Guide To 401(k) Rollovers

401(k) rollovers are the transfer of funds contained in a 401(k) plan to either another 401(k) or other retirement accounts. 401(k) rollovers are carried out for a variety of reasons. For example, a rollover might provide an investor with more investment choices or tax benefits. Per existing regulations, you can only perform one 401(k) rollover to a retirement account per calendar year. However, there is no limit on rollovers between different 401(k) accounts. 401(k) rollovers should be analyzed before being implemented.

 

Basics of 401(k) Rollover

There are several reasons why an individual might be interested in a 401(k) rollover. Some of them are outlined below:

  • Change of jobs: This is the most common reason for carrying out a 401(k) rollover. Each employer has different 401(k) providers and a change of jobs might require you to migrate funds from a previous plan to the new one.
  • More investment choices and lower fees: As compared to traditional IRAs, most 401(k) plans offer fewer choices for investing your life’s savings. 401(k) plans are also expensive. They pass on management fees from providers to account holders and those costs can add up over a period of time, eating into the gains made by funds in the accounts. Retirement accounts like traditional IRAs are relatively cheaper in comparison.
  • Tax benefits: Depending on the type of instrument that the funds are rolled over to, moving funds from a 401(k) account to another account comes with tax benefits. For example, rolling over funds from a 401(k) account to a Roth IRA provides tax-free retirement income because Roth accounts are funded with after-tax income. Distributions from 401(k) are also taxed at a higher rate as compared to retirement account distributions, making it sensible to rollover funds from a 401(k) account to retirement accounts.
  • Consolidation of accounts: Most job changes are accompanied with the creation of new 401(k) accounts. The balance in each of these accounts can build up. 401(k) rollovers simplify account and funds management by enabling you to consolidate multiple accounts into a few or, possibly, a single entity. 

You must complete a 401(k) rollover to a traditional IRA within 60 days. The IRS will waive the time period, if the financial institution responsible for the waiver received funds before the end of 60-day period and failed to deposit them into the new IRA, in spite of your instructions. The fee for requesting an automatic waiver is $10,000.

Steps to a 401(k) Rollover

Broadly, there are four steps to a 401(k) rollover. They are outlined below.

  1.  Determine your goals with a 401(k) rollover: Before actually implementing a 401(k) rollover, you must analyze your goals with the rollover. This is an important step as it will determine your plan of action and the steps you will take to accomplish that goal. For example, if you are interested in tax benefits then it makes sense to rollover your funds into a Roth IRA instead of a traditional IRA. Similarly, if your 401(k) rollover goal is to boost your retirement account holdings through trading, then you might want to opt for a retirement account with a brokerage. Generally, these accounts charge very less fees and are designed to maximize trading opportunities for account holders.
  2. Determine the type of account for your 401(k) rollover funds: Depending on your comfort level with trading, you can opt for self-directed accounts, in which the account holder is responsible for making investment decisions. The alternative to such accounts are managed accounts, in which the plan administrator makes decisions relating to investment and charges a fee for it. In recent times, the growth of index funds has led to robo-advisors becoming popular within retirement accounts. Robo-advisors simplify investing decisions by setting aside a certain amount of money to be invested in funds periodically, depending on criteria specified by the investor. For example, an investor may specify monthly contributions to an ETF of his or her choice.
  3. Select the type of 401(k) Rollover: There are two types of 401(k) rollovers: Direct and Indirect. In a direct rollover, funds are transferred between retirement accounts without being touched by the account holder. The funds are transferred between retirement accounts based simply on instructions (and the completion of a couple of forms) by the account holder. The direct rollover is considered easy and convenient and is generally recommended for transfers by financial planners. However, certain circumstances may necessitate the use of indirect transfers. For example, indirect rollovers are a good option during times when you need cash urgently. In an indirect rollover, the retirement account agency cuts a check directly to you and withholds 20% tax, as required by law, on the funds. Thereafter, you have a 60-day period during which you must deposit the withdrawn funds to the new account. The funds must be made whole again, meaning the balance in your new account must equal that of the old. For example, an indirect rollover of $100,000 from a 401(k) account incurs 20% tax, equaling to $20,000. Therefore, the 401(k) provider will give you a check for $80,000. You must add another $20,000 before depositing it into the new account within the 60-day period. If the funds are not deposited in 60 days, then the IRS slaps a 10% penalty plus income tax on the funds.
  4. Select your investments: Once you have decided on the type of rollover, it is time to execute the rollover and select the investments. Similar to step 1, this step ties back to your investment goals. Most 401(k) plans and retirement accounts offer a menu of low cost ETFs, index funds, and bonds for trading. At some brokerages and funds, you can also trade stocks. There are no fees if you trade online but using a phone brokerage generally incurs fees. Accounts that offer robo-advisors generally ask a set of questions related to your retirement goals to offer a custom menu of options.

401(k) Rollovers FAQs

401(k) rollovers are the transfer of funds contained in a 401(k) plan to either another 401(k) or other retirement accounts.
You can rollover funds from a 401(k) account either through direct rollovers or indirect rollovers. In the former, only an instruction is required and the transfer of funds takes place without any interaction with the account holder. In the indirect rollover process, funds, minus tax, are first transferred to the account holder, who has 60 days to transfer them to another account.
You must complete a 401(k) rollover to a traditional IRA within 60 days. The IRS will waive the time period if the financial institution responsible for the waiver received funds before the end of 60-day period and failed to deposit them into the new IRA, in spite of your instructions. The fee for requesting an automatic waiver is $10,000.
Most 401(k) plans and retirement accounts offer a menu of low cost ETFs, index funds, and bonds for trading. At some brokerages and funds, you can also trade stocks.
In a self-directed account, the account holder is responsible for making investment decisions. The alternative is managed accounts, in which the plan administrator makes decisions relating to investment and charges a fee for it.

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.