge impact on your retirement finances.
- Plan administration. You’re responsible for managing your IRA, with support from your IRA trustee or custodian. Services may be more limited than offered in the employer plan, so you might benefit from bringing a Financial Advisor onboard for personalized investment education and advice.
- Distributions & loans*. Plan loans aren’t permitted for IRAs. You’ll be subjected to a 10 percent tax for distributions taken prior to age 59 ½, unless an exception applies. With a traditional IRA, you must start taking RMDs at age 70 ½.
- Creditor protection. IRAs are protected under federal bankruptcy law. State laws may provide certain protections from other types of creditor claims.
- Tax treatment of stock options. Employer stock rolled from an employer plan to an IRA will be taxed as ordinary income upon distribution time. Stock held in other types of accounts may qualify for capital gains treatment. As with most things tax-related, you should prepare a tax planning strategy with a trusted Fiduciary Financial Advisor who is familiar with your state’s rules and your particular financial circumstances.
*The CARES Act, enacted on March 27, 2020, provides for special distribution options and rollover rules. Visit the IRS website for the most updated information.
What is a Rollover IRA?
Simply put, a rollover is the transfer of your retirement savings from your old employer-sponsored retirement account to an IRA. The receiving IRA account is your Rollover IRA.
With an IRA rollover, you can maintain the tax-deferred status of your retirement assets without paying taxes or penalties at the time of transfer.
You may want to initiate an IRA rollover for any number of reasons—your employment situation has changed, you want to switch investments, or you’ve received death benefits from your spouse’s retirement plan.
In general, the following types of plans allow rollovers:
- A traditional IRA
- An employer-sponsored retirement plan (e.g., 401(k), SIMPLE plan, SEP plan)
- A 457(b) plan
- A 403(b) plan
- A Roth IRA (very limited – see IRS Publication 590)
- A designated Roth Account within a plan (limited – see IRS Publication 590)
How long do I have to roll over my 401(k) from a previous employer?
- If you have less than $5,000 in your account, your old employer is legally allowed to require you to transfer your money out of that retirement plan. (It costs them money to maintain your account, after all.)
- If you contributed between $1,000 and $5,000, your employer might perform an involuntary cashout by moving your money into an IRA.
- If you have less than $1,000 in the account, they’ll likely cut you a check for the appropriate amount—in which case you should deposit it into another retirement account ASAP so that you don’t get hit with a penalty from the IRS.
You get to keep your employer matches only if the contributions had vested prior to your departure. Your old employer retains all unvested contributions.
Now, your 401(k) contributions can stay put in your old account, but does that mean they should? You’ll likely find it preferable to track your investment performance in one account versus managing investments across several accounts.
How can I roll over my 401(k) to the Rollover IRA?
If you decide to roll over an old retirement account, you can transfer funds directly or indirectly via:
- An indirect (60-day) rollover
- A direct rollover (trustee-to-trustee transfer)
The indirect, or 60-day, rollover
With an indirect rollover, you can request that your old employer make a check out to your name. Then, to complete the transaction, you can deposit your funds into your new retirement account.
One inconvenience is the mandatory tax withholding—your employer assumes you are cashing out the account, so they’re required to withhold 20 percent of the funds for federal taxes. As a result, your $100,000 401(k) nest egg is reduced to an $80,000 check.
If you want to roll over the entire distribution amount (and avoid taxes and possible penalties on the amount withheld), you’ll need to come up with that extra $20,000. Of course, you’ll be able to recover the withheld amount upon filing your tax return.
After receiving your check, you have 60 days to deposit the full amount into a new retirement account. Assuming you haven’t reached age 59 ½, missing the 60-day limit could result in a mandatory 10 percent early withdrawal penalty. The $20,000 mandatory tax withholding must be reported on your tax return—and could push you into a higher tax bracket.
The indirect rollover only makes sense if you need to use your funds temporarily, are certain that you can complete the rollover within 60 days, and can foot the cost of your withheld amount.
For most rollovers, the direct method is the most efficient option.
The direct rollover, or trustee-to-trustee transfer
Direct rollovers protect you from two key traps:
- Missing the 60-day deadline, and
- The 20 percent mandatory tax withholding
With a direct rollover, you don’t have to handle your retirement assets, which means your transfer is not treated as a distribution. Simply connect the trustees or custodians of your old and new plan, then your plan administrators will complete your rollover electronically.
Your employer is required to give you the option of a direct rollover to another retirement plan.
How long does a rollover take?
If you opt for a direct (60-day) rollover, you have 60 days—not two months—to complete the rollover. Under certain circumstances, you can apply for a waiver or extension of the 60-day period from the IRS.
A direct rollover (trustee-to-trustee transfer) takes about 2 to 3 weeks from start to finish.
How many rollovers can I do in a year?
You’re limited to one tax-free rollover per 12-month period. This applies to all IRA accounts you may own.
There are some exception to the one-rollover-per-year rule:
- You can roll over more than one distribution from the same qualified plan, 403(b), or 457(b) account within a year.
- The once-per-year limit does not apply to rollovers from traditional IRAs to Roth IRAs (e.g., Roth conversions).
What’s the difference between an IRA rollover and transfer?
If you’re switching your IRA balance between providers, use the transfer method instead of a rollover.
A transfer is non-reportable and can be done an unlimited number of times during any period. Just call your current provider and request a “trustee-to-trustee transfer.” This moves money directly from one financial institution to another, and it won’t trigger taxes.
A transfer removes the withdrawal process of the rollover, so your assets will move directly into your new account. You won’t be subject to the 60-day rule.
Why should I do a 401(k) rollover to IRA?
An IRA rollover might be a good option if you want:
- More, and more flexible, investment choices
- Better communication
- Lower fees
- The potential to open a Roth account
- Cash incentives
- Fewer rules
- Estate planning advantages
- Flexibility for withdrawals
Advantage #1: You want more, and more flexible, investment choices.
Your 401(k) plan is limited to those selected by your employer.
If you’re closer to retirement, most 401(k)s are weaker when it comes to fixed-income options. In all likelihood, you have the choice of a money market fund, a bond index fund, and an actively managed bond fund—and that’s it. Rolling your money into an IRA will provide you with many more fixed-income options, including international bond funds and CDs.
In contrast, you can invest in virtually anything with your IRA. Most types of investments are available to you—mutual funds, individual stocks, bonds, and ETFs, to name just a few. You can even hold investment real estate in your IRA.
You’re also able to make trades whenever you want. Most 401(k)s limit the number of times per year you can rebalance your portfolio, or restrict you to buying and selling during certain times of the year.
Advantage #2: You want clearer communication.
If you leave your account with your old employer, you’ll have to put in more effort to receive updates or get in contact with a 401(k) advisor or administrator. This could be problematic if, for instance, your former employer goes into bankruptcy.
Advantage #3: You want the Roth option.
You can roll over your retirement funds from your employer-sponsored plan to a traditional or Roth IRA. Everyone is eligible for a Roth IRA conversion. Remember that you must pay ordinary income taxes in the year of the conversion on all tax-deferred assets converted to a Roth IRA.
Note that your eligibility to contribute to a Roth IRA phases out at higher modified gross income levels. As a single filer, your Modified Adjusted Gross Income (MAGI) must be under $139,000 in 2020 to contribute to a Roth IRA. If you’re married and filing jointly, your MAGI must be under $206,000 in 2020.
Qualified distributions from a Roth IRA are tax-free, but you may have to pay state, local, and alternative minimum taxes. To be able to withdraw your earnings on a tax- and penalty-free basis, your Roth IRA must meet the five-year holding requirement. Additionally, you must withdraw after age 59 ½ or for qualified reasons, including death, disability, or a first-time home purchase.
Advantage #4: You want to pay less in fees & costs.
Many 401(k)s are hampered by high fees and underperforming investments. It’s possible that the funds offered through a 401(k) are higher-than-average for their asset class.
You’re also paying for the annual fee charged by your 401(k) plan administrator. And as a former employee, you might be charged higher administrative fees for keeping your old 401(k).
You could potentially save a lot in management fees, administrative fees, and fund expense ratios—all of which can shrink your nest egg over time—by rolling over into an IRA. With an IRA, you have more choices and more control over how to invest, where to invest, and what you’ll pay.
Advantage #5: You could use the cash incentives.
To entice investors, firms may offer a cash bonus to encourage you to sign up with them. For instance, TD Ameritrade offers bonuses ranging from $100 to $2,500 when you roll over your 401(k) to one of its IRAs, depending on the amount you have to invest.
Other perks include matches and bonuses, such as free trades.
Advantage #6: You prefer fewer rules.
It’s no secret that 401(k)s are complicated. Companies are free to set up 401(k) rules and regulations however they like. On the other hand, all IRAs follow rules set by the IRS. Brokers must follow the same governing rules with all IRAs.
It’s important to note that the IRS has different rules for 401(k) and IRA distributions. 20 percent of 401(k) distributions are withheld for federal taxes. Conversely, you can choose to have no tax withheld on IRA distributions. It goes without saying that you should have some tax withheld, which is vastly preferable to winding up with a big tax bill at the end of the year—and possibly interest and penalties for underpayment.
The big advantage is your choice of how much to have withheld. Rather than an automatic 20 percent—thus depleting your retirement returns unnecessarily—you can choose an amount that more accurately reflects the actual amount that you owe.
Advantage #7: You want the estate planning advantages.
Upon your passing, most companies prefer to distribute your 401(k) in one lump sum to your beneficiary so they don’t have to maintain your account. Without proper planning, you run the risk of having income and inheritance tax problems. IRAs offer more payout options in comparison.
401(k) plans typically require your spouse to be the primary beneficiary. Unlike 401(k)s, IRAs allow you to designate non-spousal beneficiaries.
If you don’t plan to use your 401(k) funds in retirement, and you’d like to leave your money to your children, consider rolling over into an IRA so your kids can “stretch” the account and pay taxes at a later period than under the 401(k).
Advantage #8: You want flexibility for withdrawals.
Most large 401(k) plans permit retirees to take withdrawals in one of two ways:
- On a regular basis (for instance, monthly or quarterly), or
- Whenever they want
But for the unlucky few who have an “all-or-nothing” requirement, you might need to leave all your money in the plan or withdraw all your funds. In this case, opt for an IRA rollover to manage your withdrawals and taxes.
Even if your 401(k) plan permits monthly or quarterly withdrawals, many plan administrators don’t allow you to pick and choose which investments to sell—instead, they take an equal amount out of each of your investments. With an IRA, you can specify whether you’d like to take the entire amount out of a specific fund and leave the remainder of your retirement assets to grow.
Finally, the distribution options in an IRA are generally more flexible than the options available in your employer-sponsored plan—especially for your beneficiary, in the event of your passing.
We Can Help
If you’re ready to roll over your 401(k) into an IRA, or if you have any questions about a 401(k) rollover, please fill out the form below and we’ll get back to you shortly. We look forward to hearing from you.
DISCLAIMER: Advisory Services offered through Prosperity Financial Group, Inc., an Independent Registered Investment Advisor. Securities offered through Fortune Financial Services, Inc. Member FINRA/SIPC. Prosperity Financial Group, Inc. and Fortune Financial Services, Inc. are separate entities.