401(k) and IRA Rollovers: How to Guide

When you leave an employer for non-retirement reasons, for a new job, or just to be on your own, you have four options for your 401(k) plan:

1. Roll the assets into an individual retirement account (IRA) or convert to a Roth IRA
2. Keep your 401(k) with your former employer
3. Consolidate your 401(k) into your new employer’s plan
4. Cash out your 401(k)

Let’s look at each of these strategies to determine which is the best option for you.

Rolling Over Your 401(k) to an IRA

You have the most control and the most choice if you own an IRA. IRAs typically offer a much wider array of investment options than 401(k)s, unless you work for a company with a very high-quality plan—usually the big, Fortune 500 firms.

Some 401(k) plans only have a half dozen funds to choose from, and some companies strongly encourage participants to invest heavily in the company’s stock. Many 401(k) plans are also funded with variable annuity contracts that provide a layer of insurance protection for the assets in the plan at a cost to the participants that often run as much as 3% per year. IRA fees tend to run cheaper depending on which custodian and which investments you choose.

With a small handful of exceptions, IRAs allow virtually any asset, including:

If you’re willing to set up a self-directed IRA, even some alternative investments like oil and gas leases, physical property, and commodities can be purchased within these accounts.

Traditional vs. Roth IRAs

Once you decide on the assets you want in your portfolio, you’ll have to figure out which kind of IRA you want—a traditional IRA or a Roth IRA. The choice is between paying income taxes now or later.

Traditional IRA

The main benefit of a traditional IRA is that your investment, up to a certain amount, is tax-deductible when you make the contribution. You deposit pre-tax money into an IRA, and the amount of those contributions is subtracted from your taxable income. If you have a traditional 401(k), the transfer is simple, since those contributions were also made pre-tax.

Tax deferral won’t last forever, however. You must pay taxes on the money and its earnings later when you withdraw the funds. And you are required to start withdrawing them at age 72, a rule known as taking required minimum distributions (RMDs), whether if you’re still working or not. RMDs are also required from most 401(k)s when you reach that age, unless you are still employed—see below.

RMDs began at age 70½, but the age has been bumped up following new retirement legislation passed into law in December 2019—the Setting Every Community Up for Retirement Enhancement(SECURE) Act.

Roth IRA

If you opt for a Roth IRA conversion, you must treat the entire account as taxable income immediately. You’ll pay tax (federal and state, if applicable) on this amount now. You’ll need the funds to pay the tax and may have to increase withholding or pay estimated taxes to account for the liability. If you maintain the Roth IRA for at least five years and meet other requirements, then your after-tax contribution and any earnings are tax-free.

There are no lifetime distribution requirements for Roth IRAs, so funds can stay in the account and continue to grow on a tax-free basis. You can also leave this tax-free nest egg to your heirs. But those who inherit the account must draw down the account over the 10-year period following your death, as per new rules outlined in the SECURE Act. Previously, they could draw down the account over their life expectancy.

If your 401(k) plan was a Roth account, then it can only be rolled over to a Roth IRA. This makes sense since you already paid taxes on the funds contributed to the designated Roth account. If that’s the case, you don’t pay any tax on the rollover to the Roth IRA. To do a conversion from a traditional 401(k) to a Roth IRA, however, is a two-step process. First, you roll the money over to an IRA, then you convert it to a Roth IRA.

Which One Do You Choose?

Where are you now financially compared to where you think you’ll be when you tap into the funds? Answering this question may help you decide which rollover to use. If you’re in a high tax bracket now and expect to need the funds before five years, a Roth IRA may not make sense. You’ll pay a high tax bill upfront and then lose the anticipated benefit from tax-free growth that won’t materialize.

If you’re in a modest tax bracket now but expect to be in a higher one in the future, the tax cost now may be small compared with the tax savings down the road. That is, assuming you can afford to pay taxes on the rollover now.

Bear in mind that all withdrawals from a traditional IRA are subject to regular income tax plus a penalty if you’re under 59½. Withdrawals from a Roth IRA of after-tax contributions (the transferred funds you already paid taxes on) are never taxed. You’ll only be taxed if you withdraw earnings on the contributions before you’ve held the account for five years. These may be subject to a 10% penalty as well if you’re under 59½ and don’t qualify for a penalty exception.

It’s not all or nothing, though. You can split your distribution between a traditional and Roth IRA, assuming the 401(k) plan administrator permits it. You can choose any split that works for you, such as 75% to a traditional IRA and 25% to a Roth IRA. You can also leave some assets in the plan.

Keeping the Current 401(k) Plan

If your former employer allows you to keep your funds in its 401(k) after you leave, this may be a good option, but only in certain situations. The primary one is if your new employer doesn’t offer a 401(k) or offers one that’s less substantially less advantageous. For example, if the old plan has investment options you can’t get through a new plan.

Additional advantages to keeping your 401(k) with your former employer include:

• Maintaining performance: If your 401(k) plan account has done well for you, substantially outperforming the markets over time, then stick with a winner. The funds are obviously doing something right.
• Special tax advantages: If you leave your job in or after the year you reach age 55 and think you’ll start withdrawing funds before turning 59½; the withdrawals will be penalty-free.
• Legal protection: In case of bankruptcy or lawsuits, 401(k)s are subject to protection from creditors by federal law. IRAs are less well-shielded; it depends on state laws.

You might want to stick to the old plan, too, if you’re self-employed. It’s certainly the path of least resistance. But bear in mind, your investment options with the 401(k) are more limited than in an IRA, cumbersome as it might be to set one up.

Some things to consider when leaving a 401(k) at a previous employer:

• Keeping track of several different accounts may become cumbersome, says Scott Rain, Manager of Consulting Services at Schneider Downs Wealth Management, in Pittsburgh, Pennsylvania. “If you leave your 401(k) at each job, it gets really tough trying to keep track of all of that. It’s much easier to consolidate into one 401(k) or into an IRA.”
• You will no longer be able to contribute to the old plan and receive company matches, one of the big advantages of a 401(k) and, in some cases, may no longer be able to take a loan from the plan.
• You may not be able to make partial withdrawals, being limited to a lump-sum distribution down the road.

Bear in mind that, if your assets are less than $5,000, then you may have to notify your plan administrator or former employer of your intent to stay in the plan. If you don’t, they may automatically distribute the funds to you or to a rollover IRA. If the account has less than $1,000, you may not have a choice as many 401(k)s at that level are automatically cashed out.

Rolling Over to a New 401(k) 

If your new employer allows immediate rollovers into its 401(k) plan, this move has its merits. You may be used to the ease of having a plan administrator manage your money and to the discipline of automatic payroll contributions. You can also contribute a lot more annually to a 401(k) than you can to an IRA.

Another reason to take this step: If you plan to continue to work after age 72, you should be able to delay taking RMDs on funds that are in your current employer’s 401(k) plan, including that roll over money from your previous account. Remember that RMDs began at 70½ prior to the new law.

The benefits should be similar to keeping your 401(k) with your previous employer. The difference is that you will be able to make further investments in the new plan and receive company matches as long as you remain in your new job.

But you should make sure your new plan is excellent. If the investment options are limited or have high fees, or there’s no company match, the new 401(k) may not be the best move.

If your new employer is more of a young, entrepreneurial outfit, the company may offer a Simplified Employee Pension (SEP) IRA or SIMPLE IRA—qualified workplace plans that are geared toward small businesses (they are easier and cheaper to administer than 401(k) plans). The Internal Revenue Service (IRS) does allow rollovers of 401(k)s to these, but there may be waiting periods and other conditions.

Cashing Out Your 401(k)

Cashing out your 401(k) is usually a mistake. First, you will be taxed on the money as ordinary income at your current tax rate. In addition, if you’re no longer going to be working, you need to be 55 years old to avoid paying an additional 10% penalty. If you’re still working, you must wait to access the money without a penalty until age 59½. 

So aim to avoid this option except in true emergencies. If you are short of money (perhaps you were laid off), withdraw only what you need and transfer the remaining funds to an IRA.

Don’t Roll Over Employer Stock

There is one big exception to all of this. If you hold your company (or ex-company) stock in your 401(k), it may make sense not to roll over this portion of the account. The reason is net unrealized appreciation (NUA), which is the difference between the value of the stock when it went into your account and its value when you take the distribution.

You’re only taxed on the NUA when you take a distribution of the stock and opt not to defer the NUA. By paying tax on the NUA now, it becomes your tax basis in the stock, so when you sell it (immediately or in the future), your taxable gain is the increase over this amount.

Any increase in value over the NUA becomes a capital gain. You can even sell the stock immediately and get capital gains treatment. The usual more-than-one-year holding period requirement for capital gain treatment does not apply if you don’t defer tax on the NUA when the stock is distributed to you.

In contrast, if you roll over the stock to a traditional IRA, you won’t pay tax on the NUA now, but all of the stock’s value to date, plus appreciation, will be treated as ordinary income when distributions are taken.

How to Do a Rollover

The mechanics of rolling a 401(k) plan over are easy. You pick a financial institution, such as a bank, brokerage, or online investing platform, to open an IRA with them. Let your 401(k) plan administrator know where you have opened the account.

There are two types of rollovers: direct and indirect.

Direct vs Indirect Rollovers

A direct rollover is when your money is transferred electronically from one account to another, or the plan administrator may cut you a check made out to your account, which you deposit. The direct rollover (no check) is the best approach.

In an indirect rollover, the funds come to you to re-deposit. If you take the money in cash instead of transferring it directly to the new account, you have only 60 days to deposit the funds into a new plan. If you miss the deadline, you will be subject to withholding taxes and penalties. Some people do an indirect rollover if they want to take a 60-day loan from their retirement account.

Because of this deadline, direct rollovers are strongly recommended. In many cases, you can shift assets directly from one custodian to another, without selling anything. This is known as a trustee-to-trustee or in-kind transfer.

Otherwise, the IRS makes your previous employer withhold 20% of your funds if you receive a check made out to you. It’s important to note that if you have the check made out directly to you, taxes will be withheld, and you’ll need to come up with other funds to roll over the full amount of your distribution within 60 days.

To learn more about the safest ways to do IRA rollovers and transfers, download IRS publications 575 and 590-A and 590-B.

The Bottom Line

When you leave a job, there are three things to consider when you’re deciding if a 401(k) rollover is right for you:

• Fees
• The range and quality of investments in your 401(k) compared with an IRA
• The rules of the 401(k) plan at your old or new job

The key point to remember about all these rollovers is that each type has its rules. A rollover usually doesn’t trigger taxes or raise tax complications, as long as you stay within the same tax category. That means you move a regular 401(k) into a traditional IRA and a Roth 401(k) into a Roth IRA.

Just be sure to check your 401(k) balance when you leave your job, and decide on a course of action. Neglecting this task could leave you with a trail of retirement accounts at different employers—or even nasty tax penalties should your past employer simply send you a check that you did not reinvest properly in time.