401(k) Rollover to IRA

As part of personal finance and investment goals, many 401(k) owners seek to rollover their 401(k) to an IRA for various benefits. These benefits include wider investment choices, the possibility of lower fees, more control over their retirement and fewer — and easier — rules, among others.

How To Roll Over a 401(k) to an IRA

The rollover of your assets from a 401(k) to a traditional or Roth IRA can take place in two major ways.

First, you can request a direct rollover. A direct rollover can be a trustee-to-trustee transfer where the administrator of your 401(k) transfers your funds to the chosen IRA without liquidating your assets.

But the administrator can also liquidate your assets by writing a check for the amount liquidated in the name of the IRA. That means, the check is not written in your name.

The other alternative is an indirect rollover. Here, the administrator of your 401(k) liquidates your assets and writes a check for the funds in your own name.

Steps to Completing a 401(k) Rollover to IRA

There are simple steps you can take to complete a 401(k) rollover to an IRA.

4 Steps to Roll Over a 401(k) to an IRA

1. Decide on the type of IRA you want. You can either choose a traditional IRA or a Roth IRA.
2. Open a new IRA or choose an existing one. A 401(k) rollover into an IRA can occur with a new or existing account. You can create an IRA through an online broker or a robo-advisor.
3. Request for a direct or indirect rollover. Choose the one that is more appropriate for your purpose and send in a request to your 401(k) administrator to complete the rollover.
4. Keep contributing to your IRA. Once your administrator has completed the rollover, you can keep contributing funds to your new or existing IRA.

Consolidating old employer 401(k)s can be an important step in organizing your finances. In addition to risking neglect of your orphaned 401(k), separation from your employment leaves you without many of the benefits of a 401(k). If you are no longer an active employee, you cannot take loans, fees may rise, and you are less likely to receive timely communication on plan changes. At a minimum, it is beneficial to rollover your plan to your new existing employer plan if not an IRA. 

Stephen Kates, CFP®Principal Financial Analyst for Annuity.org

Stephen Kates, CFP® is a personal finance expert specializing in financial planning and education. He serves as the Principal Financial Analyst for Annuity.org, where he delves into industry trends to support consumers and financial advisors on wealth management, annuities, retirement planning, and investing.

When Should You Roll Over Your 401(k) to an IRA?

A 401(k) IRA rollover can take place at two different times. First, you can rollover into an IRA when you are leaving your current employer. Second, you can do an in-service 401(k) rollover, which is a rollover into an IRA while you are still employed.

There are certain benefits to consider that might lead you to execute a 401(k) rollover to an IRA.

Reasons to Rollover 401(k) to IRA

More investment choices

IRAs typically allow you to invest in more asset types compared to a 401(k). You can also create a self-directed IRA, which allows more investment options than a typical IRA. More investment choices might mean a chance to earn higher returns or to minimize risk through diversification.

Possibility of incurring lower fees

If your 401(k) has high expenses and you have found an IRA with cheaper fees, a rollover might make sense for you.

Investing aids

Many IRA providers provide investing aids that will help you get better value for your money. Robo-advisors, for example, can use credible and successful investing theories to construct the best personalized portfolio for you.

Better communication

It can be much easier to communicate with an online broker or a robo-advisor than a 401(k) administrator. If you want someone to talk to about the state of your investment, IRA managers may be more easily accessible than 401(k) administrators.

Control

If you want more direct control of your retirement funds, an IRA will be a better fit. If you go with the online broker option, you have the freedom to buy and sell assets as you please.

Less complication

The administration of a 401(k) can be very complicated as per IRS rules when compared to an IRA. For example, 401(k) distributions and rollovers are subject to withholding tax. However, with a traditional IRA, you can elect to subject your distributions to a WHT or not. Roth IRA distributions are not taxed.

No required minimum distributions (RMDs)

If you don’t want to start withdrawing from your retirement account at age 73 or 75 — which the IRS mandates for qualified plans and traditional IRA — you can rollover your 401(k) into a Roth IRA, which does not have RMD. You’ll owe income taxes on the amount rolled over in the year that a conversion is made.

Pay taxes now rather than later

If you believe you will be in a higher tax bracket in the future, you can decide to pay taxes on contributions to your retirement account now rather than later. You can do this by rolling over your 401(k) into a Roth IRA. With a Roth IRA, you will pay taxes now and then invest and withdraw your funds tax free.

Pros and Cons of Rolling Over Your 401(k) to an IRA

To consider the pros and cons of a 401(k) rollover to IRA, it’s best to compare a traditional IRA and Roth IRA separately.

The best way to way the pros and cons is to determine what features are most valuable to you. For example, if you value the option for a loan, then you may consider keeping a 401(k) over a rollover to an IRA.

What Are the Tax Implications of Rolling Over Your 401(k)?

When it comes to tax implications, there are a few differences to note between a direct and indirect rollover.

If you don’t complete an indirect rollover within a 60-day window — from the day you liquidated the 401(k) — then the funds withdrawn will be treated as a distribution rather than a rollover. Consequently, you will pay taxes on the withdrawal. Also, if the distribution is not a qualified distribution, you will incur penalties. This requirement is known as the 60-day rollover rule.

While you should also seek to complete a direct rollover within 60 days, taxes and penalties don’t apply as they do with indirect rollovers.

When you make an indirect rollover, the administrator of your 401(k) must withhold 20% tax on the amount withdrawn. If it’s a transfer to a traditional IRA, where you are not supposed to pay tax, you can recover the withholding tax. However, to do this, you must deposit the total amount withdrawn into the traditional IRA.

Example of Tax Implications

Let’s use an example to demonstrate the tax implications.

If you withdrew $10,000 but got only $8,000 because the administrator of your 401(k) had withdrawn $2,000 as withholding tax (WHT), you will need to deposit the pre-tax amount ($10,000) into your traditional IRA before you can recover the WHT. This means, you will have to have an extra $2,000 to complete the rollover.

This does not apply with a direct rollover, which is why it is typically the preferred method.

The reason why someone may choose an indirect rollover is to get a loan from their own 401(k). So, if you withdraw $10,000 and get $8,000, you can spend that $8,000 instead of rolling it over, as long as you return it back with the $2,000 tax to the same 401(k) before the 60-day window elapses. Once you complete it within 60 days, the IRS will not charge you tax or penalties and the WHT deducted will be returned.

Alternatives to a 401(k) Rollover to IRA

It is worth mentioning that there are alternatives to a 401(k) rollover to an IRA.

Alternatives to a Rollover

Keep your 401(k)

You can change your mind and keep your 401(k) instead of doing an in-service 401(k) rollover. Also, when leaving your job, you can ask your employer if they will allow you to keep the 401(k) with them. With this option, your money will continue to grow tax deferred, but you can’t make new contributions.

Roll over into another 401(k)

If you are changing jobs and you want the benefits of a 401(k) that are not available with IRAs, you can rollover into the 401(k) provided by your new employer.

Roll over into a Roth 401(k)

If you want the benefits of a 401(k) and a Roth IRA at the same time, you can ask if your new employer has a Roth 401(k). Like a 401(k), you can enjoy higher contribution limits, employer matching contributions and loans. Like a Roth IRA, you will put post-tax funds into the account and enjoy the benefit of paying tax now rather than at withdrawal. However, starting in 2024 and subsequent years, designated Roth accounts will no longer need Required Minimum Distributions (RMDs). Also, you won’t have the wider investment choices that a Roth IRA provides.

Roll over into an annuity

If you want a guaranteed income at retirement, you can consider rolling over into an annuity. A 401(k) rollover into an annuity can take place through a direct transfer or a qualifying distribution.

Take a cash distribution

If you need the money, you can just liquidate your 401(k) and spend the cash. With this option, you will pay taxes and penalties if it is not a qualified distribution.

In the end, you must choose the option that best aligns with your retirement goals. Therefore, you should first speak to your financial advisor to find out what makes best sense for your future.