Guide to 401(k) Rollover

A 401(k) rollover is moving assets from one account to another. A 401(k) rollover may be necessary when you leave your employer, retire, or are unable to continue making contributions toward your 401(k) plan.

If you leave your job, the amount of money in your 401(k) accounts will need to be rolled over into either another retirement plan or an IRA since it cannot remain in the former employer’s 401(k).

How Does a 401(k) Rollover Work?

Rolling over a 401(k) means transferring all or part of these plans into an IRA or another employer-sponsored plan such as a qualified pension, profit-sharing, simplified employee pension (SEP), or 401(k) plan.

You can either have the money sent directly to the new plan or IRA, or you can take possession of the funds and do the rollover yourself. However, if you choose to do the rollover yourself, you must complete it within 60 days of receiving the distribution.

There are two ways to rollover a 401k: a direct rollover and a 60-day rollover.

Direct Rollover

A direct rollover is when the money goes straight from your old account to your new account without ever touching your hands. This is usually done by your former employer sending the money directly to your new 401(k) plan or IRA account.

The advantage of this method is that there are no tax consequences since the money never hits your wallet. You’ll still have to pay taxes on the funds once you withdraw, but you will not incur a penalty from the IRS since you did not actually receive a distribution from your old 401(k) account.

60-Day Rollover

A 60-day rollover is when you take possession of the funds and then redeposit it into an IRA or new employer plan within sixty days. The benefit of taking possession of the assets yourself is that this gives you enough time to find out whether or not a direct rollover is allowed.

For instance, if your new employer’s plan does not accept incoming rollovers, there would be no reason for them to complete a direct rollover, so instead, they may send the funds to you and you would have to do a 60-day rollover.

The downside of this option is that if the funds are not deposited back into an IRA or new employer plan within 60 days, the money will be treated as a taxable distribution and you will likely have to pay a 10% penalty for withdrawing funds before retirement.

Steps in Doing a 401(k) Rollover

Here are the steps in completing a 401(k) rollover:


1. Choose the type of IRA account you wish to rollover your 401(k) into.

This process can be a little daunting because there are so many different types of IRA accounts to choose from. The most common are Roth and traditional IRAs.

It is an advantage to transfer your old 401k into another retirement plan of the same nature as a traditional IRA or Roth IRA or another Roth 401(k). This will help you avoid paying taxes on the distribution when you eventually withdraw the money.

2. Choose where to open your new IRA account.

You have a few different options here, but it is important to do your research to make sure you are getting the best deal. Most people choose online brokerages because they offer low-cost trading and a wide variety of investment options.

You may also opt for a full-service broker, but this will likely come at a higher cost. Finally, some people choose to set up their IRA account with their current bank.

3. Proceed with the rollover.

Once you have chosen the type of IRA account and where to open it, you can start the process of rolling over your 401(k). This is usually done by filling out a form provided by the new account provider and sending it back along with a copy of your old 401(k) statement.

It is in this stage where you decide whether to do a direct rollover or a 60-day rollover.

4. Begin making investments with your new IRA account.

You now have a few options to choose from when deciding how and where you will invest the money deposited into your new IRA account. You can take advantage of low-cost index funds, Robo advisors, or traditional stockbrokers depending on which path you wish to take as far as finances go.

Tax Implications of Making a 401(k) Rollover

When doing a 401(k) rollover there are many different taxes that come into play regarding both withdrawals and contributions moving forward. First off, it is important to remember that all distributions taken prior to age 59 1/2 will result in a 10% penalty unless an exception applies.

In addition, it is important to remember that doing a 401(k) rollover will not change the taxation of your contributions as they are subject to normal income tax rates. It is only your contribution limits that will be affected moving forward after making a 401(k) rollover.

Doing the rollover via direct rollover will have the least amount of tax implications as the money technically never leave the account. If you do a 60-day rollover, on the other hand, you will be taxed on the withdrawal and then have another 60 days to put the money back into an IRA or employer plan.

Pros and Cons of Making a 401(k) Rollover

Now that you understand all of the different tax implications of doing a 401(k) rollover, it is important to weigh out the pros and cons to see if this is the right decision for you.

The biggest pro of doing a 401(k) rollover is that it allows you to keep your money in a retirement account, which can help defer taxes and allow the funds to grow tax-free until you withdraw them.

Another advantage of making a 401(k) rollover is the accession of more investment freedom along with higher contribution limits. 

When you roll over your 401(k), as long as the new account is also a traditional IRAs or Roth IRA, there are no income limitations on who can contribute to it. You will now be able to make contributions from any type of employment income and earn any amount of money you want without penalty.

The biggest con of doing a 401(k) rollover is that it leaves you with fewer investment options than staying put in the old account. This may not seem like a big deal now, but if you end up changing jobs multiple times throughout your career then this could end up being more costly for you financially.


Final Thoughts

Before making the decision to do a 401(k) rollover, it is important to consult with a financial advisor to weigh out all of the different consequences both short and long term. This is a big decision that should not be taken lightly and should only be done if it is the best option for your specific situation.

Some people might be tempted to simply cash out their 401(k) when they leave their jobs to avoid any penalties. However, this is a big financial mistake as it is better to keep your money in a tax-advantaged account. Once you have left your employer-sponsored plan, most providers will allow you to continue making contributions into the same account with some limitations. You can therefore choose to rollover your 401(k) to an IRA, as this will give you more investment freedom and have less tax implications.
There are no additional taxes associated with rolling over your 401(k) to an IRA. You will only need to pay taxes if you choose to withdraw the money before reaching retirement age.
The entire process of doing a 401k rollover should only take a few days. However, you will have 60 days to put the money back into an IRA or employer-sponsored plan if you do a 60-day rollover.
Yes, you can do a 401(k) rollover even if you are still employed. However, make sure that you are aware of any restrictions that might be placed on contributions from your current employer.
Yes, you can continue making contributions to your old 401(k) after doing a rollover but there may be some limitations on how much you can contribute.

401(k) Plan | A Complete Beginner's Guide

401(k) Meaning

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

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401(k) Plan FAQs

True Tamplin, BSc, CEPF®

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.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.