Reasons to Roll Over Your 401(K) To an IRA
A 401(k) Rollover to IRA is when you take the money out of your 401(k) plan and put it into an Individual Retirement Account (IRA).
It’s very easy to roll over a 401(k) to an IRA. There are many reasons why you’d want or need to transfer money from one account or investment vehicle into another, including:
- You’ve changed jobs and the new employer doesn’t offer a 401(k) plan.
- Your investment choices in your current 401(k) are limited, or you can’t invest as much as you want to.
- The fees on your current 401(k) plan are too high for the services received – either because it is a 401(k) plan offered through an employer, or because the investment options are high-cost mutual funds.
- You want to diversify your retirement savings into more than one account.
- You’re approaching retirement age and want to start taking distributions from your 401(k) account.
- You need to take a distribution from your 401(k) account, but you don’t want to pay the early withdrawal penalty.
- You’re moving to a new state and want to rollover your 401(k) into an IRA in order to continue to use it as your retirement savings account.
- You’ve decided to retire and would like to move your 401(k) savings into a traditional IRA account.
401(k) rollovers can be a great way to save for retirement. When you roll over your 401(k) into an IRA, you get to keep all of the money in the account and you don’t have to pay any taxes on it.
You also get to choose your own investments, which gives you a lot more flexibility than you would have if you left your money in a 401(k).
How Rollover Works
There are two ways to roll over a 401(k) into an IRA – you can either do a direct rollover or an indirect rollover.
This is when the money from your 401(k) plan goes directly to your new IRA account, without going through your own hands first. This is the best way to rollover a 401(k) because it ensures that you receive the money immediately.
If you take possession of the check for your 401(k) distribution, then it becomes taxable that year – even if you deposit it into your IRA rather than spend it!
You can also rollover a 401(k) by doing an indirect rollover through what’s called a 60-day rollover. This is when you withdraw the money from your current 401(k) plan and wait at least 60 days before rolling it over into either another 401(k) or an IRA.
If you don’t wait the required time period, then the IRS considers this a taxable distribution, and you’ll have to pay taxes on the money as well as a 10% early withdrawal penalty if you’re under age 59½.
Best Option for You
The direct rollover is generally the best option when rolling over a 401(k) into an IRA, because it’s simpler and faster.
However, not everyone is able to do a direct rollover – if your 401(k) is held with the old employer, then they may be unwilling to release the money to the new provider. In this case, you’ll have to do an indirect rollover.
Just be sure to follow all of the rules so that you don’t get hit with any penalties from the IRS.
Benefits of Rolling Over Your 401(k)
The benefits of rolling over your 401(k) into an IRA include:
- You choose the type and amount of investments that your IRA holds.
- You can keep your existing 401(k) or change to a lower-cost provider or investment options with higher returns, which may save you money in the long run.
- You’re able to save a substantial amount of money for your retirement needs, with a variety of tax advantages including:
a) Contributing to an IRA is tax-deductible, which can help reduce your taxable income and lower your current year’s taxes if you qualify.
b) You can set up a Simplified Employee Pension, or SEP-IRA – a traditional IRA that allows you to contribute as much as 25% of your income from self-employment for retirement purposes.
- If you have multiple 401(k) accounts from prior employers, then rolling them all into one IRA can simplify your financial situation and make it easier to manage all of your retirement savings in one place.
- You can always move your IRA money back into a 401(k) plan when you change jobs, retire, leave an employer, or switch employers – but if you stay with the same provider and put your IRA money there instead, then it’s harder to get it back out again.
Disadvantages of Rolling Over Your 401(k)
The disadvantages of rolling over a 401(k) may include:
- You lose the ability to take loans against your 401(k) account.
- You may have to pay administrative fees if you rollover your 401(k) into an IRA with a different provider.
- If the fees are higher, then this could reduce your returns.
- You may have to deal with minimum balance requirements if you want an IRA through the same provider that holds your 401(k) account(s).
- If you were to rollover your 401(k) into an IRA, then you would lose the opportunity to do a Roth conversion.
Things to Consider Before Making the Switch
Before you decide to rollover a 401(k) into an IRA, there are a few things you should consider:
- How much money do you have in your 401(k) account?
- What is the current balance of your 401(k) account?
- What type of investments does your 401(k) account hold?
- What type of investments does your IRA account hold?
- Are you happy with the investment choices available through your 401(k) plan?
- Are you happy with the administrative fees charged by your 401(k) provider?
- Are you happy with the investment fees charged by your IRA provider?
- Do you have to meet any minimum balance requirements to keep your IRA account with your current provider?
- Are you comfortable with the idea of losing the ability to take loans against your 401(k) account?
- Would you be willing to pay administrative fees in order to have a 401(k) account with your current provider?
401(k) Rollover to IRA FAQs
401(k) Plan | A Complete Beginner's Guide
The 401(k) retirement savings account got its name from the Revenue Act of 1978, where an addition to the Internal Revenue Services (IRS) code was added in section 401(k). Consequently, 401(k) does not stand for anything except for the section of IRS tax code it was created in.
Traditional 401(k) vs Roth 401(k)
There are two types of 401(k) plans: Traditional and Roth 401(k)s. The traditional 401(k), named after the relevant section of the IRS code, has been around since 1978. With this plan, any contributions you make to the 401(k) account will reduce your income taxes for that year and will be taxed when they are withdrawn. Roth 401(k)s, named after former senator William Roth of Delaware, were introduced in 2006. Unlike a traditional 401(k), all contributions are made with after-tax dollars and the funds in the Roth 401(k) account accrue tax free. Typically, employees can take advantage of both plans at the same time, which is recommended among financial advisors to maximize retirement savings. Because of the way the contribution limits work, it is possible to invest different amounts into each account, even year-to-year, so long as the total contribution does not exceed the set limit.
Contributing to Your 401(k) Retirement Plan
Contributing to a 401(k) plan is traditionally done through one’s employer. Typically, the employer will automatically enroll you in a 401(k) that you may contribute to at your discretion. If you are self-employed, you may enroll in a 401(k) plan through an online broker, such as TD Ameritrade. If your employer offers both types of 401(k) accounts, then you will most likely be able to contribute to either or both at your discretion. To reiterate, with a traditional 401(k), making a contribution reduces your income taxes for that year, saving you money in the short term, but the funds will be taxed when they are withdrawn. With a Roth 401(k), your contributions can be made only after taxation, which costs more in the short term, but the funds will be tax free when you withdraw them. Because of this, deciding which plan will benefit you more involves figuring out in what tax bracket you will be when you retire. If you expect to be in a lower tax bracket upon retirement, then a traditional 401(k) may help you more in the long term. You will be able to take advantage of the immediate tax break while your taxes are higher, while minimizing the portion taken out of your withdrawal once you move to a lower tax bracket. On the other hand, a Roth 401(k) may be more advantageous if you expect the opposite to be true. In that case, you can opt to bite the bullet on heavy taxation today, but avoid a higher tax burden if your tax bracket moves up. Check out this article from Forbes to see the IRS tax rate tables for 2020, but remember that they are subject to change. A smart move may be to hedge your bets and divide your contributions between the two types of IRAs. If your employer allows you to add funds to both a traditional and Roth 401(k), then doing so reduces the potential risks of each. In this case, you will also have the ability to decide what proportion of your income goes into each account, meaning that as you near retirement and have a clearer idea of what position you will be in, you can put more into one or the other. When you do decide which avenue to take, make sure to thoroughly evaluate your decision. Moving funds from one account to another, such as from a traditional to a Roth 401(k), is time consuming and expensive, if even possible. Likewise, transferring a 401(k) from one employer to another in the event of a job change is also tricky. You want to make sure that when you put money into your plan, it will be able to sit undisturbed for a very long time.
Pension vs 401(k)
Pensions are similar to a 401(k), but are a liability to a company. If an employer offers an employee a pension, it means that they are promising to pay out a set amount of money to the employee at the time of their retirement. There is typically no option to grow this amount, but it also does not require any financial investment from the employee. Pensions, also referred to as defined-benefit plans, are becoming increasingly rare because it puts the financial burden of offering a retirement fund for employees entirely on the employer. 401(k)s, which are also called defined-contribution plans, take some of the financial pressure off of an employer, while also allowing employees to potentially earn a larger retirement package than they would have with a pension.
How Much Should I Contribute to My 401(k)?
Most financial experts say you should contribute around 10%-15% of your monthly gross income to a retirement savings account, including but not limited to a 401(k). There are limits on how much you can contribute to it that are outlined in detail below. There are two methods of contributing funds to your 401(k). The main way of adding new funds to your account is to contribute a portion of your own income directly. This is usually done through automatic payroll withholding (i.e. the amount that you wish to contribute, counting all adjustments for taxation, is simply withheld when receiving payment and automatically put into a 401(k)). The system mandates that the majority of direct financial contributions will come from your own pocket. It is essential that, when making contributions, you consider the trajectory of the specific investments you are making to increase the likelihood of a positive return. The second method comes from deposits that an employer matches. Usually employers will match a deposit based on a set formula, such as 50 cents per dollar contributed by the employee. However, employers are only able to contribute to a traditional 401(k), not a Roth 401(k) plan. This is especially important to keep in mind if you want to utilize both types of plans. A key variable to keep in mind is that there are set limits for how much you can add to a 401(k) in a single year. For employees under 50 years of age, this amount is $19,500, as of 2020. For employees over 50 years of age, the amount is $25,000. If you have a traditional 401(k), you can also elect to make non-deductible after-tax contributions. The absolute limit, counting this choice and all employer contributions, is $57,000 for employees under 50, and $63,000 for those over 50 as of 2019.
Plan in Advance
401(k) Plan FAQs
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.