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What You Need to Know About 401(k) Rollovers

A 401(k) rollover is the process by which you move the funds in your 401(k) to another retirement account – usually either an IRA or another 401(k). A 401(k) rollover typically happens when you leave your employer, either to retire or to start a new job. There are certain regulations you need to follow when rolling over your assets, most notably the 60-day rule. And you will also need to choose a new financial institution to house your account when you roll over your money into an IRA. If you’re considering a 401(k), a financial advisor can help you set up a retirement plan for your nest egg. Let’s break down everything you need to know about 401(k) rollovers.

What Is a 401(k) Rollover?

There are many ways to save for retirement, and an employer-sponsored plan like a 401(k) is one of the most common. But when you leave the employer that sponsored the 401(k), you’ll likely choose to roll over the funds from that account. You might choose to roll it into your new employer’s 401(k) plan, if one exists. You might also choose to put it into an individual retirement account (IRA), which can provide more control and flexibility.

Just like IRAs, 401(k) plans come in two forms: traditional and Roth. In most cases, someone directing a 401(k) rollover will transfer their funds to a new account that features the same tax benefits. So if you have a traditional 401(k), you’ll likely roll its assets over to a traditional IRA or 401(k). The same is generally true for Roth accounts.

But nothing in the IRS’ rules says you have to go with the same type of account. Instead, you could roll over money from a traditional 401(k) to a Roth IRA. However, you would then owe taxes on that money for the current tax year, as Roth accounts are funded with post-tax dollars. Because of this, you cannot do the reverse and roll over money from a Roth 401(k) to a traditional IRA.

According to the IRS, a 401(k) rollover can be done in one of two ways: a direct rollover or a 60-day rollover. The first route involves transferring the funds directly from one custodian to another; this might involve your custodian transferring the funds directly, or writing a check that you take to the new custodian. The IRS will not charge you taxes on this type of rollover.

You could also complete a 60-day rollover. This involves the custodian of your 401(k) making a check out to you in the amount of your account balance;  But since the money will technically pass through your hands, there are some unfavorable tax implications, including a 20% tax withholding by your employer.

The IRS does not place any limits on how much money can be transferred through a 401(k) rollover. However, certain IRA providers may have a minimum requirement for opening a new account.

How to Roll Over Your 401(k)

What You Need to Know About 401(k) Rollovers

There is a multi-step process for initiating and completing a 401(k) rollover to your new traditional or Roth IRA. More specifically, you’ll need to choose what kind of account you want, where to open it, how you’ll transfer the funds and what investments you’ll make once the assets are available. Be sure to follow each step in order so you don’t run into any tax issues with the IRS.

Below is a step-by-step breakdown of how to handle your 401(k) rollover.

1. Pick an IRA Account Type

There are two main types of IRAs that you can transfer 401(k) funds to: a traditional IRA or a Roth IRA. As we mention above, most people roll over their money into an account that has the same tax benefits as the one they’re transferring from.

For instance, let’s say you have a traditional 401(k) account that allows you to contribute money and deduct it from your taxable income, all while staving off income taxes until you withdraw in retirement. In order to maintain this tax-deferred status, you’ll need to roll your 401(k) asset over into a traditional IRA. You still have the option of rolling over to a Roth IRA, though that’ll mean you’ll pay taxes on that money for the current year.

On the flip side, those with a Roth 401(k) gain the perk of tax-free growth since the money they contribute has already had taxes paid on it. Because of this, the IRS does not allow Roth 401(k) account holders to roll funds over to anything but a Roth IRA or another Roth 401(k).

Only you can choose which type of IRA is best for your situation. If you can figure out whether your tax rate is higher now than it will be in retirement, then that should lead you in the right direction. You could also speak with a financial advisor if you have further questions.

2. Decide Where to Open Your New IRA

When opening an IRA, most people will look towards a brokerage, and for obvious reasons. 401(k) accounts are notorious for their relatively limited investment selections. But by rolling your funds into an IRA at a brokerage, you’ll get to choose from a significantly larger pool of potential investments. In fact, many offer some combination of stocks, bonds, exchange-traded funds (ETFs), mutual funds, options and more.

Managing your own retirement funds takes a lot of time and energy, but a financial advisor can do it for you. Many financial advisors specialize in retirement planning and investing, which is exactly the combination you’ll need. If you go this route, your advisor will manage your investments in an IRA according to your needs and current savings situation.

If you prefer an even more hands-off approach to investing, a robo-advisor could be a good option. When you open an IRA with a robo-advisor, an asset allocation profile will be created for you based on your age, risk tolerance and proximity to retirement. The robo-advisor will then invest and manage your assets for you according to this plan.

Regardless of which way you go, make sure you understand any account, investment or advisory fees you may incur. An overbearing fee structure can have an extremely negative effect on your portfolio, so keep an eye out for this.

3. Initiate and Complete the 401(k) Rollover Process

Once you open your new IRA account, it’s time to begin the rollover process. The simplest way to do this is to get your 401(k) provider to complete a direct rollover from your 401(k) account right to your IRA. Each provider will have its own set of requirements for this process, so contact your plan administrator. The IRS will not charge you any taxes in this situation.

The second and less preferable option is the 60-day rollover. In this case, your 401(k) provider withdraws your 401(k) balance and gives it to you in the form of a check. Then, as you might expect, you have a 60-day window to get that money deposited in your new tax-deferred account.

However, because this situation involves money passing through your hands, the IRS stipulates that the employer must withhold 20%. That means in order to get the same amount of money into your new account that you had in your 401(k), you’ll have to use separate money to make up the difference.

For example, let’s assume you’re rolling over $50,000 from a 401(k) to an IRA through a 60-day rollover. Because the check is in your name, your employer withholds $10,000, or 20%, based on IRS rules. If within 60 days, you can find enough cash to replace that $10,000 and deposit the full $50,000 in your new tax-deferred IRA, then you’ll report that $50,000 as a nontaxable rollover and the $10,000 as taxes paid. Then, come tax time, the IRS will consider that $10,000 to be part of your federal taxes withheld, which means you’ll get it back.

Now let’s say you can’t make up that $10,000 that your employer is withholding. In this case, you deposit just $40,000 in your new tax-deferred IRA. In turn, you’ll report on your tax return $40,000 as a nontaxable rollover, $10,000 as taxable income and $10,000 as taxes paid. Because of this, you’ll lose the tax-deferred status on that money.

As you can see, it would be ideal if you could avoid the 60-day rollover and instead go with a direct rollover. But if for some reason a direct transfer can’t be made, have your plan provider send you a check made out to the custodian of your new account rather than you. This will likely let you bypass this problematic situation.

4. Start Investing With Your New IRA

Ever IRA provider will have its own set of investments that it makes available to you. So hopefully during the account choosing process, you picked a brokerage that offers what you want. Once your account is open and fully funded, you can begin making investments as you see fit. Of course, if you go with a robo-advisor, this work is done for you.

In general, those close to retirement keep their investments on the safer side. This could involve investing in bonds or ETFs, both of which are typically reliable. On the other hand, someone further from retirement can afford to be riskier and more speculative. As a result, younger investors often include more stocks in their portfolio in an effort to achieve higher returns.

Rolling Over Your Old 401(k) to a New Employer

Many companies offer 401(k) plans, so people often end up having multiple 401(k)s over their years in the workforce. If you’d rather keep your funds in a single 401(k) or don’t want to open an IRA, you might have the option of transferring assets from your old 401(k) to your new one at your current job. If not, you’ll need to keep an eye on how each is performing individually.

The process for this is as simple as talking to both your current and past plan providers to make sure they will both accept a transfer of assets. While the providers can offer more specific instructions, you’ll likely use one of the methods above to complete the rollover.

Note that not all plan providers will accept employees’ past 401(k) funds as a rollover. This is because they may not be willing to add more assets to the plan, which could overwhelm it.

Tax Consequences of a 401(k) Rollover

What You Need to Know About 401(k) Rollovers

If you handle it correctly, there are basically no tax consequences that come with a 401(k) rollover. More specifically, if you complete a direct rollover, your assets seamlessly move from one account to the other without any intervention from the IRS. The rollover doesn’t show up on your tax return, nor does the IRS levy any taxes.

Conversely, the 60-day rollover faces a few tax implications. The reason for this is despite the fact that the money will pass through your control only momentarily, the IRS views it as a potential distribution. And because the IRS offers major tax benefits with retirement accounts, it’s extremely wary of when someone makes a withdrawal, especially a large one.

To cover itself, the IRS orders employers who you take a distribution from to withhold 20%. That can be a massive amount, especially if you have a large 401(k) balance. It’s unfortunately up to you as the account holder to make up that difference before the 60-day period ends, otherwise you’ll lose the tax-deferred status for that money. Beyond that, if you’re making the distribution before age 59.5, the IRS will hit you with a 10% early withdrawal penalty.

In today’s day and age, there’s virtually no reason a 401(k) plan provider wouldn’t have the technical capabilities to transfer your rollover funds for you. But if the 60-day rollover is unavoidable, simply ask to have the check sent to you in the name of your new account’s custodian.

Note that rolling over a Roth 401(k) has extra tax considerations if you receive matching contributions from your employer. Employer matching contributions are made on a pre-tax basis, which means they reside in a traditional 401(k). At the same time, the contributions you make exist in the same 401(k)’s Roth account. So when you initiate a rollover, these funds undergo different tax treatments.

This situation leaves you with two options: Either you can roll over the funds and place them in separate traditional and Roth IRAs, or you can include your employer contributions in your new Roth IRA. If you choose the former, you’ll have two separate accounts to manage. But if you go with the latter, you’ll need to pay income taxes on the amount of your employer’s contributions for the current tax year.

Reasons for and Against Rolling Over Your 401(k)

Saving for retirement doesn’t necessarily have to include a 401(k) rollover to an IRA. In many cases, you’re able to keep your 401(k) account even if you no longer work for the employer. However, like all financial decisions, there are pros and cons to both sides.

One major reason that rolling over your 401(k) can be helpful is that IRA providers boast better investment selections. 401(k)s often have minimal choices, with target-date funds being some of the most common. But if you want to diversify your assets across stocks, ETFs, bonds, options and more, a brokerage is the way to go. The same goes for robo-advisors, though those decisions are automatic instead.

Brokerages that offer IRAs may also give out bonuses to prospective clients who open an account. These can come in the form of cash bonuses or even extra features and membership tiers. Taking advantage of offers like this can give a little boost to your retirement savings.

But perhaps the most important reason to roll over your 401(k) funds into a single IRA is consolidation. After all, the fewer accounts you have to manage, the more likely you’ll do so successfully. It can also be a pain to watch over multiple 401(k)s at a few employers at once.

On the contrary, you may be fully happy with your 401(k). Simply put, if you’re comfortable with your 401(k) provider, fees and investments, you may feel completely unmotivated to make a change.

401(k)s also provide an early withdrawal benefit that an IRA can’t match. While most IRA distributions made before age 59.5 incur a 10% penalty, 401(k) account holders can withdraw penalty-free after age 55 under certain circumstances. If distributions are made to you after you leave your employer and you left during or following the year you turned 55, you can avoid the 10% penalty altogether.

Fees are one area that’s completely dependent on your personal situation. In order to determine whether your 401(k) or an IRA is cheaper, you’ll have to personally compare fees. Look not only at account fees, but also investment charges and expense ratios.

Bottom Line

The 401(k) rollover process is fairly simple, especially if you set up an automatic transfer from your current plan. While you have to choose which type of IRA to roll your money into, the choice is usually fairly obvious based on your needs and current 401(k) arrangement. If you happen to get a direct check for your rollover, be sure to follow the IRS’ rules so you don’t incur unnecessary penalties.

Retirement Tips

  • Managing your retirement assets over the long term can be tough to do on your own. This is where a local financial advisor can really help out, and finding one doesn’t have to be hard. In fact, SmartAsset’s free tool can match you with as many as three advisors in your area in just five minutes. Get started now.
  • Beyond your own money, your Social Security payments can help you fund your retirement. To get an idea of how much you’re in line to receive, use SmartAsset’s Social Security calculator.

Photo credits: ©iStock.com/Paperkites, ©iStock.com/AndreyPopov, ©iStock.com/blackCAT

Chris Thompson, CEPF® Chris Thompson is a retirement, savings, mortgage and credit card expert at SmartAsset. He has reviewed hundreds of credit cards and loves helping people find the one that best matches their financial needs. Chris is a Certified Educator in Personal Finance® (CEPF®) and a member of the Society for Advancing Business Editing and Writing. He graduated from Montclair State University where he received the Journalism Achievement Award. Chris’ articles have been featured in places like Yahoo Finance, MSN and Bleacher Report. He lives in New Jersey and is a Mets, Jets and Nets fan.
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