Leaving your job is a big life change. So we don’t blame you if your employer-sponsored 401k 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 we urge you to consider 401k rollover options.
Below we cover different approaches to the 401k rollover and how to transfer a 401k.
What is a 401k rollover?
A 401k rollover is when you direct the transfer of the money in your 401k plan to a new 401k plan or an IRA.
401k Rollover Options
Let’s start with your options when it comes to your old 401k.
- Leave your money with your old employer’s 401k plan. This is the simplest option — essentially doing nothing and leaving your 401k funds where they are.
- Roll your assets over to an individual retirement account (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 401k money over into it.
- Roll your old 401k over into your new employer’s 401k plan. If your new employer offers a 401k, this might be a good option because it will enable you to keep your 401k momentum going.
- Cash out all of your 401k. Here, you’ll “take the money and run” by taking a lump-sum distribution from your old 401k account. If you’re younger than 59½, you’ll probably have to pay income tax on the distribution plus a 10% tax penalty. Calculate It: 401k Early Withdrawal Calculator
- Cash out a portion of your 401k. Alternatively, you could distribute some of your 401k money, pay the taxes and penalties that are due, and roll over the rest into an IRA or your new employer’s 401k plan.
Benefits of Rolling Over Your 401k to an IRA
A common misconception about 401k 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 401k at all.
So for most, the decision is clear: roll over your 401k assets into an IRA.
However, there are specific scenarios when a cash-out might make sense, such as if you own stock in your company in your 401k. Additionally, some scenarios may cause high-income earners to encounter a taxable situation when attempting a backdoor Roth conversion after rolling over a 401k into an IRA. If you think this might apply to you, talk to your financial advisor about your rollover options.
1. 401k Rollover Lowers Fees
401ks can be costlier than IRAs if they come with an extra layer (or layers) of fees. First, there are administrative fees. These are in place to cover the day-to-day operations of a 401k, including record-keeping, accounting, legal and trustee services. In addition, 401k investment options tend to be more expensive than other investments available outside of a 401k.
All in, 401k fees are, on average, around 1% of plan assets, according to the Center for American Progress. One percent doesn’t sound like a whole lot, but let’s take a look at a simplified example to see how much of an impact 1% can have on your retirement assets.
Say you’re 40 years old with an old 401k from a prior job with $150,000 in assets. That plan charges 1.5% a year in annual expenses. Fast forward 30 years and the account is now worth more than $560,000 (assuming a 6% compounding growth rate and a 1.5% fee).
With a fee that is 1% lower, or 0.5%, the value of your portfolio would be a staggering 33% greater in 30 years. If your $150,000 is invested in funds with a 0.5% fee, your net annualized gain is 5.5%. That will turn today’s $150,000 into nearly $750,000 in 30 years. Lowering your investing costs could boost your retirement savings by nearly $200,000 – and you didn’t assume any additional risk for the increased value.
IRAs don’t come with any of these plan fees, which is a great reason to consider a 401k rollover. Personal Capital’s 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 401k over into an IRA is to improve your investment selection. Once the money settles into your IRA, you or your advisor can choose among thousands of ETFs, bonds, mutual funds or individual stocks. You’re no longer limited to the dozen or so mutual funds typically offered in a 401k. And here’s a startling fact: By law, 401k plans can offer as few as three investment options.
Mutual funds are not only expensive, but also tend to underperform the market. ETFs, on the other hand, provide a relatively low-cost, tax-efficient way to create a well-diversified portfolio. Low-cost investments help boost your retirement security – without having to ramp up savings or portfolio risk.
Read more: ETFs vs Mutual Funds: What’s the Difference?
Your investment time horizon and risk tolerance, along with several other factors, will ultimately guide your asset class decisions. You can use the Personal Capital 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 unload shares, you’re not taking a distribution, and you’re not making a contribution when you use the profits to re-invest. With more flexibility in your investments, this benefit is more pronounced in IRAs.
Cashing Out Your 401k
As explained above, you can cash out all or part of your 401k if you want. However, we generally do not recommend cashing out your 401k if you are younger than 59½ due to the current taxation and 10% penalty that will be assessed.
However, if a portion of your 401k 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 a lump sum distribution from a 401k. Typically, whether you withdraw money from a 401k as a lump sum distribution or as income during retirement, you pay tax on all of 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 from a 401k as a lump sum 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, within one year, you must distribute the entirety of the vested balance held in the plan, including all assets from all of the accounts sponsored by the same employer.
All distributions must be taken 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 be sure to consult your financial and tax professionals before moving forward.
Read more: Can I Withdraw From My 401k or IRA Penalty-Free?
How to Roll Over Your 401k to an IRA
To rollover your 401k to an IRA, follow these steps.
- Open an IRA if you don’t have one. Consider choosing an investment company that offers a wide range of investment options — including mutual funds and ETFs and individual stocks and bonds — so you can achieve broad asset allocation and diversification.
- Inform your former employer that you want to roll over your 401k funds into an IRA. Make sure the check is payable to the investment company, instead of you personally — this is referred to as a trustee-to-trustee transfer. Otherwise, 20% of the money will automatically be withheld to pay taxes.
- Once the transfer is complete, you can decide how to invest the money in order 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 401k?
A rollover is when you move funds from one eligible retirement plan to another, such as from a 401k to a Rollover IRA.
Is It Worth Rolling Over a 401k?
In many situations, yes, rolling over your 401k into an IRA account is worth the effort. This is because you typically have lower fees, a greater selection of investment options, and potentially increased withdrawal flexibility.
Do You Lose Money When You Roll Over a 401k?
When you roll over your 401k money into an IRA, 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 401k. Your money will maintain its tax-deferred status until you withdraw it.
Suggested Next Steps for You
Sign up for Personal Capital’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 to guide you through your decision to roll over your old 401k.