401(k) Rollovers: What You Need to Know

What we’ll cover:

• Things you can do with your 401(k) when you leave a job
• The difference between a direct and indirect rollover
• Alternatives to a 401(k) rollover

If you’re reading this article, chances are you’ve been a responsible adult, stashing a part of your paychecks into your company’s 401(k) retirement savings plan. Well done! But what are you supposed to do with your 401(k) when you’re ready to switch jobs? 

Whether you’re moving to a new job or retiring, you can take the money in your 401(k) with you. Broadly speaking, you can:

• Roll over the money to your new employer’s 401(k) plan (if permissible)
• Roll over the money to an IRA
• Leave the money in your former employer’s 401(k) plan
• Cash out your 401(k)

Makes you want to run off and take a nap, doesn’t it? Fret not and read on. In the sections below, we’ll discuss some 401(k) rollover options and consider the alternatives to a rollover. 

What is a 401(k) rollover?

Before diving into your rollover options, let’s get some definitions out of the way. A 401(k) rollover occurs when you move money from your former employer’s 401(k) plan to another retirement account – either a new 401(k) or an IRA. There are two types of rollovers: direct and indirect. 

In a direct rollover, the money in your old 401(k) plan is sent directly to your new 401(k) plan or IRA. This is the simplest way of moving your 401(k). You save yourself the hassle of having to touch the funds at all. 

An indirect rollover is more complicated. With an indirect rollover, you are effectively cashing out your 401(k) and holding on to the money until you can put it back into another retirement account (which you must do within 60 days). An indirect rollover is generally not recommended because it is treated like a distribution (an IRS term for withdrawing money from your plan) if you do not put the money back into another retirement account within the 60-day period and therefore, subject to taxes plus a 10% early withdrawal penalty if you’re under 59 ½. 

When it comes to deciding between a direct and indirect rollover, it is advisable to stick with a direct rollover. It keeps the process simple and helps you avoid taking a potential tax hit.

How do I start my 401(k) rollover?

Here are three steps to help you get started:

1. Decide where you want to move your 401(k) savings
2. Decide whether you want a direct or indirect rollover
3. Call your old 401(k) plan administrator

See? Nothing to it. Requesting a 401(k) rollover is actually the easy part. The real challenge is deciding where you want to direct your rollover. 

Option 1: 401(k) rollover to a new employer’s 401(k) plan

If your new employer offers a 401(k) plan, you may have the option of rolling your old 401(k) into the new one. Not all 401(k) plans accept rollovers, however, so it’s important that you check with your new employer’s plan. 

And before pulling the trigger, check the fees and investment details of your new employer’s plan. Some plans could have higher fees and fewer investment options. A benefit of rolling over to a new 401(k) plan is you can consolidate your 401(k) savings all in one place, which means one less account to keep track of. 

A drawback to rolling over to a new 401(k) is that the process may take some time, as the new plan administrator would have to vet your old plan to determine the amount that is eligible for transfer, among other things. And with some employers, you may also have to wait a certain amount of time before you can join their plan. 

Option 2: 401(k) rollover to a traditional IRA

If your new employer doesn’t offer a 401(k) plan or if you’re not thrilled with the plan options, you can choose to roll your 401(k) into a traditional IRA. A traditional IRA may offer a wider range of investment options than a 401(k) plan. 

Rolling over to an IRA may also be a good option for freelancers or individuals who typically don’t have access to a 401(k) through their jobs. 

Of course, if you do not have a traditional IRA, you will need to open an account. This may take some time since you will have to do a little homework and call around to see which IRA provider is right for you.

Option 3: 401(k) rollover to a Roth IRA

You could also roll over your 401(k) savings into a Roth IRA. But it matters whether you’re rolling from a Roth 401(k) plan or a traditional 401(k) plan. The latter is a little less straightforward due to some complex tax and timing rules. That said, let’s get the “easier” one out of the way first. 

Roth 401(k) rollover to a Roth IRA and the 5-year rule:

If your old employer’s 401(k) plan is a Roth 401(k), you can roll the money directly over to a Roth IRA. Generally, you do not have to pay taxes for this direct rollover.

Sounds simple enough, right? Not when the IRS is involved. 

Before we go any further, let’s address those tricky timing rules that come with Roth accounts. Withdrawals from Roth accounts are subject to a “5-year rule.” Generally, in order to withdraw your earnings tax- and penalty-free from a Roth account, you must have had the account for at least five years (and be age 59 ½ years or older). But remember, even though the withdrawal of your earnings is subject to special timing rules, you can withdraw your contributions from your Roth account any time with no tax or penalty.  

When does the clock start for the 5-year rule when you roll over from a Roth 401(k) to a Roth IRA? The timing of the 5-year rule is tied to your Roth IRA when you initiate a Roth-to-Roth rollover. For example, if you roll over a Roth 401(k) account that you’ve had for eight years into a Roth IRA that you’ve only had for three years, you’d have to wait two years before you satisfy the 5-year test. 

Tricky stuff. This is why it’s helpful to consult with a financial advisor before making any money moves when it comes to Roth rollovers.  

Traditional 401(k) rollover to a Roth IRA:

If your old 401(k) is a traditional 401(k) plan, you’re going to have to two-step your way into a Roth IRA. 

First, you must roll your traditional 401(k) to a traditional IRA. Once the money is parked in a traditional IRA, only then can you roll those funds into a Roth IRA. The process of moving money from a traditional IRA to a Roth IRA is known as a Roth IRA conversion. Got all that? The process can be a little taxing, both figuratively and literally. You’re going to have to pay taxes on the money you move (or “convert”) from a traditional 401(k) to a Roth IRA.    

The good news is that Roth IRA conversions are relatively common and your IRA provider should be able to handle the process. Most major banks and brokerage firms can guide and help you complete the conversion.  

If you need a quick refresher on the differences between a traditional and Roth IRA, check out our article on the topic here.

Alternatives to a 401(k) rollover: leave it alone or cash it in

Many 401(k) plans allow you to keep your account in place even though you’re no longer an employee of the company. You just won’t be able to contribute money to the account.

If your former employer’s 401(k) plan carries low management fees and delivers great returns, leaving your old 401(k) plan in place after you leave your job might be a reasonable option. But be aware that some employers might charge former employees higher fees, so definitely keep a close eye on those numbers. 

Hey, at least that’s one thing you could thank your old employer for! 

But one potential inconvenience is that you would have to check the account from time to time. A 401(k) plan’s fees and investment strategy can change over time. This means you would have to monitor the plan’s performance and periodically ask yourself whether it’s still worth keeping in place instead of rolling it over.  

Look, changing jobs can be stressful. So if you don’t want to move your 401(k) money right after you leave a job, you can always go back and roll it over later. 

You also have the option of cashing out your 401(k) account by taking a one-time lump sum distribution. But financial experts generally advise against this move, as your cash-out is subject to a withholding tax, an early distribution penalty and additional income tax. Translation: It’s expensive. By cashing out, you could lose more than 50% of your 401(k)’s account value to taxes, according to FINRA, an independent financial regulator in the United States.

Should I roll over my 401(k)?

As with every financial question, the answer is: It depends. 

In this case, it depends on your overall investment strategies and retirement goals. Talk to your financial advisor and see how a rollover may help streamline your retirement accounts and bring you closer to your financial goals. 

There are likely plenty of other things you’d rather be doing than deciding what to do with your old 401(k). But once it’s done, you can proudly check it off your to-do list and give yourself a pat on the back for taking care of your financial health.