How Does a 401(k) Rollover Work?

If you currently have a 401(k) plan but are unsure of what to do with it because you’re switching jobs or retiring, a 401(k) rollover could be worth exploring.

Below, we’ll take a closer look at what a 401(k) rollover is and how it works, so you can confidently decide if it makes sense for your situation.

What is a 401(k)?

A 401(k) is a retirement savings plan sponsored by your employer that allows you to contribute a portion of your paycheck to an individual investment account. A 401(k) typically has two types of contributions: the money you choose to have deducted from your paycheck and the money your employer adds to the plan.

What is a 401(k) rollover?

A 401(k) rollover is when you transfer the money from your current 401(k) plan to another retirement account, such as a new 401(k) or an individual retirement account (IRA). While you might be able to move funds from your current employer’s 401(k), 401(k) rollovers are more common after you change jobs, retire or are no longer with your employer for any other reason.¹

In general, there are two types of 401(k) rollovers, including:²

• Direct 401(k) rollovers: A direct 401(k) rollover is when you transfer your 401(k) balance to a different retirement account. In most cases, you’ll share your new account details with your current plan administrator, and they’ll complete the process for you. You won’t have to worry about any tax consequences with a direct 401(k) rollover.
• Indirect 401(k) rollovers: An indirect 401(k) rollover occurs when you receive your 401(k) balance directly, typically in the form of a check, minus 20% federal tax withholding. If you choose this type of 401(k) rollover, you must deposit the money into a qualifying retirement account within 60 days or you’ll face a 10% early withdrawal penalty and taxes. If you roll over the account within 60 days, the 20% federal tax that was withheld will be returned as a tax credit for the year when the rollover process is complete.

Next steps for your 401(k)

Depending on whether you have a direct or indirect rollover, there are several options for how to handle the funds in your 401(k). Since each option has its own costs and benefits, it’s important to become familiar with all of them. Doing so can help you make informed decisions about your situation.

Below are three ways to roll over your 401(k) and two additional options:

Roll over to a new 401(k) plan

You could roll over your current 401(k) balance into a new 401(k) account without paying any taxes or fees until you begin receiving distributions from your 401(k) upon retirement. If you change jobs and your new employer offers a 401(k) plan, you might want to consider this route to consolidate your 401(k) plans and continue growing your retirement savings.³

Roll over to a traditional IRA

Another option is to roll your current 401(k) balance into a traditional IRA. Traditional IRAs allow you to contribute your pre-tax dollars or deductible post-tax dollars, but they are not offered by your employer and do not include employer matching contributions. Depending on your income level and whether you or your spouse are covered by a workplace retirement plan, contributions may be tax deductible. Traditional IRAs are offered by various financial institutions, including investment and brokerage firms, banks and some life insurance providers.⁴ A traditional IRA typically offers more investment choices and potentially lower fees than a 401(k). With a traditional 401(k), you’ll owe taxes once you withdraw money from your account.⁵

Roll over to a Roth IRA

If your current 401(k) plan allows for it, you could transfer your traditional 401(k) funds into a Roth IRA, which is like a traditional IRA but involves after-tax contributions, or money you earn after taxes, and deductions are subtracted from your paycheck. Many financial institutions offer Roth IRAs, including banks, online brokers, as well as digital financial planning and investing platforms (known as robo-advisors). A Roth IRA allows you to avoid taxes when you withdraw funds in retirement. Note that if you choose this method, your taxable income will increase in the year you make the transfer.⁶

Take a cash distribution

While you may cash out your 401(k) at any time, doing so could be expensive because of the tax consequences and penalties. The plan administrator could write you a check, but as with an indirect rollover, they’ll have to withhold 20% of your balance for taxes. Also, if you’re under age 59 ½, the IRS might consider your cash-out an early distribution and charge you a 10% penalty.⁷ Be careful before you move forward with this option, as this penalty could cause you to miss out on a lot of the retirement money you saved.

Leave the money in your current plan

If you leave a job, you have the option to keep the money in your current 401(k) plan, although if your balance is below $5,000, your employer may require you to roll it over. You won’t be able to keep making contributions, but if the plan has low fees, good investment options or otherwise fits your needs, you don’t typically need to roll over your account just because you leave a job.⁸

Reasons to consider a 401(k) rollover

If any of the following scenarios apply to you, it might make sense to roll over your 401(k):

You have changed jobs or are retiring

Most rollovers occur after a change in employment. If you switch jobs, get laid off or retire, you’ll no longer be able to contribute to your current 401(k) account, so a rollover may help you consolidate the funds you’ve worked so hard to save.⁹

You want more control or better investment options

With a 401(k), you may not have as many investment options as you might with an IRA, for example. By rolling over your 401(k) funds to an IRA account, you’ll have access to a wider range of investments, such as stocks, bonds, mutual funds and index funds. You might also save on maintenance and investment fees.¹⁰

You want to avoid the taxes or penalties that come with a withdrawal

As long as you do it properly, a direct rollover might not trigger any income tax or early withdrawal penalties. You could confidently move your money into another 401(k) or IRA account without any consequences.¹¹

How to complete a 401(k) rollover

If you’d like to roll over your 401(k) funds, follow these steps:

Step 1: Decide where to move your money

First, research your options and decide where you want your funds to go. You may roll over your 401(k) balance into a new 401(k) if available, traditional IRA or Roth IRA. Carefully consider the tax implications no matter which choice you make and be sure to review the agreements of your existing 401(k) and the new account before moving forward.¹²

Step 2: Open your new account

Regardless of whether you decide to transfer your 401(k) funds into a new 401(k) or an IRA, you’ll have to open a new account to get started. Each provider has their own process for new accounts, but you could always contact the firm you’ve chosen to answer any questions you may have.¹³

Step 3: Contact the current plan administrator

Next, reach out to the administrator of your current 401(k) to request a rollover. The plan administrator may inform you of any required paperwork and provide a timeframe for the deposit. Be prepared to share your old and new account numbers. Depending on the administrator, you may also need a Letter of Acceptance from the plan administrator for your new account.¹⁴

Step 4: Deposit the funds (if indirect)

If you opt for an indirect rollover, you should deposit the check into your new account within 60 days. Remember, the funds you withdrew were subject to 20% withholding, but if the rollover process is completed within 60 days, the withheld amount will be returned as a tax credit for that year. Note that if you make your deposit past the 60-day deadline, you’ll have to pay income taxes on the total amount plus an early withdrawal penalty, which is typically 10%.¹⁵

Step 5: Invest your rollover

The funds you’ve rolled over need to be re-invested so that your money in the new account continues to grow. Consider your risk tolerance and retirement goals to help you determine the ideal investment strategy.¹⁶ If you’re unsure, speak to a financial professional for guidance.

Common 401(k) rollover mistakes to avoid

Before you go ahead and pursue a 401(k) rollover, be sure to consider these common 401(k) pitfalls, as they could lead to unnecessary expenses and headaches.

Missing the 60-day deadline

If you choose an indirect rollover and get your 401(k) funds sent to you, you’ll have 60 days to deposit them into your new account. Missing this deadline has these costs to consider: The 20% tax withholding rate, income tax and a potential 10% early withdrawal penalty.¹⁷

Not checking for fees or transfer restrictions

Closely review the agreements of both the 401(k) account you plan to roll over and the new account, which may be another 401(k) or an IRA. Make sure you’re aware of any account closure fees or restrictions.

Mixing pre-tax and Roth funds incorrectly

If you roll over your 401(k) balance to a traditional IRA account, your funds will keep their tax-deferred status, meaning you won’t owe any taxes when you make the transfer. However, if you roll over your 401(k) money to a Roth IRA, which involves after-tax contributions, you’ll have to pay taxes on the entire amount as well as potential early withdrawal penalties.¹⁸

Is a 401(k) rollover right for you?

While a 401(k) rollover might be a smart move for some people, it’s not right for everyone. Whether or not a 401(k) rollover makes sense depends on your situation and goals.

You may want to consider a rollover if you:

• Are leaving your current job: If you’ll no longer be with your current employer because you found a new job or experienced a recent job loss, for example, a 401(k) rollover may be worthwhile. You won’t be able to contribute to your existing employer-sponsored 401(k) plan once you leave, although you can change the allocations.
• Want to consolidate retirement savings: It may be overwhelming to manage multiple retirement accounts. By rolling over your 401(k), you can keep more of your retirement funds in one place. Be sure to consider the investment options on all your retirement accounts before deciding where to concentrate your savings.
• Prefer more investment options or lower fees: A 401(k) is a powerful retirement savings tool, but it often comes with fees and limited investment options. If you’d like access to other investment options with fewer and/or lower fees, a 401(k) rollover to an IRA could be beneficial.

You may want to consider avoiding a rollover if you:

• Are happy with your current 401(k): If you’re actively employed and have money in your employer’s 401(k) plan, there may be no need for a rollover. Even if you’ve left your job, if you’re happy with the investment choices, fees and rate of return, you can generally keep your money in that employer’s 401(k). Just be aware in this case that you won’t be able to keep contributing funds.
• Want to avoid the hassle of transferring: A 401(k) rollover takes some time and effort, especially if you’re unfamiliar with the process or have never done it before. If you don’t want to commit to it, you could always just let your 401(k) funds stay put.
• Are close to retirement and plan to withdraw soon anyway: If you’re over age 59½, nearing retirement and looking to pull money from your 401(k) account, it probably doesn’t make sense to roll over your money. When you turn 73, you’ll need to begin required minimum distributions (RMDs) from your 401(k). RMDs are annual minimum amounts that you must withdraw from your retirement account.¹⁹

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Take the next step with confidence

With a 401(k) rollover, you’ll want to optimize your retirement savings. However, it’s important to pursue this method carefully to avoid any unwanted surprises, like early withdrawal taxes and penalties. If you need assistance or want to ensure you roll over your funds correctly, reach out to your financial advisor or retirement plan provider.

Sources

1,15 https://finance.yahoo.com/personal-finance/investing/article/401k-rollover-151537723.html
2,10 https://www.investopedia.com/articles/personal-finance/071715/8-reasons-roll-over-your-401k-ira.asp
3, 5,6 https://money.com/what-is-a-401k-rollover/
4 https://www.irs.gov/retirement-plans/individual-retirement-arrangements-iras
7,11 https://www.irs.gov/retirement-plans/plan-participant-employee/401k-resource-guide-plan-participants-general-distribution-rules
8, 9 https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-termination-of-plan
12,13, 14,16, 17, 18 https://www.kiplinger.com/retirement/401ks/how-to-roll-over-a-401k
19 https://www.irs.gov/retirement-plans/retirement-plan-and-ira-required-minimum-distributions-faqs