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401(k) Rollovers: Everything You Need to Know
Fifty million. That’s how many people left their jobs in 2022 as the Great Resignation continued to turn the U.S. jobs market upside down.1
While there’s nothing wrong with blazing new career paths, many of those folks are leaving a trail of forgotten 401(k)s, with thousands of dollars in retirement savings left behind. Maybe you’re one of them!
If you have money gathering dust in a long-forgotten retirement account, it’s time to find it a new home with a 401(k) rollover.
What Is a 401(k) Rollover?
A 401(k) rollover simply allows you to transfer your retirement savings from a 401(k) you had at a previous job into an IRA or another 401(k) with your new employer. And you won’t have to pay any taxes on the money you transfer (in most cases).
401(k) Rollover Options
Let’s say you’re starting a new job and you’re wondering what to do with the money in a 401(k) you had at an old job. You have four options:
- Option 1: Cash out your 401(k).
- Option 2: Do nothing and leave the money in your old 401(k).
- Option 3: Roll over the money into your new employer’s plan.
- Option 4: Roll over the funds into an IRA.
We’ll walk you through the pros and cons of each one:
Option 1: Cash out your 401(k).
Let’s get this out of the way—this is the worst thing you can do with your old 401(k).
If you withdraw the money from your 401(k) plan and take a direct cash distribution, you’ll have to pay any state and federal income taxes you owe on every last penny. And if you’re under 59 1/2 years old, you can go ahead and add another 10% early withdrawal penalty to your tab.
But the worst part is you’re robbing yourself of the chance to continue earning tax-free or tax-deferred growth on your investments for years, maybe decades. It’s just a bad idea all around, folks.
Option 2: Do nothing and leave the money in your old 401(k).
Now, you could just leave the money in your old 401(k) if you’re really happy with your investments and the fees are low.
But that’s rarely the case. Most of the time, leaving your money in an old 401(k) means you’ll have to deal with higher fees that cut into your investment growth and settle for the limited investment options from your old plan. Most people come out way ahead by doing a direct transfer rollover to an IRA (more on how that works later).
Option 3: Roll over the money into your new employer’s plan.
Rolling your money over to your new 401(k) plan has some benefits. It simplifies your investments by putting all your retirement savings in one place. And you also have higher contribution limits with a 401(k) than you would with an IRA—which means you can save more!
But there are lots of rules and restrictions for rolling money over into your new employer’s plan, so it’s usually not your best bet. Plus, your new 401(k) plan probably only has a handful of investing options to choose from. And if you’re feeling iffy about those options, why put all your retirement savings there? Which brings us to . . .
Option 4: Roll over the funds into an IRA.
Many times, transferring the money from your old 401(k) into an IRA could be one of your best options. That’s because an IRA gives you the most control over your investments.
You see, an IRA gives you potentially thousands of mutual funds to choose from. You can pick from a vast library of options. You can work with an investment professional who can walk you through the rollover and help you manage your investments for the long haul—no matter where your career takes you.
Direct Rollover vs. Indirect Rollover: Which One Is Better?
Okay, once you decide to roll money from one account to another, you have two options on how to do the transfer: a direct rollover or an indirect rollover. Spoiler alert: You always want to do the direct rollover. Here’s why.
With a direct rollover, the money in one retirement account—an old 401(k) you had at your last job, for example—is transferred directly to another retirement account, like an IRA. That way, the owner of the account (that’s you) never touches the money, and you won’t have to pay any taxes or penalties on the cash being transferred. Once it’s done, it’s done!
Indirect rollovers, on the other hand, are a bit more complicated—and are much riskier (for no good reason). When you do an indirect rollover, the cash goes to you first instead of going straight into your new account. Here’s the problem with that: You have only 60 days to deposit the funds into a new retirement plan. If not, then you’ll get hit with taxes and penalties.
See why the direct rollover is the only way to go? There’s just no reason to take a chance on an indirect rollover that leaves you open to heavy taxes and penalties. That’s just dumb with a capital D!
Do I Have to Pay Taxes When I Roll Over a 401(k)?
It depends on whether or not you’re changing account types with the rollover:
- Traditional 401(k) to a new traditional 401(k) or traditional IRA: If you go from a traditional account to another traditional account, you won’t owe any taxes when you transfer. But you will have to pay taxes when you start withdrawing at retirement.
- Traditional 401(k) to a Roth 401(k) or Roth IRA: This is called a Roth conversion—and you will owe taxes on the money you transfer in a Roth conversion. And that could create a hefty tax bill!
- Roth 401(k) to a new Roth 401(k) or Roth IRA: If you transfer funds from a Roth account to a new Roth account, you won’t owe taxes on that rollover (except for any employer contributions—that money always counts as traditional, even under the umbrella of a Roth account, which means it will be subject to taxes if you roll them into a Roth).
If you have questions about whether your 401(k) rollover counts as a “taxable event,” get in touch with a tax advisor.
Get Help With Your 401(k) Rollover
Having an investment professional in your corner, someone who can help you find the right investments to add to your portfolio and walk you through all the ins and outs of a 401(k) rollover, makes this process a lot easier.
Don’t have an investment professional? No worries! Our team can help you get started.
Frequently Asked Questions
Still have questions about your 401(k) rollover? Don’t worry, we have answers for you!
Is a 401(k) rollover worth it?
Absolutely! Like we’ve already mentioned, rolling over a 401(k) into an IRA gives you more investment options to choose from, makes it easier to manage your retirement funds, and usually offers you lower fees than leaving your money in your old 401(k) account.
One potential drawback however, is that most company sponsored retirement plans (such as a 401k) allow participants to make a penalty-free withdrawal after the age of 55. Yet, Traditional IRA's require that a client wait until they reach 59 1/2 years old in order to avoid paying an early withdrawal penalty. You should ensure that you will not need this money for any other purpose or emergency before rolling over these funds into an IRA.
How long do I have to roll over my 401(k) from my old job?
If you have money sitting in a 401(k) with your last employer and you decide to leave the money in there, there’s no time limit. You can roll those funds into an IRA or your new employer’s retirement plan whenever you want to.
However, if you have your old 401(k) money sent directly to you from your retirement plan (huge mistake, by the way—don’t do it!), the IRS says you have just 60 days from the date you receive a retirement plan distribution to roll it over into another plan or an IRA. Otherwise, you will get hit with taxes and an early withdrawal penalty.
What’s the difference between a 401(k) and an IRA?
A 401(k) is a retirement savings plan sponsored by an employer. With a 401(k) plan, employees can have a set amount of retirement savings taken out of their paychecks before taxes. There are two types of 401(k)s out there: traditional and Roth. Here are the differences between them:
- With a traditional 401(k), your contributions are tax-deferred. In other words, you get a tax break now, which sounds great! But the catch is that you’ll owe Uncle Sam taxes when you start withdrawals in retirement, and who knows how much tax rates will rise by then?
- With a Roth 401(k), your contributions are made after taxes have already been taken out of your paycheck, so the money you put into your Roth 401(k) grows tax-free and you’ll receive tax-free withdrawals when you retire. Sweet!
An individual retirement account (IRA) is a tax-favored account for retirement savings that you open yourself without an employer. Instead, you can open an IRA through a bank, brokerage firm, or with help from a financial advisor. Just like with a 401(k), there are basically two main types of IRAs you need to know about: traditional and Roth.
- A traditional IRA is similar to a traditional 401(k) when it comes to taxes—a traditional IRA is funded with pretax dollars, which means you can lower your tax bill this year by writing off your contributions as a tax deduction. That’s the good news. The bad news is you’ll have to pay taxes on that money and its growth when you start taking money out of the account at retirement.
- With a Roth IRA, you’ve already paid taxes on the money you put into the account, so now you can watch your money grow tax-free and enjoy tax-free withdrawals in retirement. And that’s not the only advantage of going with a Roth IRA. You can also leave the money in a Roth IRA for as long as you like—no required minimum distributions when you reach a certain age (like you have with a traditional IRA). Your money can stay put and continue to grow in a Roth IRA as long as you want.
What is a Roth conversion?
A Roth conversion is when you convert traditional retirement funds into a Roth account.
Even though we love the benefits of a Roth account (your money grows tax-free and your retirement withdrawals will be tax-free!), we recommend waiting until you’re on Baby Step 7 to do a Roth conversion. Why? Because when you transfer your pretax retirement savings into a Roth 401(k) or Roth IRA, you’ll have to pay taxes on it now.
Yep, a Roth conversion can add thousands of dollars to your tax bill, so you want to be sure you have the extra cash on hand to pay those taxes. Always talk to a financial advisor and a tax pro before doing a Roth conversion—getting an expert opinion could save you a big headache when tax season rolls around!
Damon Walker may be reached at 877-299-6237 or email@example.com
Source: Ramsey Solutions
Please be sure to speak to your financial professional to carefully consider the differences between your company retirement account and investment in an IRA. These factors include, but are not limited to changes to availability of funds, withdrawals, fund expenses, and fees