When you change jobs you need to decide what to do with your 401k plan. There are 3 basic options: (1) cash it out, (2) leave your funds in your old 401k plan, (3) do a 401k rollover into an IRA or other tax deferred plan. Rolling your 401k into an IRA is often the best option as it allows to keep your investments in a tax deferred plan, avoid taxes and early withdrawal penalties, and give you total control over where and how you invest your money, the fees you pay, etc.
Rolling Over a 401k Plan into an IRA
We’re assuming you chose option #3 from the above options. Doing a 401k rollover into an IRA is easy, and is basically a three step process: (1) open an IRA, (2) transfer your funds into an IRA via a trustee-to-trustee transfer or an indirect rollover, (3) allocate your funds. The second step is the most important because it can have an affect on your taxes. Note: These steps are similar for transferring 401(k), 403(b), Thrift Savings Plan and similar tax deferred retirement plans.
Opening an IRA
The first step is opening an IRA, which only takes a few minutes. All you need to do is open an account with the financial institution if you don’t already have one, sign a form, transfer some funds, then allocate them. For more information regarding what to look for when opening an IRA, I recommend reading about how to start an IRA, and following that up with where to open an IRA for some great investment houses and brokerages.
Roll over your 401k assets into an IRA
There are two primary 401k rollover options to transfer your assets into an IRA – by a direct or indirect transfer. You can also transfer your money into a conduit IRA, which is a Traditional IRA set up to hold your old 401(k) assets until you move the money into another qualified retirement plan.
Indirect IRA rollover. With an indirect IRA rollover, you receive a check for the amount of your 401k plan assets, minus an automatic 20% tax withholding. You then have up to 60 days to deposit the entire amount that was in your former plan into a tax deferred retirement account. Otherwise the amount you don’t deposit will be treated as a withdrawal for tax purposes, and may be subject to income taxes and early withdrawal penalties. That means you need to come up with 20% out of pocket to make up for the amount that was automatically withheld. You will receive a tax refund for the 20% when you file your taxes the following year, but you are on the hook in the meantime. Thankfully, there is an easier way to rollover your 401k, which avoids any deductions or tax withholdings.
Trustee-to-Trustee Transfer of a 401k plan. A trustee-to-trustee transfer, or direct transfer, moves your 401k plan assets to another qualified retirement plan without having to worry about cashing it out and having to pay taxes or early withdrawal penalties. This way you can safely and easily transfer the funds in your account and not worry about coming up with 20%, forgetting to deposit the assets, or making any other mistakes along the way. The paperwork is easy to fill out, and most banks brokerages, or investment houses will be happy to do the paperwork for you. Once the paperwork is filled out, your new brokerage will initiate the funds transfer from your old brokerage and the transfer is made.
Allocate your funds
Most brokerages will allow you to elect which funds you wish to invest in before you transfer your funds from your former 401k plan trustee to your IRA custodian. However, some IRA custodians may just place the money in a money market account or high yield savings account until the transfer has been completed; then you need to allocate the funds according to your risk tolerance and investment needs.
What to look for with a 401k Rollover into an IRA
- Rollover contributions do not count toward annual IRA contribution limits. You can still contribute up to the maximum amount allowed based on your age and income.
- Most Roth 401k plans will automatically roll over into a Roth IRA, and a Traditional 401k plan will roll into a Traditional IRA. You can transfer a traditional IRA into a Roth 401k, but you will need to pay taxes and meet certain income qualifications. Consult with your broker or a financial planner for more details.
- All 401k plans must allow you to transfer your funds via a trustee-to-trustee transfer.
- Verify transfer eligibility, fees, and/or tax considerations before transferring your 401k plan.
- You may wish to contact a financial planner if you have company stock in an old 401(k) plan.
- When in doubt, consult with your broker or a certified financial planner before making any financial decisions.