How to Roll Over a 401(k) Into an IRA

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When you roll over a 401(k) into an IRA, you can keep retirement savings growing when you plan to switch jobs or retire from the 9-to-5 for good. This type of rollover can also confer tax benefits and give you more control over your investments.

A 401(k), of course, is an employer-sponsored retirement savings plan. In contrast, an IRA, or individual retirement plan, is a personal account set up at a brokerage firm or mutual fund company that the saver manages.

Rolling over a 401(k) to an IRA allows you to move funds from your previous employer’s retirement plan into an IRA. The big benefits of a rollover is that you can preserve the tax-deferred status of your retirement account, avoid a distribution that results in a tax bill, and sidestep early withdrawal penalties if you haven’t yet reached the full retirement age of 59 ½ when you move the money to the IRA.

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“A rollover from a 401(k) to an IRA is about the added flexibility, the greater range of investment options, and continuing to maintain the same tax advantages that you had in your 401(k),” said Rob Williams, managing director of financial planning at Charles Schwab.

Roll over a 401(k) into an IRA: benefits and choices

Of course, rolling over a 401(k) plan into an IRA isn’t your only option. “You have a choice,” said Williams. You can always leave your nest egg in your former employer’s 401(k) if they permit you to do so. You may also have the option of rolling your money into your new employer’s retirement plan. You could also opt for a cash distribution and take the money and run, but that option could result in taxes and paying a 10% penalty if you’re younger than 59 ½.

There are many reasons why rolling over a 401(k) plan to an IRA makes the most financial sense.

Rollovers are tax-friendly. You’ll maintain the tax-deferred status of your retirement account and avoid taxes and potential penalties. If you move your account balance from a 401(k) to an IRA your money will continue to grow tax-free, allowing more of your savings to benefit from compounding.
IRAs offer a wider range of investment choices. 401(k) plans typically offer limited investment options, including broadly diversified stock and bond funds and target-date funds that adjust the fund’s risk profile as the investor ages. In contrast, IRAs provide investors with a much wider array of investment choices, including the ability to invest in any mutual fund or ETF offered by a slew of different mutual fund companies, but also individual stocks, bonds, CDs and Treasury securities.
Rollovers keep you from raiding your nest egg. Saving for retirement is a long game. Building wealth through automatic payroll deductions to a 401(k) takes decades. Your path to a secure retirement gets that much tougher if you raid your 401(k) or take a lump-sum payout if you leave a job or retire before age 59 ½. “Taking a lump sum can be tempting, but avoid the temptation,” said Williams. Rolling over a 401(k) to an IRA helps you avoid shrinking your account balance as well as paying taxes and penalties on early distributions.

Direct vs. indirect rollovers

It makes sense to roll over a 401(k) to an IRA if your ex-employer’s retirement plan doesn’t offer a wide breadth of investment options and charges high fund investment fees and administration expenses, notes Christine Benz, director of personal finance and retirement planning for fund-tracker Morningstar.

Knowing the difference between a direct IRA rollover and an indirect rollover is also important. A direct rollover — which personal finance experts recommend — is when the administrator of your 401(k) plan delivers your distribution check directly to the financial company where your IRA rollover is set up. The main benefit of a direct rollover is you never touch the money and, therefore, avoid the risk of being hit with a tax bill on the distribution from the IRS or paying the 10% early withdrawal penalty if you’re not yet at full retirement age.

In contrast, an indirect rollover is when your 401(k) administrator sends your assets directly to you, typically in the form of a check. It is then your responsibility to roll over all the assets into an eligible plan, such as a rollover IRA, within 60 days of receiving the distribution. The 60-day rule is important to understand. If you don’t roll over your 401(k) to an IRA within the 60-day grace period, the money will be treated as a distribution and will be taxed at your ordinary income rate. If you’re younger than 59 ½, you’ll also be subject to a 10% penalty. If your employer-sponsored plan sends a check directly, they might be required to withhold 20% in federal income taxes, although you can recover that money if you rollover your total 401(k) balance. (The IRS, however, may waive the 60-day rollover requirement in certain situations if you missed the deadline because of circumstances beyond your control. But it’s best to avoid this inconvenience if possible.)

Rolling a 401(k) into a Roth IRA

Before deciding on a rollover, review your existing accounts to see if you have a Roth 401(k) or a traditional 401(k). Savers in traditional 401(k)s — accounts funded with pre-tax dollars that are taxed as ordinary income at the time of withdrawal — can roll over their money into a Roth IRA. But there’s a catch. “The transaction is effectively a Roth conversion,” said Nilay Gandhi, senior wealth advisor at Vanguard. Since Roth accounts are funded with dollars that have already been taxed but come with tax-free withdrawals, you will have to pay taxes at your personal income tax rate on any traditional 401(k) assets you roll over to the Roth IRA at the time of the conversion, according to IRS rules.

The calculus — or bet you’re making — when rolling over a 401(k) into a Roth IRA is that you will be in a higher tax bracket in retirement than you are now, says Gandhi. Here are ways to reduce your tax burden now if you opt for a rollover from a traditional 401(k) to a Roth IRA.

Do the rollover in years when your reported taxable income is lower. The timing of your rollover to a Roth IRA is also critical. Just as a contestant on The Price Is Right who wins a new car is responsible for the tax bill on that “extra” earned income the car’s value represents, so too is a retirement saver responsible for paying taxes on the 401(k) assets he or she rolls over into a Roth IRA.

One way to reduce the hit is to do the conversions over a number of years rather than converting the whole thing at once. Say you have $500,000 in your 401(k). You could roll over the total balance over four or five years, which means you’ll only add $100,000 or $125,000 to your taxable income in a single tax year instead of the entire $500,000.

But remember, in order to take tax-free withdrawals from a Roth, you must be at least 59½ and have held the account for at least five years. Otherwise, you could owe taxes on your earnings and a 10 percent early-withdrawal penalty, too. So, rolling over a 401(k) to a Roth IRA makes less sense if you need access to the money now.

There are reasons, though, to keep your money in your existing 401(k) plan. Such factors include things like finding value in the tools and advice that your employe-sponsored plan offers. And for those under the age of 59 ½ who think they might need to tap their retirement account at some point, a 401(k) allows you to take loans against your balance, whereas an IRA does not. “Where there are needs for liquidity or access to the funds, it may still make sense to leave the money in the 401(k),” said Gandhi.

Adam Shell is a veteran financial journalist who covers retirement, personal finance, financial markets, and Wall Street. He has written for USA Today, Investor's Business Daily and other publications.