So you’ve decided to roll over your old employer-sponsored 401(k) balance(s) into a new account. Now comes the tricky part: deciding where your savings should go and figuring out how to actually get it from one account provider to another without doing damage to your wallet.
Here’s everything you need to know about rolling over a 401(k), from beginning to end:
How to start the 401(k) rollover process
There are two main reasons you would do a 401(k) rollover: You’ve either proactively decided to move the money from your former employer’s plan into a new employer-sponsored plan or an outside individual retirement account (IRA), or you’re being forced out of an old plan after leaving that job because there is less than $5,000 in the account.
If you’ve chosen to roll over an old 401(k) into another account, the first step you’ll need to take is to get in contact with your previous retirement benefits provider to see what options are available to you. In some cases your old employer’s benefits provider may only allow rollovers to an account within their own institution or certain types of outside accounts.
For those facing a force-out, you’ll usually receive information from the account provider about what options you have for rolling over the funds. In some cases you may be able to select an IRA from your plan provider. If you don’t choose an option, your account will either be transitioned into a low-cost tax-deferred traditional IRA or sent to you via check, depending on how much money is in the plan.
In almost all cases, it’s important to opt for what’s known as a direct rollover if you want to avoid getting hit with any unnecessary penalties or fees.
The difference between a direct vs. an indirect 401(k) rollover
There are two main ways to go about rolling over a 401(k) into another retirement plan: a direct or indirect rollover.
A direct rollover allows you to transfer the money from a former employer’s 401(k) plan (or non-profit or government agency equivalent) into a different retirement account without having to actually withdraw and deposit it yourself. Your 401(k) administrator simply writes or wires a check to the account you wish to send it to.
You can make a tax-free, direct rollover when moving money from an old employer-sponsored retirement account to a traditional tax-deferred IRA or qualified company plans, including a new 401(k) or 403(b). While you can also roll a 401(k) into a Roth IRA, you’ll have to pay taxes on the money transferred because Roth IRAs are funded with post-tax contributions.
In the case of an indirect rollover, your previous retirement plan administrator writes you a check, which you’re then responsible for depositing into its new location within 60 days. This is a much riskier choice and can often end up costing you thousands of dollars in taxes and penalties, as the money is no longer safely in a pre-tax account.
An indirect rollover usually includes your previous employer withholding 20% of the total amount for pending taxes, which is then refunded to you as a tax credit the following year. The big catch? You’ll need to front the money that’s being withheld when you roll the rest of your savings into the new plan, or else risk being hit with extra taxes and penalties for early withdrawal. Yes, that means if you withdraw your entire $10,000 401(k), you’ll need to be able to front $2,000 to the next provider.
Most of the time when transferring an employer-sponsored plan, you’ll be provided with at least a few options for a direct rollover, though the options vary from plan to plan and depend on how much money is in the account. While you might already have your own IRA with a brokerage firm or a robo-advisor, if you can only indirectly rollover your 401(k) into that account, you’re probably better off selecting one of the direct rollover options. Unless you can absolutely cover that 20% withholding until tax season and the investment choices in your existing IRA are much better than any other option, you risk losing ground on your retirement savings.
What type of account should you roll your 401(k) into?
Depending on your employment and financial situation, there are a few different routes you can take when rolling over a 401(k). Here’s an outline of each option and its unique pros and cons:
A new 401(k) or other employer-sponsored retirement plan
Doing a direct rollover of your 401(k) into another 401(k) probably seems like the easiest option for employees, but that’s not always the case. For one, the retirement plan at your new job may not accept rollovers from a previous plan. Even if they do accept rollovers, that doesn’t necessarily mean you’ll be getting the most bang for your buck.
“Look at how the new 401(k) plan is set up, what investing options you have and if there are any minimums you need to meet before you can invest in certain funds,” says Andrew Meadows, senior vice president at Ubiquity Retirement + Savings.
It may be the case that while you should certainly take advantage of your new employer-sponsored plan with your new salary, holding onto your old 401(k) or rolling it into an IRA could give you access to more investment choices.
A direct rollover into a 401(k) does still have distinct advantages. Namely, that you can avoid paying unexpected taxes and penalties.
A Roth IRA is an individual retirement account that allows you to contribute after-tax money that grows through investments like exchange-traded funds, stocks and bonds and can then be taken out tax-free after you turn 59 ½. While you can withdraw your contributions penalty-free any time before that, any earnings you withdraw early may be met with taxes and penalty fees.
Rolling a 401(k) into a Roth IRA tends to be best for people who are at the start of their career, who will most likely be making more money in the future and have a fairly small amount (between $1,000 and $5,000) in their old 401(k). This is especially true if you’ve switched from a full-time job to working as a contractor, freelancer or just launched your own business and don’t have access to an employer-sponsored retirement plan.
Unlike with a traditional IRA or 401(k), you won’t have to pay any taxes on Roth IRA withdrawals in retirement, opting instead to pay those taxes now when you have a lower income and tax bracket rather than in retirement, when you will likely have a higher standard of living.
“You’re betting that you’re going to be taxed harsher when you’re older than when you are now. That’s why a lot of folks in their 20s or 30s will get a Roth IRA,” Meadows says.
Here’s what this means: Say you’re 25 years old, had an income of $50,000 last year and now you’re going to roll over your previous 401(k) with $2,000 into a Roth IRA. Since that $2,000 has been untaxed in the 401(k) account, when it is rolled into the post-tax Roth IRA, you will now owe income taxes on that money. If you’re a single filer, with $50,000 plus the $2,000 from the rollover, you’d be in the 22% tax bracket for 2020. Come tax season, you’ll owe an extra $440 (22% of $2,000) on top of your regular taxes.
While that is an extra tax burden for lower earners, it’s a much smaller burden than if you were a 45-year-old joint filer, had a combined income of $330,000 last year and tried to roll over $70,000 from a previous 401(k) into a Roth IRA. In that case, you would be in the 32% tax bracket and owe an additional $22,400 at the end of the year.
The key difference between a traditional IRA and a Roth IRA is that the former is funded with pre-tax money, like a traditional 401(k), which allows you to do a direct rollover without being hit by extra income taxes for the year. That’s why a traditional IRA can be a better option than a Roth IRA for someone with a higher income considering a rollover.
Take the previous example of someone who is a joint filer earning $330,000 with a $70,000 401(k). If their previous employer’s retirement plan provider allows for a direct rollover into a traditional IRA, they can keep the entire sum and completely avoid paying any sort of penalties or unexpected taxes. Then come retirement, when they're living off of their savings, they'll drop into a lower tax bracket. They'll have to make required minimum distributions from any IRAs, but withdrawals from tax-deferred accounts will be taxed at a lower rate because their income will likely be much lower.
Cashing out or depositing into a savings account
In case it hasn’t been drilled into your head yet by seemingly everyone: Unless the circumstances are extremely dire, withdrawing any funds from a 401(k) before you turn 59 ½ is never a good idea. Why? Because not only will your 401(k) provider automatically withhold 20% of the total for tax purposes, you’ll also get hit with a 10% penalty fee come tax season.
But along with potentially giving up 30% of the money, you also stand to lose out on the unique security retirement accounts provide: Thanks to a 1974 law known as the Employee Retirement Income Security Act (ERISA), the money in your employer-sponsored retirement plan is protected from an assortment of financial fallouts. For example, the money in a 401(k) can’t be seized by creditors if you’re in debt, and your account is exempt from bankruptcy proceedings. Traditional and Roth IRAs are also protected from being seized (unless the entity seizing your assets is the IRS). If you put that money in a savings account or personal investment portfolio, you lose those protections.
“You’ve worked your entire life for this savings and that retirement money is protected in a way that so many other accounts aren’t,” Meadows says.
For those with smaller sums in their old 401(k), it may not seem like that big of a deal (the buying power of $1,400 and $2,000 isn’t all that different), but every dollar counts after you stop earning a regular paycheck — which is often earlier than you think.
Opening an IRA account
If you can’t roll your old 401(k) into a new 401(k) and you don’t already have an individual retirement account, now is the time to get one set up.
You’ll want to keep in mind the conditions of a 401(k) rollover from your previous employer and your own financial situation when selecting an account: Does the provider allow for a direct rollover to a different financial company’s traditional IRA; as in, can you do a direct rollover from a Principal retirement account to an account from Fidelity? If not, are you able to front 20% of the actual value of the account? Would a Roth 401(k) make more sense based on your potential future income, despite the bigger tax bill this year?
With all of these in mind, you then need to decide what type of IRA you’d like and where you want to open an account. But some may have high minimum initial deposits and fees or have limited options for allocating your money between stocks, bonds, mutual funds and ETFs. You can learn more about IRA options here: What Is an IRA?
Does a 401(k) rollover count toward your annual contribution limit?
Good news! No matter how much you’ve saved up in a previous 401(k), it will have no bearing on this year’s contribution limits for the account you transfer into.
The 2021 annual contribution limit for a 401(k) is $19,500 and $26,000 for employees over 50, and $6,000 or $7,000 if you’re over 50 for IRAs. But according to Meadows, your rollover “will definitely not count as anything additional” because “you already acknowledged that income on a previous W-2 as pre-tax contributions.”
Completing your 401(k) rollover
Once you’ve made your decision, opened a new retirement account (if need be) and contacted the financial institutions involved, if you’re able to do a direct rollover then your work is mostly done. The last major step is completing some required forms.
After you’ve alerted your new account provider that you intend to roll another account into this one, they’ll provide you with instructions to give your old account administrator on how the deposit should be made and where to send it.
In the case of an indirect rollover, a check or deposit will be made out to you directly and it is then your responsibility to deposit that money (plus the 20% you have to front yourself) into the new account within 60 days. If you're moving the money to a pre-tax account, once it's deposited you'll get the full 20% refunded come tax season. If you move it to a Roth account, the money from that 20% withholding that doesn’t go toward income taxes will also be refunded. Your final step is to select your new investments and get back to funding your retirement.