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Friday, April 07, 2023

401(k) rollover options

401(k) rollover options

401(k) Rollover Options

By
Brian Cocos, CFP®

02.01.2023

A 401(k) rollover is when you move money from your former employer-sponsored retirement plan into another employer-sponsored retirement plan or an individual retirement account (IRA).

Leaving your job is a big life change. So, we don’t blame you if your employer-sponsored 401(k) isn’t immediately top-of-mind. You’re likely finding your feet at your new job, sorting through administrative tasks and absorbing new information during company onboarding. It can be an overwhelming time. But you may want to consider 401(k) rollover options.

Below we cover different approaches to the 401(k) rollover and how to transfer a 401(k).

What is a 401(k) rollover?

A 401(k) rollover is when you direct the transfer of the money in your 401(k) plan to a new employer-sponsored retirement plan or an IRA.

401(k) rollover options

Let’s start with your options when it comes to your old 401(k).

  1. Leave your money with your old employer’s 401(k) plan. This is the simplest option — essentially doing nothing and leaving your 401(k) funds where they are. (In some cases, balances under $5,000 may be automatically forced out of the plan).
  2. Roll your assets over to an IRA. You’ll need to open a new IRA if you don’t currently have one. If you do have an IRA, you can roll your 401(k) money over into it.
  3. Roll your old 401(k) over into your new employer’s plan. If your new employer offers a retirement plan, such as a 401(k), this might be a good option because it will enable you to keep your retirement savings momentum going.
  4. Cash out all your 401(k). Here, you’ll “take the money and run” by taking a lump-sum distribution from your old 401(k) account. You will have to pay income tax on the distribution and if you’re younger than 59½, you’ll probably have to pay an additional 10% tax penalty. Calculate it: 401(k) Early Withdrawal Calculator.
  5. Cash out a portion of your 401(k). Alternatively, you could distribute some of your 401(k) money, pay the taxes and penalties that are due, and roll over the rest into an IRA or your new employer’s retirement plan.

A common misconception about 401(k) plans is that if you leave your funds in the account after leaving the employer, you will continue to receive matching contributions or continue to vest the previously added match. We hate to be the bearers of bad news, but that’s not the case. Not only will you not receive any matching contributions, but you won’t be able to contribute to your old 401(k) at all.

There may be specific scenarios when a cash-out might make sense, such as if you own stock in your company in your 401(k). Additionally, some scenarios may cause high-income earners to encounter a taxable situation when attempting a backdoor Roth conversion after rolling over a 401(k) into an IRA. If you think this might apply to you, consider talking with a financial advisor or other financial professional about your rollover options.

Consider all your options and their features and fees before moving money between accounts.

Benefits of rolling over your 401(k) to an IRA

1. The potential to lower fees

In some cases, 401(k)s can be costlier than IRAs if they come with an extra layer of fees. First, there are administrative fees. These are in place to cover the day-to-day operations of a 401(k), including record-keeping, accounting, legal and trustee services. All in, 401(k) fees are, on average, around 1% of plan assets, according to the Center for American Progress.1 In addition, 401(k) investment options can sometimes be more expensive than other investments available outside of a 401(k).

However, it’s important to point out that there are fees with both types of accounts, so it’s important to understand the fees associated with your specific plan.

Our free Fee Analyzer will tell you what impact fees might have on your retirement goals.

2. More investment options

The second reason to think about rolling your 401(k) over into an IRA is to potentially improve your investment selection. Once the money settles into your IRA, you or your financial professional can choose among the investments offered in the IRA which may include exchange-traded funds (ETFs), bonds, mutual funds or individual stocks. An IRA may offer you more investment options than those typically offered in a 401(k).

Your investment time horizon and risk tolerance, along with several other factors, can ultimately guide your asset class decisions.

You can use the Personal Asset Investment Checkup tool to help determine your target allocation and see how your existing portfolio compares.

Finally, as with any retirement account, when you make trades within your IRA, you can do so without generating IRS reporting requirements. Think of it this way: When you sell shares, you’re not taking a distribution, and you’re not making a contribution when you use the profits to reinvest.

Cashing out your 401(k)

As explained above, you can cash out all or part of your 401(k) if you want. However,  it may be a poor financial decision to cash out your 401(k) if you are younger than 59½ due to the current taxation and 10% penalty that will be assessed.

However, if a portion of your 401(k) is invested in company stock, then cashing out a portion could make sense. The reason? Company stock has different tax treatment if it’s taken out as part of a lump sum distribution from a 401(k). Typically, whether you withdraw money from a 401(k) as a lump sum distribution or as income during retirement, you pay tax on all your withdrawals at ordinary income rates. Gains that came from appreciation and income, therefore, have the same tax treatment.

Company stock, on the other hand, can be distributed as shares “in-kind” from a 401(k) as part of a lump sum distribution and the ordinary income tax rate will be applied only to the cost basis of the stock. Any growth in your company stock is considered “net unrealized appreciation,” or NUA. You’ll only pay tax on your NUA once you sell the stock, and if you sell it a year after taking the lump sum distribution, you’ll be taxed at long-term capital gains rates.

There are some other requirements that must be met as part of the NUA rules. First, the distribution must be part of a lump sum distribution of your account from the plan which means that within one year, you must distribute the entirety of the vested balance held in the plan.

All distributions must be taken in-kind as shares and cannot be converted to cash at this time. You must have either separated from the company, reached the minimum age for distribution, suffered an injury resulting in disability or have passed away. The NUA strategy must be vetted carefully and is not for everyone, so consider consulting your financial and tax professionals before moving forward.

How to roll over your 401(k) to an IRA

To rollover your 401(k) to an IRA, follow these steps:

  1. Open an IRA if you don’t have one.
  2. Inform your former employer that you want to roll over your 401(k) funds into an IRA. Make sure the check is payable to the financial services company, instead of you personally — this is referred to as a direct rollover. Otherwise, 20% of the money will automatically be withheld to pay taxes.
  3. Once the transfer is complete, you can decide how to invest the money to achieve your retirement goals. Everyone’s asset allocation will be different based on their goals, time horizon and risk tolerance — there’s no cookie-cutter approach to retirement investing.

Frequently asked questions

What is a rollover in a 401(k)?

A rollover is when you move funds from one eligible retirement plan to another, such as a 401(k) to an IRA or another 401(k).

Is it worth rolling over a 401(k)?

In many situations, yes, rolling over your 401(k) into another employer retirement plan or an IRA account can be worth the effort. This is because you may have lower fees, a greater selection of investment options.

Do you lose money when you roll over a 401(k)?

When you roll over your 401(k) money, you won’t lose the contributions you’ve made, your employer’s contributions if you’re vested, or earnings you’ve accumulated in your old 401(k). Your money will maintain its tax-deferred status until you withdraw it.

Suggested next steps for you

Sign up for Personal Asset ’s free financial tools to get access to the Fee Analyzer, which will allow you to see how much you are paying in investment fees. When you sign up, you’ll also get access to the Retirement Planner, which will allow you to see how likely your portfolio is to support you through retirement based on your individual goals.

Consider speaking to a financial advisor or other financial professional to guide you through your rollover decisions.

1 Center for American Progress, Fixing the drain on retirement savings, April 11, 2014.

 

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Brian Cocos, CFP®

Brian Cocos, CFP®

Contributor

Brian Cocos, CERTIFIED FINANCIAL PLANNER™, is a financial advisor at Personal Asset , where he works with clients to help them achieve their best financial outcomes.

The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. No part of this blog, nor the links contained therein is a solicitation or offer to sell securities. Compensation for freelance contributions not to exceed $1,250. Third-party data is obtained from sources believed to be reliable; however, Personal Asset cannot guarantee the accuracy, timeliness, completeness or fitness of this data for any particular purpose. Third-party links are provided solely as a convenience and do not imply an affiliation, endorsement or approval by Personal Asset of the contents on such third-party websites. 

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