If you’re leaving your job and have a 401(k) with your soon-to-be former employer, it’s often a good idea to take the account with you. You can do this by rolling over your 401(k) into an IRA.
Considering how hard you’ve worked for the money, it pays to ensure that you make the best choices when rolling over an IRA. Follow these steps.
- Decide between a traditional or Roth IRA.
- Choose an investment company/broker and open an IRA account, or use an existing one for the rollover.
- Instruct the 401(k) plan administrator to implement a direct rollover to your new IRA account.
- Select investments for your IRA.
Factors to consider
- Tax consequences of rolling over your IRA
- Investment options for your IRA money
- Withdrawal requirements, penalties, fees or expenses involved in the rollover
- Protection from creditors
Determine if a rollover is best for you
You might be able to keep your 401(k) with your former employer. This isn’t an ideal choice, though. You won’t be able to contribute to the account anymore, and you’ll no longer have the support of the company’s human resources department. You may also be hit with higher administration fees than employees.
Most financial experts suggest always rolling over your 401(k) to an IRA—like Doug Carey, a retirement expert and president of WealthTrace, which provides financial planning software for consumers.
High fees and limited investment choices in many 401(k) plans make it beneficial to almost always rollover your 401(k) into an IRA.Doug Carey
Certified financial planner Paul Jacobs, chief investment officer of Palisades Hudson Financial Group in Atlanta, agrees.
A rollover to an IRA is often the best approach when you leave a company. By transferring the funds to an IRA, you gain the ability to invest in stocks, bonds, mutual funds and other investment options that may not be available in your old 401(k.)Paul Jacobs
Consider the many benefits of rolling over an IRA
Though you could leave your IRA at your former employer, there are many good reasons to remove the money and roll it over. Consider the following perks of a rollover:
- Provides more flexibility. You have more control over an IRA, including being able to choose from a wide variety of investment options.
- Enables you to view your entire retirement plan in a single view, rather than having to look up multiple accounts.
- Keeps your retirement savings tax-efficient.
- Allows you to enjoy lower fees, including administration costs.
Choose from two types of rollovers
You have two options when it comes to rolling over your 401(k). You can do a direct or an indirect rollover.
A direct rollover is by far your simplest option. You contact your former employer’s 401(k) administrator and request that they transfer your balance to an IRA. They will fill out several required forms and send the money in your 401(k) to your new IRA. During this transaction, the money never passes through you but goes directly into the IRA.
You can also opt for an indirect rollover, which refers to you withdrawing the money and moving it to an IRA account on your own. This process, which must be completed within 60 days of your terminated employment, is much more complicated and risky than a direct rollover.
Start by asking your former employer to release the money in your 401(k), so you can deposit it in an IRA. When your former employer does this, they are required to withhold 20% of your account balance. That money isn’t returned to you until the following April when you file your taxes. The tricky part is that you must deposit the entire amount in your IRA within 60 days. If you don’t, you pay a 10% penalty.
Here’s an example of how this works with a $60,000 401(k) balance:
- Your employer sends you a check for $48,000, withholding $12,000 for taxes.
- Within 60 days, you must deposit the $48,000 into an IRA account, plus the additional $12,000 to total the original balance of $60,000. If you don’t deposit the full amount, you may owe taxes and will need to pay a 10% penalty.
- The $12,000 being held by your former employer will be credited back to you when you file taxes in April.
- If you miss the 60-day deadline altogether and don’t deposit anything in an IRA, you’ll have to pay a 10% penalty on the entire amount, because it’ll be considered an early distribution. For example, on the $60,000, you would owe a $6,000 penalty.
Open a rollover IRA
If you have an existing IRA, it’s easy to have the funds transferred into that account. When you don’t have an IRA, it’s necessary to open one. You’ll need to first select an online broker. When choosing an online broker, look for one with reasonable fees and a wide selection of investments. Check out SuperMoney’s recommendations here.
Understand the Types of IRAs
You need to choose between a traditional IRA or what is known as a Roth IRA. Each has its benefits and drawbacks.
The main difference between a Roth and traditional IRA is how they are taxed. Traditional IRAs give you a tax deduction on the contributions you made that year, but you pay taxes when you withdraw money at retirement.
With a Roth IRA, you don’t get any tax benefits now, but all of your withdrawals when you retire are tax free. If you roll your 401(k) into a Roth IRA, you must pay taxes on the money. The advantage of doing this is that when you hit 59 ½ years old, any money you withdraw will be tax free. If that is years away, the eventual tax savings could be substantial.
Select investments for your IRA
Rather than being limited to just 10 to 20 various investment options, an IRA offers you a world of possibilities. Your most inexpensive options are low-cost index funds or ETFs, such as offered through USAA and TD Ameritrade.
These funds are cheaper and yet allow you to minimize risk by buying into a wide range of investments. For instance, according to TD Ameritrade, index funds are lower in cost than managed funds. They report that the Schwab 500 Index’s SWPPX expense ratio is 0.09% compared to 0.84% for a typical managed fund.
Index funds and ETFs also tend to have lower management costs than mutual funds—primarily because of low-cost trading commissions when you buy and sell them.Index funds aren’t actively managed like active fund managers are, which keeps management costs low.
Rolling over a 401(k) to an IRA is a fairly simple process, as long as you follow the correct steps. To help you choose the right money management company, check out SuperMoney’s Wealth Management and Brokerage Reviews page.
Julie Bawden-Davis is a widely published journalist specializing in personal finance and small business. She has written 10 books and more than 2,500 articles for a wide variety of national and international publications, including Parade.com, where she has a weekly column. In addition to contributing to SuperMoney, her work has appeared in publications such as American Express OPEN Forum, The Hartford and Forbes.