Rolling Over a 401(k) to an IRA
A 401(k) can be a great way to invest for retirement. But if you’ve since left your employer after setting one up, then you might want or need to roll it over to an Individual Retirement Account (IRA). So it’s good to know the ins and outs of how it works.
Here’s what we cover in this guide
What does it mean to roll over
Why you would want to roll over your 401(k)
Why you might not want to roll over
How to roll over your 401(k)
What does it mean to roll over a 401(k)?
Basically, rolling over means transferring the money you’ve invested in your 401(k) into an IRA, or potentially into a new 401(k) if your new employer allows it. Also, if your employer offers a match, you’ll be able to take the matched portion that has already vested. Make sure you know how your employer’s vesting schedule works so you know how much you’ll be entitled to receive.
Why would you want to rollover your 401(k)?
For starters, some employers won’t let you stay invested in your old 401(k) after you’ve left the company, so you’ll need to roll it over. Others may allow you to keep it, but you might still want to roll it over for a few reasons;
More investment options – Usually your 401(k) will have a limited number of investment funds to choose from. With an IRA, you’ll have a much wider range of choices – basically any kind of stock, bond, fund or other investment security you want buy.
Easier to keep track of your accounts – Trying to keep track of multiple 401(k)s from previous employers can get to be a hassle from an administrative perspective. So transferring your accounts to a single IRA might make the process easier.
Potentially more flexibility with future distributions – In addition to offering more investment choices, IRAs can sometimes offer more flexibility when you’re ready to take your money out in retirement. Some 401(k) plans have more rigid rules for how you can take your money out. You’ll want to know how your plan works.
Why you might not want to roll over a 401(k)
While rolling over can be a good idea, it isn’t always, particularly if your 401(k) offers lower fee investments. This isn’t always the case, but some 401(k) plan sponsors are able to negotiate lower fees on your selection of investments than what you’ll see when you sign up for an IRA. So you’ll want to compare what you’re currently paying in fees with what you would be paying in an IRA.
Also, if you do rollover to an IRA, watch out for any potential conflicts of interest if an employee of the investment firm offers advice on particular investments. Some of these investments might carry high fees and commissions that you probably don’t want to be paying. So make sure you understand what fees you’ll be on the hook for and how the person recommending the investments gets paid. Don’t be afraid to ask tough questions.
How to roll over your 401(k)
The actual process for rolling over shouldn’t be too complicated. But there are a few steps and you’ll want to make sure you get them right.
Step 1) Set up an IRA
Before you roll over, you’ll want to open an IRA first. So spend a little time comparing offers form different IRA providers.
You’ll also want to decide between a Roth IRA and a traditional IRA. We have a short guide explaining the difference. If you have a traditional 401(k) and you choose a Roth, it will be considered a Roth conversion. So you would have to report the money as income that year and pay taxes on it. But then you won’t have to pay any additional taxes on your investment gains or when you take the money out in retirement.
If instead you roll over to a traditional IRA, you won’t owe any taxes now and your taxes are deferred until you take the money out in retirement. At that point though, your distributions will be taxed as income (the same way they would have been if you stayed with your traditional 401(k)). For the most part, the mechanics of a traditional IRA will be closer to most 401(k)s, that is unless you have a Roth 401(k).
Step 2) Transfer your funds
Once you’ve set up your IRA, contact your previous employer or third party administrator (the financial firm that manages your 401(k) plan) and tell them you want to do a direct rollover to your new IRA. This means the funds will be transferred directly to your IRA rather than to you personally. If the money goes to you, you’ll only have 60 days to deposit it in the IRA without it being taxed as income. You may also want to contact your new IRA provider to let them know you’re rolling over.
Step 3) Choose your new investments
Typically when you roll over, your previous investments will be sold and your money will then be deposited as cash. So you’ll need to select new investments. We can help you think about this in our Core Content or you can get started with our Investing Cheat Sheet.
Summary
Overall, rolling your 401(k) to an IRA can be a good idea if you’re able to invest in a wider range of lower cost funds and if you want to limit the number of investment accounts you have. However, it’s not always a no-brainer since some 401(k) plans have negotiated lower fees on their funds. No matter what you choose, make sure you do your research first and keep investing!
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