When you move on from one job to the next, you have options about what to do with your 401(k) or similar retirement plan.
You can:
Some options have tax consequences and penalties, so choosing the right option for you can save you a lot of money.
Before we get too far, here are some terms involving 401(k) rollovers that are important to understand.
A 401(k) is a plan employers offer that allows employees to save and invest for retirement. (The name comes from a subsection of the tax code.) Employees contribute pretax money directly from their paychecks, and many employers match those contributions up to a certain level.
There is often a vesting schedule, or a period of time you must remain in the plan until all of the money your employer contributes as a match is yours. Money in 401(k) plans is protected from claims from creditors. When you reach a certain age, usually 70 ½, you must start taking distributions from a 401(k).
An IRA, or individual retirement account, is an investment account designed to build savings for retirement. There are two main types of IRA: traditional and Roth. The main difference between the two involves taxes.
With a traditional IRA, contributions are tax-deductible. You don’t owe taxes until you withdraw the money. With a Roth IRA, contributions are not tax-deductible, but you can withdraw the money later without paying taxes.
Money in IRAs is not usually protected from creditors except in the case of bankruptcy. When you reach 70 ½, you must begin taking distributions from a traditional IRA, but Roth IRAs don’t require minimum distributions as long as the account holder is alive.
People who work for some nonprofits or schools, or as ministers, often have 403(b) plans instead of 401(k)s. The plans are similar, and rolling over a 403(b) is much like rolling over a 401(k).
A rollover is when the money from one 401(k) goes directly into a different 401(k), IRA or another approved retirement plan.
When someone leaves a job and wants to withdraw their funds from their employer-sponsored 401(k), the old plan makes a check directly payable to another retirement plan or IRA.
This is when the owner of the retirement plan receives a check from the old 401(k) plan made out to them. To avoid tax penalties, you have 60 days to deposit all of it into an approved retirement plan.
Cashing out is when you withdraw all of the money from your 401(k) to do something else with it. There are severe tax and early withdrawal penalties associated with cashing out a 401(k).
Let’s take a closer look at the options we outlined earlier about what to do with a 401(k) when you leave a job.
Some companies allow you to keep your money in their 401(k) plan even if you’re not working there anymore. Exceptions are if you have less than $5,000 in the plan you might be required to move it or if you have less than $1,000, the plan can automatically transfer it out and write you a check for the balance.
There are pros and cons to remaining in an old 401(k).
Pros:
Cons:
“A reason to stay in the existing plan is you like the choice of investment options, and it’s a plan with a lot of options that suit your needs,” said Jeff Pedersen, a Sioux City, Iowa-based certified financial planner and vice president of private wealth management for Baird. “Generally, 401(k) expenses are less than what they would be for an individual IRA.”
When you make a job change, sometimes simplifying things makes sense. With many different plans, it can be difficult to know if you’re on track to reach your retirement goals.
“It’s not uncommon that somebody gets to retirement age, and says ‘I’ve got three or four different 401(k) plans’ and so I take a look at it and ask, ‘OK, how easy is it to manage and are they even being managed?’” Pedersen said.
Pros:
Cons:
IRAs have some benefits 401(k) plans do not, mainly involving the choice of investments. IRAs often have many more options for how to invest your money. There is no limit to how much you can roll over into an IRA.
Pros:
Cons:
The biggest difference between rolling a 401(k) into a Roth IRA versus a traditional IRA is taxes. If you roll your 401(k) into a Roth IRA, you will owe income taxes on the amount you roll over since that money has never been taxed before.
Pros:
Cons:
Cashing out your 401(k) is also an option, but it has many drawbacks.
“You’re going to get taxed on it plus pay a penalty if you’re under 59 ½,” Pedersen said. “So depending on your income, you can figure that you’re going to give up anywhere from 15% to 50% in the form of taxes and penalties.”
Pros:
Cons:
Every situation is different, so there is no perfect answer about what is the best option for your retirement accounts.
“Unless there’s something specific about that existing plan that makes you say, ‘I don’t want to move these assets,’ generally most plans are comparable,” Pedersen said. “They offer a wide range and variety of investments. You don’t want 12 different 401(k) (plans) hanging out there, because you’re not going to be managing them, so you either want to roll them all to your current employer, or you want to roll anything from past plans to an IRA. That way, you’re basically managing your accounts.”
Some things to consider?
It doesn’t always not need to be all or nothing. Some plans allow a partial rollover.
Deciding where to put your money is the hard part. Making it actually happen is relatively easy if you follow three basic steps.
Sometimes, you can do the entire process online and it’s simple. Some companies require a formal filing request with a notary. Find out what your plan requires.
There are a few things to remember.
“I would say the average investor doesn’t know if [their options] suit their needs or not because more often than not, they’re not going to know what they need for retirement,” Pedersen said. “Which is why it helps to have somebody walk through and do retirement plan analysis for them.”
Tiffani Sherman is a Florida-based freelance reporter with more than 25 years of experience writing about a variety of topics, including finance, health and travel. She likes to save money so she can travel more.
This was originally published on The Penny Hoarder, which helps millions of readers worldwide earn and save money by sharing unique job opportunities, personal stories, freebies and more. The Inc. 5000 ranked The Penny Hoarder as the fastest-growing private media company in the U.S. in 2017.