How to Roll Over Your 401(k): An Expert’s Guide

Regardless of the reason, leaving a job is a big change. And if you have a 401(k) with an employer you’re leaving, there are decisions to make about what you should do with those funds. In some cases, it’s possible to leave the money where it is. Alternatively, individuals can roll over the funds into an individual retirement account (IRA) or a new employer’s 401(k). There’s also the option to withdraw the money—albeit with associated costs. All of these options come with pros and cons, particularly when it comes to taxes.

What is a 401(k) rollover?

A 401(k) rollover is the process by which an account holder transfers funds from one 401(k) to another 401(k) account or an IRA. It’s usually done when someone leaves one job for another, gets laid off, or leaves the workforce (before reaching retirement age) and opts to switch their 401(k) funds to another account. Note that it’s not always required to roll over 401(k) funds when leaving an employer; in some cases, the money can stay invested in the 401(k) account managed by the previous employer.

A rollover does not count as part of one’s annual contribution limit, whether the funds are transferred to a 401(k) or IRA. However, because 401(k)s come with a variety of tax implications, it’s important to correctly follow the rollover steps to avoid accidentally triggering income tax on the funds.

There are two options for rolling over a 401(k), each with its own set of benefits and drawbacks that depend on the investor’s circumstances. Although there’s no set time frame for when an investor can initiate a 401(k) rollover after their employment ends, there is a deadline by which an indirect rollover must be completed.

• Direct rollover.

  With this approach, assets are transferred directly from one account to another without incurring a tax penalty.

• Indirect rollover.

  In this case, the account holder receives the funds to manually transfer to a new account; 20% is withheld to cover the potential for federal income tax, and there is a 60-day time limit to transfer the funds without penalty.

The pros and cons of rolling over your 401(k)

There are benefits and drawbacks to rolling over a retirement plan distribution.

Pros

• More investment opportunities.

  Many employer 401(k)s offer a limited selection of investments. A rollover gives investors the ability to manage their funds or find a brokerage to create a customized portfolio.

• Potential for lower management fees.

  A 401(k) rollover allows investors to shop around for their ideal fee structures. They may wish to pay more for a fully managed portfolio, or they may opt for a robo-advisor that uses data-driven research to make investment decisions.

• Streamline retirement funds.

  Investors can calculate their net worth, and track their portfolio’s overall asset allocation, without having to manage several accounts.

Cons

• Tax penalties may be triggered by indirect rollovers.

  A direct rollover makes it easy to transfer funds from one retirement account to another, but not all brokerages offer this option. An indirect rollover—in which funds are distributed to the account holder and they must put the money into another retirement account—involves a mandatory tax withholding and a 60-day time limit to transfer the funds without penalty.

• Loss of potential gains.

  Investors happy with their former 401(k)’s performance and fees may prefer not to roll over funds.‍
  

What to consider before rolling over your 401(k)

Keep the following factors in mind before initiating a 401(k) rollover.

• Employer 401(k) fees:

  An employer plan may come with a lot of fees, including investment management fees. High expense ratios for ETFs and mutual funds are common. There are also several potential hidden fees, including administrative fees, asset fees, commissions, and audit fees. Investors can use a 401(k) fee analyzer tool to identify the true cost of an existing 401(k) account.

• Investment options:

  Keeping an employer 401(k) means available investments are dictated by the plan administrator—usually in the form of mutual funds and ETFs. Investors who want a greater variety of funds, individual stocks, or even cryptocurrency may choose to roll over funds into a more flexible account.

How to roll over your 401(k)

There are two options for rolling over an existing 401(k) to another retirement account.

1. Roll over the 401(k) to an IRA

Rolling over a 401(k) to a traditional IRA doesn’t have any tax penalties, since both accounts hold tax-deferred earnings. But the account holder does have to pay taxes on any transfer of a 401(k) to a Roth IRA, as all distributions made in retirement are tax-free.

Transferring a 401(k) to an IRA may provide more flexibility, as an IRA allows penalty-free withdrawals in certain situations:

• Unreimbursed medical expenses over 7.5% of an individual’s adjusted gross income
• Health insurance premiums during unemployment
• Permanent disability
• Purchase of first home ($10,000 lifetime limit)
• Qualified active duty
  

IRA funds aren’t as protected as 401(k)s from a lawsuit or bankruptcy. (As of 2021, up to $1,362,800 in IRA assets are protected from creditors, which applies to the sum of the assets, not individual accounts.) There is almost no protection from owed lawsuit settlements.

2. Roll over to another 401(k)

Individuals switching jobs with a new 401(k) can complete a direct rollover from the previous account. The human resources department should be able to explain how to start a 401(k) with the company. The process typically involves filling out forms and initiating a wire transfer between the old and new accounts. If the individual is leaving a job to become self-employed, they can roll over their funds to a solo 401(k). Once the individual has set up a 401(k) with their new employer, they can contact the plan administrator for instructions on how to transfer their other 401(k) funds to their new job’s 401(k).

If investors stick with a 401(k) instead of an IRA, the funds are protected from creditors, unless the IRS or a spouse makes claims on the money. The Employee Retirement Income Security Act (ERISA) protects 401(k) accounts from:

• Creditors
• Bankruptcy
• Civil lawsuits
  

Another benefit of rolling over funds to a 401(k) instead of an IRA is that account holders can take out a 401(k) loan. They could qualify to borrow up to $50,000 repaid over five years. The loan amount is limited to the lesser of 50% of the vested account balance or $50,000. Both principal and interest are repaid to the account.

If the borrower leaves their job (by choice or not) while there’s still an outstanding balance, the remaining loan must be repaid by the next year’s federal tax deadline. If it’s not repaid by then, the borrower (if 55 or younger) will be charged a 10% early withdrawal penalty, plus income tax.

Alternatives to 401(k) rollovers

1. Keep the 401(k)

Many employers allow former employees to keep funds in their existing 401(k) plan; however, the company may no longer cover some fees. Additionally, while the current invested funds may continue to grow, no new contributions may be made.

Some investors opt to keep the funds in an old 401(k) if the portfolio has performed well. It may also have lower fees compared to a new employer’s plan.

Another consideration is for individuals who own company stock in their 401(k). If the value has grown, a rollover could trigger tax implications on the net unrealized appreciation (NUA). Investors may consult with a tax advisor to determine the best way to rollover funds or decide if it’s best to keep the stock in the existing 401(k).

2. Withdraw funds

Withdrawing funds from a 401(k) rather than rolling them into another tax-advantaged retirement account has tax implications. Original contributions to a 401(k) provide an income tax deduction, so any withdrawals (including those made in retirement) are generally taxed. Additionally, early withdrawals before age 59 ½ also incur a 10% penalty on top of income taxes.  

One exception is the IRS’s Rule of 55. Traditionally, how a 401(k) works is that penalty-free withdrawals may only be made when the account holder reaches 59 ½ years old. However, if the individual leaves a job in the calendar year they turn 55 (or later), they can take withdrawals without penalties.

The bottom line

Investors must decide how to handle a 401(k) from a former employer. Considerations include age, current financial and employment situations, and tax implications.‍