Here’s Exactly How to Roll Over a 401(k) to an IRA

If you’ve recently left your job where you had a 401(k), you may be wondering what to do with that account. You may be questioning if you should take a different approach to managing your 401(k) during a recession, or if rolling it over should be on your list of things to do after being laid off. This article will discuss how to roll over your 401(k) to an IRA and some reasons it might be a good financial move for you.

Generally, 401(k) participants have multiple options when it comes to what they can do with their account: leave the money where it is; roll it over into a new employer’s 401(k) plan; roll it over to an individual retirement account (IRA); or cash it out. Rolling over your 401(k) to an IRA helps you save for retirement and has a number of benefits, but there are also a few reasons it might not be the right move for some people.

The basics of rolling over your 401(k) to an IRA

Most often, rollovers from a 401(k) occur when the 401(k) participant changes jobs. When you roll over your 401(k) to an IRA, you typically have two options:

• Direct rollover: You can have your 401(k) plan transfer the distribution directly to your IRA. This can be done by an electronic transfer from your old plan provider to your new plan provider, or you may receive a check in the mail that you then need to deposit in your new account.
• Indirect rollover: You can have the distribution paid to you, in which case you then need to deposit the distribution into the IRA yourself. This is a less commonly used option and there are some important things to know about it that we’ll discuss shortly.

A direct rollover is the most common and most recommended method to convert your 401(k) funds to an IRA. The details of how it works will vary from one plan provider to the next. But for the most part, you simply need to contact your 401(k) provider and request the rollover. They will then ask you for information about your new account and explain how they will transfer your funds. Some providers will let you do this whole process online, while others may require a phone call.

Note: There are instances in which you might be able to roll over funds from your active 401(k), i.e., while you’re still working. This is known as an in-service 401(k) rollover. This maneuver tends to be reserved for those aged 59 1/2 and older. However, if you’re under 59 1/2 and your plan doesn’t have a specific provision against it, you may be able to roll over funds from your 401(k) to an IRA while you’re still working.

A special note about indirect rollovers

If you opt for an indirect rollover as a way to get a short-term loan before you deposit your money in a new account, there are some important factors to be aware of. Any distribution paid to you is subject to a mandatory withholding of 20%, regardless if you intend to roll it over. This 20% withholding is used to prepay the tax you’ll owe if you don’t roll over your distribution and keep the check for yourself.

To have the 401(k) distribution be tax-free, you must roll over the check amount and the 20% that was withheld into your IRA account within 60 days. If you do this, you may receive most of the 20% that was withheld back in a refund when you file your taxes, as it won’t be needed to pay the tax on the 401(k) withdrawal.

Let’s walk through this all with an example. Say you elect to have the distribution paid to you with the intention of depositing it into an IRA yourself. If your 401(k) distribution is $5,000, you would receive a check for $4,000 ($5,000 x 20% = $1,000; $5,000 - $1,000 = $4,000). However, for the distribution to be tax-free, you must put all $5,000 into your IRA. That means you’ll have to come up with the $1,000 that was withheld. When it comes time to file your tax return, you should receive that $1,000 back, as it wasn’t needed to pay the tax on the withdrawal.

Any portion of the distribution that you keep is taxable. And if you are under 59 1/2 at the time of the distribution, any taxable portion may be subject to an additional 10% early withdrawal penalty. You can avoid having taxes withheld altogether by choosing to have your 401(k) distribution transferred directly to your IRA.

Benefits of rolling over your 401(k) to an IRA

There are a number of benefits to rolling over your 401(k) to an IRA:

• More investment choices: Compared to an IRA, your 401(k) likely has limited investment options based on what your employer has selected. With an IRA, most types of investment products are available to you. So although you may have been limited to a few mutual funds and bonds funds in your 401(k), an IRA can open the door to individual stocks, bonds, exchange-traded funds, and mutual funds, to name a few.
• Lower fees: The investment options in your 401(k) may come with higher administrative fees. And because 401(k)s tend to have more limited investment options, it may be difficult to avoid these fees. With an IRA, it’s typically easier to find investments with lower costs and fees.
• Multiple 401(k) accounts leftover from prior jobs: If you’ve changed jobs frequently, you may have a trail of 401(k) accounts left behind. In that case, it might be a good option to consolidate all your old 401(k) plans into an IRA for the sake of simplicity.
• Opportunity for a Roth account: Prior to 2006, if you wanted to roll over your 401(k) assets to a Roth IRA, you had to first roll over your 401(k) funds to a traditional IRA. Then, if you were eligible, you could convert that to a Roth IRA. However, with the passage of the Pension Protection Act of 2006, you can now roll over your 401(k) assets directly to a Roth IRA. One thing to note, though, is that with a Roth IRA, you contribute after-tax dollars, which means there is no tax due when you withdraw from them. So unless you roll over funds from a Roth 401(k), you will have to pay tax on the rollover.

Reasons not to roll over your 401(k) to an IRA

Although there are a number of reasons you might want to roll over your 401(k) to an IRA, there are also some reasons not to:

• You plan to retire before you’re 59 1/2. Rolling over your 401(k) into an IRA means you could be hit with a 10% early withdrawal penalty if you take money out of your IRA before you’re 59 1/2. However, with a 401(k), if you leave your job in the same year you turn 55, you can take a penalty-free withdrawal from that employer’s 401(k) plan.
• Legal protection: Unlike IRAs, 401(k) plans are covered under the Employee Retirement Income Security Act and are protected from private creditors. Any private creditor to which you owe money cannot go after the funds in your 401(k). However, a court can award part or all of your 401(k) to a spouse or child during a divorce. And if you owe back taxes, the IRS may garnish your 401(k) as well. All in all, if you live in a state in which your IRA is not protected from creditors, you might be better off leaving your retirement savings in your 401(k) plan.
• Tax savings on company stock: If your old 401(k) includes employer stock that has greatly increased in value, you may experience tax consequences by rolling it into an IRA. The difference between the price you initially paid for a stock and its current worth is known as net unrealized appreciation. If you roll over your company stock into an IRA, the NUA will be taxed at your ordinary income tax rate when you take the distribution. It’s a better strategy to move this sort of stock to a taxable brokerage account instead of an IRA. This way you pay income tax only on the amount you paid for the stock, not what it’s currently worth. You won’t pay for the capital gains on that stock until you actually sell it.
• Postponing RMDs: RMD is short for required minimum distributions. These are the minimum amounts you must withdraw from your retirement account each year. With a traditional IRA, you have to start taking RMDs at age 72, regardless of whether you’re still working. However, if you’re still working in your 70s and have a 401(k), you can defer taking RMDs until you retire. This doesn’t apply to 401(k) accounts from previous employers, so you’d want to transfer your funds to your current employer’s 401(k) if you plan to continue working in your 70s.

How to roll over your 401(k) to an IRA: step-by-step

If you’ve decided to do an IRA rollover, you may be wondering exactly how you actually go about doing it. Here’s what you need to know:

1. Decide on the type of IRA

When you’re ready to roll over your 401(k), your first step is to choose between a Roth and a traditional IRA. Both are good retirement options, but they have some differences you should be aware of that will be critical to your retirement planning.

The biggest difference between a Roth and traditional IRA is that a Roth IRA allows you to take advantage of tax benefits in the future, whereas a traditional IRA allows you to take advantage of tax benefits today. Here’s why:

• Contributions to a Roth IRA are made with after-tax dollars. This means you’ve already paid taxes on that money right now and your distributions in retirement will be tax-free.
• Contributions to a traditional IRA are made with pre-tax dollars. As a result, contributions to a traditional IRA can be deducted from your taxable income in the year they’re made. But when it comes time to take distributions in retirement, you will have to pay tax on that money.

If you feel your tax bracket will be higher when you’re ready to retire, a Roth IRA might be the better option. The inverse is true for a traditional IRA.

The type of IRA you choose also has implications for right now. If you roll your 401(k) into a Roth IRA, you will have to pay taxes on that money. If you want to roll over your 401(k) without incurring taxes right now, a traditional IRA might be a better option. Alternatively, if you have a Roth 401(k), you can roll it into a Roth IRA without incurring taxes.

2. Open your IRA account

The actual process of opening your IRA account is typically fast and easy. If you want to manage your investment portfolio yourself, online brokers such as TD Ameritrade, Charles Schwab, and Fidelity are good places to start. This gives you more control over your investments, but requires more hands-on involvement from you. You can also choose to hire an investment broker, but then the fees you pay will be higher as well.

If you prefer to have your investments be more automated, you’ll need to choose an IRA provider that will do that. Robo-advisors allow you to fill out a profile and pick your risk tolerance when it comes to your investments. Then they put together a portfolio for you using algorithms. Companies like this generally have lower fees for their services than traditional brokerages.

For example, Betterment charges an annual advisory fee of just 0.25% and has no minimum balance requirements. Plus, right now you can get up to one year with no advisory fees when you sign up for an account with Betterment and roll over your 401(k) within 45 days.

3. Request a rollover from your 401(k)

As mentioned earlier, you can avoid getting tangled in a tax mess by having your 401(k) rolled directly into your IRA. This is known as a direct rollover and it’s often the easiest route to take, though you’ll want to check with your current 401(k) plan administrator as to what options are available to you. If you’re stuck having to receive the distribution yourself, make sure to roll the entire amount into an IRA within 60 days to keep the distribution tax-free.

4. Choose how to invest the money in your IRA

When your funds are deposited into your IRA, they will be available as cash. Unless you choose to open an IRA with a financial institution that will manage your investments for you, you will need to choose how to invest your money.

If getting into purchasing individual stocks doesn’t sound like something you’re ready for, index funds are a great option. An index fund is a type of mutual fund or ETF that aims to track the returns of a particular market index, such as the S&P 500. Because they aren’t actively managed funds, fees are typically much lower. They’re also what Warren Buffet recommends for the majority of investors.

Other things to keep in mind with your 401(k)

Depending on the amount in your 401(k), you may choose to leave it in your former employer’s plan if they allow you to do so. But be aware that if your balance is below $5,000, your previous employer can remove you from the plan and automatically roll your funds into an IRA of their choosing. This can happen if you take too long to decide what to do with your funds, so make sure to take action sooner rather than later.

If you have a 401(k) with your new employer, you may also be able to just roll your old 401(k) into your new employer’s plan. Just as you would with an IRA, you can typically have your old 401(k) provider perform a direct transfer, which allows you to avoid paying taxes on any distributions. 401(k) plans also have higher annual contribution limits — $22,500 for tax year 2023, compared to $6,500 for an IRA — which allows you to lower your taxable income by a greater amount.

In 2024, these limits increase to $23,000 for 401(k) and $7,000 for IRAs.

FAQs

Bottom line

When deciding on what to do with an old 401(k), you need to consider your unique personal finance situation and the best choice for your retirement plan. Considering all the different tax implications and complications that can come with different financial products, you may want to talk with a financial advisor and/or tax advisor if you feel your particular situation is too complicated to handle on your own.

But for most of us, rolling over a 401(k) to an IRA can be a good move and can even be done all online.