When you leave a job where you have contributed to a 401(k) plan, you have three options for the money: Cash out your 401(k), keep it in your current plan, or move it to another qualified retirement account. A qualified retirement account can be your new employer’s 401(k) plan, a Traditional IRA, or a Roth IRA. The action of moving money out of your current 401(k) plan to a new qualified account is called a rollover.
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You are eligible for a rollover when you leave your job, voluntarily or involuntarily. Some plans also offer what is called an “In Service 401(k) Distribution,” which allows you to rollover your 401(k) fund even while you are still working.
Before going through with a rollover, you should consider your options carefully.
Don’t do it. This is the worst thing you could do with your 401(k). When you cash out your 401(k), you are taxed on the withdrawal and potentially penalized.
Any amount withdrawn is subjected to federal, and possibly state and local, taxes. The increased income could also push you into a higher tax bracket. Also, you may be subject to a 10% early withdrawal penalty if you are younger than 59 1/2. Assuming an effective combined federal and state tax rate of 35%, a $100,000 cash out could cost you $45,000 in taxes and penalties, leaving you with only $55,000.
Typically, you only want to do this if your current plan offers great investments at low costs. Check with the current plan administrator to see if this is an available option for your plan. If it is, ask if there are extra fees for keeping your money in the current plan, and if you can roll the plan over down the road if you change your mind. If everything checks out, work with your current
If you have access to your new employer’s plan right away, and it offers great low-cost investments, then this might be a good option for you. To rollover into your new plan, work with the new plan administrator to coordinate the process.
Compared to the options above, a rollover to an IRA is usually the best option. You can usually lower your investment expenses and gain access to a much wider variety of investment options. You can even switch among the many different brokerage firms to take advantage of different investment options, tools, features, prices, fees, and other benefits.
Also, you also have the option of converting your 401(k) to a Roth IRA, which allows your retirement savings to grow tax-free.
We already discussed what happens if you cash out your 401(k) — not good!
When you keep your 401(k) in your current plan, roll it over to your new employer’s plan, or rollover to a Traditional IRA, there are no tax liability as long as you do it right; make sure you use a trustee-to-trustee transfer (also called a direct transfer, see below).
A rollover from a Traditional 401(k) to a Roth IRA does trigger a taxable event, however. It will increase your taxable income, and potentially bump up your tax marginal rate into the next tax bracket.
Now that you’ve decided on the 401(k) rollover to IRA option, here is what you need to do:
Trustee-to-Trustee transfer is an instruction to your plan administrator to send money directly to your new 401(k) plan, or to your IRA custodian. In the event that you fail to specify this action and an indirect transfer occur, i.e., the check is made out to you instead, several things happen:
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.