401k Rollover To IRA: What is it and how does it work?

By Pinyo, on August 31, 2009

When you are leaving a job where you have contributed to a 401k plan, you have three options: cash out your 401k, keep it in your current plan, or move it to another qualified retirement account. A qualified retirement account could be your new employer’s 401k plan, a Traditional IRA, or a Roth IRA. The movement of your 401k to this account is called a rollover.

Why You Should Rollover Your 401k To An IRA

Before we discuss why 401k rollover to IRA is the best option, let’s look at why you should not cash out your 401k.

Cashing out your 401k is a bad idea

Typically, this is the worst thing your could do to your 401k fund. When you cash out your 401k, 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 401k could cost you $45,000 in taxes and penalty leaving you with only $55,000.

401k rollover to IRA is usually the best course of action

Unless your current 401k plan is great — i.e., excellent investment options and low fees — this usually is not the best option. And unless you know for certain that your new 401k will be great, you shouldn’t consider a 401k to 401k rollover either.

With an IRA, you can usually lower your investment expenses significantly and gain access to 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 401k to a Roth IRA, which allows your retirement savings to grow tax-free.

How To Do A 401k Rollover To IRA

Now that you’ve decided to go with the 401k rollover to IRA option, here are the main steps on how you can accomplish the rollover.

1. 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.
2. Inform your employer that you want to do a 401k 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.
   
3. 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 401K 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.

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Pinyo is the brain behind Moolanomy personal finance blog and a few other web sites. If you like this article, please subscribe for free daily email updates.

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