401(k) Rollover to IRA: How to Transfer Your 401(k) Fund
, on April 25, 2011
When you are leaving a job where you have contributed to a 401(k) plan, you have three options: cash out your 401(k), keep it in your current plan, or move it to another qualified retirement account. A qualified retirement account could be your new employer’s 401(k) plan, a Traditional IRA, or a Roth IRA. The movement of your 401(k) to this account is called a rollover.
Why You Should Rollover Your 401k to an IRA
Before we discuss why 401(k) rollover to IRA is the best option, let’s look at why you should not cash out your 401(k).
Cashing out your 401(k) is a bad idea
Typically, this is the worst thing your could do to your 401(k) fund. When you cash out your 401(k), you’ll be taxed on the withdrawal. The combined federal and state taxes could be significant due to the higher marginal tax rate that the withdrawal will bump you into. Also, you may be subjected to a 10% early withdrawal penalty if you are not yet 59 1/2. Assuming an effective combined federal and state tax rate of 35%, a $100,000 cashed out of 401(k) could cost you $45,000 in taxes and penalty leaving you with only $55,000.
401(k) rollover to IRA is usually the best course of action
Unless your current employer’s 401(k) plan is great — i.e., excellent investment options and low fees — keeping your 401(k) with them is usually not the best option. And unless you know for certain that your new 401(k) will be great, 401(k) to 401(k) rollover might not be that great either.
With an IRA, you can usually lower your investment expenses and gain access to a much wider variety of investment options. You can even switch to a different discount brokerage firm to take advantage of different investment options, tools, features, prices, fees, etc. Additionally, you have the option of converting your 401(k) to a Roth IRA, which allows your retirement savings to grow tax-free.
These are some answers to the most commonly asked tax questions when it comes to 401(k) rollover:
- 401(k) rollover to another 401(k) plan and Traditional IRA does NOT impact your taxable income, because they are all pre-tax accounts.
- 401(k) rollover to a Roth IRA does increase your taxable income, and potentially bump up your tax marginal rate into the next tax bracket.
- If you anticipate high taxable income this year, it may be worth while holding off on your rollover to a Roth IRA. You can either keep your money in your current employer’s plan (if they allow a rollover at a later date), or rollover to a traditional IRA then later convert it to a Roth IRA.
- Rollover into a Roth IRA does not increase your Modified AGI, so your ability to contribute to an IRA should not be impacted by the rollover. (See clause 1b under Modified AGI on the IRS.gov web site)
How to Do a 401(k) Rollover to IRA
Now that you’ve decided to go with the 401(k) rollover to IRA option, here are the main steps on how you can accomplish the rollover.
- Open an Individual Retirement Account (IRA) with any financial institution that offers an IRA. Usually, this end up being one of the many discount brokers. Here’s a guide to help you choose a discount broker. In general, you want to pick the investment company that offers the type of investments you want that are accessible at low trade commissions and fees.
- Inform your employer that you want to do a 401(k) rollover to IRA. Make sure your employer makes the check payable to the investment company that you choose. This is call a trustee-to-trustee transfer and it helps you avoid the automatic 20% tax withholding.
- Invest Your Money. Once the transfer is complete, your money will be sitting in some sort of interest bearing investment such as a money market account that earns very little interest. You will have to invest your money according to your asset allocation plan. The exact investment options you have will depends on your investment company. In general, you want to invest in a well-diversified portfolio of low cost and passively managed mutual funds or ETFs.
If you are facing this decision, consider performing a 401(k) rollover to IRA to take advantage of the opportunity to lower your costs and gain greater flexibility. Remember to research the investment company well before you open an IRA with them, and do your due diligence when selecting your investments. If you are uncertain, it’s usually a good idea to consult a professional to help guide you through this process and answer your questions.
Alternatively, you can use the following service to help with your rollover.
Betterment offers a set and forget investment service that will let you rollovers into both Traditional and Roth IRAs. With a fee of only 0.15% to 0.35%, Betterment empowers you to put more of your hard-earned income toward a comfortable future.
If you like this article, please sign up for our free weekly updates
The information on this site is strictly the author's opinion. It does NOT constitute financial, legal, or other advice of any kind. You should consult with a certified adviser for advice to your specific circumstances.
While we try to ensure that the information on this site is accurate at the time of publication, information about third party products and services do change without notice. Please visit the official site for up-to-date information.