401(k) Rollovers Explained
There are four ways to handle the money in your 401(k) when you leave a company: cash out, leave the money where it is, roll it over to a 401(k) at your new company, or roll it over to an IRA. With the last two choices, it’s important to follow the rules carefully so you don’t wind up paying taxes earlier than you planned.
You want to delay paying tax on your retirement money, avoid an early-withdrawal penalty, and keep your savings growing for retirement. Keep in mind that rolling over assets to an IRA is just one of multiple options for your retirement plan. Each of the following options are different and may have distinct has advantages and disadvantages.
- Roll assets to an IRA
- Leave assets in your former employer’s plan, if plan allows
- Move assets to your new/existing employer’s plan, if plan allows
- Cash out or take a lump sum distribution
Below are the pros and cons of each option.
Nearly half of U.S. employees cash out their 401(k) accounts when leaving their jobs, according to a recent survey by consulting firm Hewitt Associates.
But cashing out your 401(k) is almost never a good idea. In fact, it’s a fast way to wipe out any progress you have made towards saving for retirement. Plus you’ll pay federal taxes, which might be 28%, and a 10% early withdrawal penalty (if you’re not yet 59 1/2), in addition to any state and local taxes. Click on this cash-out tool to see how it would play out for you.
You are free to do this if you have more than $5,000 in your 401(k) when you’re ready to switch jobs. (If the amount is less than $5,000 but more than $1,000 and you don’t direct a transfer, the employer may opt to retain the money in the plan or open an IRA for you and transfer the money into that IRA. If the amount is less than $1,000 and you don’t direct a transfer, the employer can direct that a cash distribution be made.) About a third of workers leave 401(k)s with their old employers, according to the Hewitt study.
You cannot continue to make contributions to the ex-employer’s plan, however. And be aware that some employers charge a fee to administer accounts for non-employees. You should check the plan's rules to determine if there are unique plan provisions for former employees.
This can be a sound move if you like the investments that are offered in the new plan. But it’s important to find out if your new employer accepts prior employer plans, and if so how soon you can roll over your money. Many employers don’t allow new employees to participate in a 401(k) plan for six months or even a full year after they begin working, so check the plan’s rules.
If there’s a waiting period, you may have to leave your money in your former employer’s plan or open an IRA to hold the money. If that happens to you, be sure to continue saving for retirement on your own until the waiting period is over.
An IRA typically offers more investment choices than an employer’s plan, allowing you to invest in a vast array of securities — stocks, bonds, ETFs, and mutual funds.
Having a wider range of investment options can help reduce your investing risk by diversifying your holdings. It’s also easier to monitor an IRA account and stay on top of your investment strategy, giving you more control over your retirement savings. You can open an IRA at a bank, brokerage house, or mutual fund company. For more information on whether a rollover is something you should consider, click here.
If you roll over to an IRA, you might consider converting a portion of it to a Roth IRA. You pay taxes on the amount converted but earnings can generally be withdrawn tax-free at age 59 1/2 if you have owned the Roth for at least five years. You also won't have to bother with required minimum distributions. Owners of traditional IRAs, on the other hand, are required to make mandatory withdrawals when they turn 70 1/2 whether they need the money or not. But Roth conversions are not right for all investors. Contact your tax advisor for more information and to see if a Roth conversion may be suitable for your specific situation.
If you don’t plan to take withdrawals from your IRA for many years, a Roth might work for you. “The longer you can leave money in the Roth, the more effective the conversion will be,” says Ed Slott, IRA expert and author of Stay Rich for Life: Growing & Protecting Your Money in Turbulent Times. Even a 60-year-old could benefit from a conversion, he adds, if she doesn’t need to take withdrawals for another 15 or 20 years.
If you’re rolling over your retirement savings to your new employer’s plan or to an IRA, be sure to request that the funds be transferred directly to your new account. If you request a check payable to you, the amount will be assessed a mandatory 20% withholding for income tax. If that happens:
- You will have 60 days to roll over all or a portion of the amount you receive
- If you want to roll over the total amount, you must personally deposit, out of your own pocket, the 20% tax withholding that was deducted from your distribution.
Any portion not rolled over into the IRA, including the 20% withholding, will be considered a distribution and will be subject to income tax and, generally, a 10% penalty if you’re under age 59 1/2.
Try to stay at your current job until you’re officially vested in the company’s 401(k) plan (and eligible to get the company match).
If you change jobs just three months shy of vesting, you could forfeit thousands of dollars that your employer has already contributed to your 401(k). In many cases, you would only get back what you put in, plus any earnings.
So before you change jobs, be sure to:
- Ask your current employer whether you’re already vested or when you will become vested
- Get an updated statement of your accumulated retirement benefits
- There are four ways to deal with the funds in your 401(k) when you’re switching jobs, taking time out from the workforce, or retiring. Each option has advantages and disadvantages, including investment options and fees and expenses.
- Cashing out is generally a bad idea, because you’ll pay income tax on the money and possibly a penalty.
- If you’re rolling over your funds to a 401(k) with your new employer or to an IRA, it’s important to follow the rules carefully to avoid complications.