401(k) to IRA Rollover Rules: What You Need to Know
Most of us don't stay at the same job forever. If you have a 401(k) plan through an employer and are downsized or decide to switch jobs, you'll generally have a few options for what to do with that money. You could leave it where it is (provided your plan's rules allow for that), you could move it into another 401(k), or you could roll it into an IRA.
There are several good reasons to initiate a 401(k) to IRA rollover, but the primary benefit is the world of investment choices IRAs typically offer. That said, there could be tax implications when you transfer money from a 401(k) to an IRA, so it's important to understand how this conversion might impact you financially.
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Why choose an IRA?
IRAs provide certain benefits that 401(k)s do not. While most 401(k)s offer limited investment choices, IRAs tend to give savers far more options for where to put their money. These added choices can help you avoid high investment fees while allowing for greater diversification. Furthermore, while it's usually not a good idea to take an early withdrawal from a retirement account, IRAs offer more flexibility should this need arise. Specifically, you can withdraw up to $10,000 penalty-free from an IRA before age 59-1/2 to purchase a first-time home. You can also avoid an early withdrawal penalty if you take money out of an IRA to pay for qualified college expenses.
How to roll over your 401(k)
The easiest way to move your 401(k) without tax implications is to initiate a direct rollover, where your former plan assets are transferred directly from your employer-sponsored plan to a traditional IRA. Once you complete the appropriate paperwork, the money from your 401(k) is typically moved over by electronic transfer or check, and you won't be required to pay any taxes as part of the process.
While rolling a 401(k) into a traditional IRA is generally a fairly seamless process, transferring a traditional 401(k) to a Roth IRA is bit more complicated due to the tax implications involved. Unlike traditional 401(k)s and IRAs, which are funded with pre-tax dollars, Roth IRAs are funded with after-tax dollars. While all of these accounts get to grow tax-deferred, Roths offer the added benefit of tax-free withdrawals in retirement, whereas distributions from traditional IRAs and 401(k)s are taxed in retirement as ordinary income. If you decide to roll assets from a traditional 401(k) to a Roth IRA, you will need to pay taxes on whatever amount you convert.
Now if you happen to have a Roth 401(k), you can roll it into a Roth IRA and avoid taxes completely. But moving assets from a traditional 401(k) to a Roth IRA will trigger a tax situation.
Indirect 401(k) rollovers
While a direct 401(k) rollover is generally the easiest way to facilitate a transfer, some people opt for indirect rollovers. Why might you do this? If you want to move money out of your former plan immediately but aren't sure where to put it, an indirect rollover buys you a little more time to make that decision.
Furthermore, under the right circumstances, an indirect rollover can serve as a short-term loan of sorts. If, for example, you're between jobs and need a little extra cash to tide yourself over, you can indirectly roll over your 401(k). When this happens, you'll get a check for your account value minus 20% for tax withholding purposes. As long as you redeposit that money into another 401(k) or IRA within 60 days, you won't face an early withdrawal penalty, and if you complete your rollover within that timeframe, your withheld funds will be returned to you when you file your tax return for the year.
There are many good reasons to roll a 401(k) into an IRA. The more aware you are of the rules and tax implications involved, the better your chances of a smooth transfer that will ultimately benefit you financially.
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