Guide to 401(k) and IRA Rollovers

When you leave an employer for non-retirement reasons, for a new job or just to be on your own, you have four options for your 401(k) plan. You can:

• Roll the assets into an IRA or Roth IRA
• Keep your 401(k) with your former employer
• Consolidate your 401(k) into your new employer’s plan
• Cash out

Let's look at each of these strategies.

IRAs usually give the owner the ability to choose from a much wider array of investments than 401(k)s do. Some plans have only half a dozen funds to choose from, and some companies strongly encourage participants to invest heavily in company stock. Many 401(k) plans are also funded with variable annuity contracts that provide a layer of insurance protection for the assets in the plan at a cost to the participants that often runs as much as 3% per year.

With a small handful of exceptions, IRAs allow virtually any type of asset: stocks, bonds, certificate of deposits (CD), mutual funds, real estate investment trusts (REITs), annuities and derivatives and even some alternative investments like oil and gas leases can be purchased inside these accounts.

If you opt for an IRA, your second decision is whether to open a traditional IRA or a Roth IRA. Basically, the choice is between paying income tax now or later.

Traditional IRA

The main benefit of a traditional IRA is that your investment is tax-deductible now; you put pre-tax money into an IRA and those contributions are not part of your taxable income. If you have a traditional 401(k), the transfer is simple, since those contributions were also made pre-tax. Tax deferral won’t last forever, however. You have to pay taxes on the money and its earnings later when you withdraw the funds. And you are required to start withdrawing them at age 70½, a rule known as Required Minimum Distributions (RMDs), whether if you’re still working or not. (RMDs are also required from most 401(k)s when you reach that age, except the one at your current employer—see below.)

Roth IRA

In contrast, if you opt for a Roth IRA rollover, you must treat the entire account as taxable income immediately. You’ll pay tax now on this amount (federal income tax as well as state income taxes if applicable). What’s more, you’ll need the funds to pay the tax and may have to increase withholding or pay estimated taxes to account for the liability. However, assuming you maintain the Roth IRA for at least five years and meet other requirements, then all of the funds—your after-tax contribution plus earnings on them—are tax-free.

There are no lifetime distribution requirements for Roth IRAs so funds can stay in the account and continue to grow on a tax-free basis. You can leave this tax-free nest egg to your heirs (although they will have to draw down the account over their life expectancy).

Note: If your 401(k) plan was a Roth account, it can only be rolled over to a Roth IRA. This makes sense since you already paid tax on the funds contributed to the designated Roth account. If that's the case, you don’t pay any tax on the rollover to the Roth IRA.

Deciding Which IRA to Choose

Where are you financially now versus where you think you’ll be when you tap into the funds? Answering this question may help you decide which rollover option to use. If you’re in a high tax bracket now and expect to need the funds before five years, a Roth IRA may not make sense. You’ll pay a high tax bill up front and then lose the anticipated benefit from tax-free growth that won’t materialize. Conversely, if you’re in a modest tax bracket now but expect to be in a higher one in the future, the tax cost now may be small compared with the tax savings down the road (assuming you can afford to pay taxes on the rollover now).

Will you need money before you retire? Bear in mind that all withdrawals from a traditional IRA are subject to regular income tax, plus a penalty if you’re under age 59½ and they don’t qualify for one of the exemptions (like buying a house). In contrast, withdrawals from a Roth IRA of after-tax contributions (the transferred funds you already paid taxes on) are never taxed. You’ll only be taxed if you withdraw earnings on the contributions before you've held the account for five years; these may be subject to a 10% penalty as well if you’re under age 59½ and don’t qualify for a penalty exception.

It’s not all or nothing, though. You can split your distribution between a traditional and Roth IRA (assuming the 401(k) plan administrator permits this). You can choose any split that works for you (e.g., 75% to a traditional IRA and 25% to a Roth IRA). You can also leave some assets in the plan.

If your former employer allows you to keep your funds in its 401(k) after you leave, this may be a good option, but only in certain situations, says Colin F. Smith, president of The Retirement Company in Wilmington, N.C. Staying in the old plan may make sense “if you like where you are and they may have investment options you can’t get in a new plan,” says Smith.

Additional advantages to keeping your 401(k) with your former employer include:

• Maintaining the performance. If your 401(k) plan portfolio has substantially outperformed the markets over time, then you may want to think twice before rolling over your plan.
• Special tax advantages. If you leave your job in or after the year you reach age 55 and think you'll start withdrawing funds before turning 59½, the withdrawals will be penalty-free.
• Legal protection. In case of bankruptcy or lawsuits, 401(k)s are subject to protection from creditors by federal law. IRAs are less well-shielded; it depends on state laws. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 does protect up to $1.25 million in traditional or Roth IRA assets against bankruptcy. But protection against other types of judgments varies.

Some things to consider when leaving a 401(k) at a previous employer:

• If you plan on changing jobs a few more times before retirement, keeping track of all of the accounts may become cumbersome.
• You will no longer be able to contribute to the old plan and receive company matches, one of the big advantages of a 401(k)—and in some cases, may no longer be able to take a loan from the plan.
• Your investment options are more limited than in an IRA.
• You may not be able to make a partial withdrawal and may have to take the entire amount. 

Bear in mind that, if your assets are less than $5,000, you may have to notify your plan administrator or former employer of your intent to stay in the plan; otherwise, they may automatically distribute the funds to you or to a rollover IRA. If the account has less than $1,000, you may not have a choice—many 401(k)s at that level are automatically transferred out.

If your new employer has a plan that allows immediate rollovers, and you like the ease of having a plan administrator manage your money, consider this step instead of opening an IRA. Another reason to take this step: If you plan to continue to work after age 70½, you should be able to delay taking RMDs on funds that are in your current employer's 401(k) plan, including that rollover money from your previous job.

The benefits should be similar to keeping your 401(k) with your previous employer. The difference: You will be able to make further investments in the new plan and receive company matches as long as you remain in your new job.

Avoid this option except in true emergencies. First, you will be taxed on the money as ordinary income, at your current tax rate. In addition, if you’re no longer going to be working, you need to be 55 to avoid paying an additional 10% penalty. If you’re still working, you must wait to access the money without penalty until age 59½. 

Most advisors say that if you are short of money (perhaps you were laid off), withdraw only what you need until you can find another income stream. Move the rest to an IRA or similar tax-advantaged retirement plan.

One big exception to all this: If you hold your company (or ex-company) stock in your 401(k), it may make sense not to roll over this portion of the account. The reason is net unrealized appreciation (NUA). NUA is the difference between the value of the stock when it went into your account and its value when you take the distribution.

You’re only taxed on the NUA when you take a distribution of the stock and opt not to defer the NUA. By paying tax on the NUA now, it becomes your tax basis in the stock, so when you sell it—immediately or in the future—your taxable gain is the increase over this amount. Any increase in value over the NUA becomes a capital gain. You can even sell the stock immediately and get capital gains treatment (the usual more-than-one year holding period requirement for capital gain treatment does not apply if you don’t defer tax on the NUA when the stock is distributed to you).

In contrast, if you roll over the stock to a traditional IRA, you won’t pay tax on the NUA now, but all of the stock’s value to date, plus appreciation, will be treated as ordinary income when distributions are taken.

There are two types of rollovers: direct and indirect. in a direct rollover, also called a direct transfer, money is transferred electronically from one account to another. In an indirect rollover, the funds come to you to re-deposit. If you take the money in cash instead of transferring it directly to the new account, you have only 60 days to deposit the funds in a new plan. If you miss the deadline, you will be subject to withholding taxes and penalties.

Because of this deadline, direct rollovers are strongly recommended. Nowadays, in many cases, you can shift assets directly from one custodian to another, without selling anything—a trustee-to-trustee or in-kind transfer. If for some reason the plan administrator can't transfer the funds directly into your IRA or new 401(k), have the check they send you made out in the name of the new account care of its custodian. This still counts as a direct rollover.

Otherwise, the IRS makes your previous employer withhold 20% of your funds if you receive a check made out to you. Bear in mind, though, if you take a check made out to the new plan but fail to get it deposited within the 60 days, you still get socked with the penalties.

To learn more about the safest ways to do IRA rollovers and transfers, download IRS publications 575 and 590 from the IRS website. And be sure to check carefully for fees before choosing your plan.

When you leave a job, one key task is deciding whether to transfer your 401(k) into another account. Neglecting this task could leave you with a trail of retirement accounts at different employers—or even nasty tax penalties should your past employer simply send you a check that you did not reinvest properly in time.

“Workers are much more transient today,” says Scott Rain, tax senior at Schneider Downs & Co., in Pittsburgh, Pa. “If you leave your 401(k) at each job, it gets really tough trying to keep track of all of that. It’s much easier to consolidate into one 401(k) or into an IRA.”

The key point to remember about all these rollovers is that each type has its rules. It's important to be sure that you are in compliance so you can benefit from the tax advantages and not find yourself paying penalties. Of course, if a rollover is what you plan to do, you'll need to open a retirement account with a broker. To decide which broker fits your needs check out Investopedia's list of the best brokers for IRAs and the best brokers for Roth IRAs.