What is A 401(k) Rollover And How Can It Impact You?

Employee Benefits, Investing, Planning, Retirement, Saving

Moving jobs can come with many changes: cleaning out your desk, onboarding and learning a role at your new employer, and adjusting to a different team and office environment. One thing people don’t always think about is what to do with all the money accrued in their 401(k). 

After all, it is your money! Having a game plan is critical. 

In general, you have three options:

• Keep the money where it is
• Cash it out (except don’t do that unless you want up to half of the value taken away by taxes)
• Roll the funds over into a different account, usually your new company’s 401(k) or an IRA

A 401(k) rollover can be a beneficial strategy to maximize your money while still keeping it safe to grow and yield returns. So what’s a 401(k) rollover, how does it work, and which account makes the most sense to store your assets? 

Let’s find out.

What Is a 401(k) Rollover?

A 401(k) rollover is a process where you transfer funds from one 401(k) provider into another tax-advantaged retirement account. This process gives you the opportunity to take your money with you from job to job. 

Did you know that on average people will change jobs 12 times throughout their career? That would be a lot of open 401(k) accounts if you never transfer your plan when you move. 401(k) rollovers can also be beneficial for keeping track of your accounts and encouraging active participation in your retirement savings. 

How a 401(k) Rollover Works

A 401(k) rollover allows you to transfer money in your old employer account into a new tax-advantaged retirement account (such as a new 401(k) or an IRA). You can do this in two ways: through an indirect or direct transfer. 

Indirect Transfer

An indirect transfer is slightly more complicated than a direct transfer in that the money passes through more hands before it ends up in your new account. 

With an indirect transfer, you notify both your new plan administrator (401(k) or IRA that you want to start a rollover, and you let your old 401(k) provider know that you want to empty your account. Your old provider will mail you a check to you personally as the employee. You then must deposit the check into your new IRA account within 60 days in order to avoid owing full taxes on the distribution plus penalties.  

Under IRS rules, your old employer is typically required to withhold  20% of your account balance in case you don’t deposit the money in your new account within 60 days. 

After you deposit your first check, you’ll then need to make out another one to cover the 20% initially withheld (or else this could be deemed a distribution). That means you’ll need to have enough in a savings or other account to replace that 20%. When all is said and done, you will get that 20% back at tax time should you meet the 60-day deadline.

While totally do-able, this process requires you to put in more work, fork over the additional 20% balance, and keep track of deadlines and changing hands. Plus you’re limited to one indirect rollover in a 12 month period. It is often much smoother to go ahead with a direct transfer. 

Direct Transfer

A direct transfer is much more, well, direct. With this process, you still notify your new provider that a rollover is initiated, and let your old provider know you want to roll the funds over into your new plan. 

What’s different is that your old provider will either mail or electronically deliver a check directly to your new plan provider, and it’s automatically deposited for you. This option is much more straightforward, and ensures that you won’t owe additional taxes assuming that the transfer is done with equal accounts, for example, a traditional to a traditional or a Roth to a Roth.

Important Rules to Know About 401(k) Rollovers

As with most things in life, there are a set of rules that you should know before you initiate a 401(k) rollover. The most important being the 60-day rule. 

60-Day Rule

In the case of a 401(k) rollover, 60 is the magic number. When you begin a transfer, you have 60 days to transfer the funds into your new account. Should you miss that deadline, you will be faced with massive tax consequences. Bypassing the 60-day limit triggers the IRS to think that you simply cashed the funds, which will all be counted toward your ordinary income. 

There are some notable exceptions to this rule. In 2016, the IRS created a list of 11 reasons why you can be late to make the transfer including a lost check, severe home damage, or a death or illness in the family. 

Handling Company Stock

If your old 401(k) held stock from your previous company, it’s important to know that by transferring to an IRA, you will miss out on tax benefits. Your new 401(k) asset allocation will be determined by your employer which means that they probably wouldn’t allow you to retain stock in your old company. Be sure to work with a tax professional to navigate this situation and come up with a plan that makes the most sense for you depending on how much stock you owned in your old company and what a full transfer might mean for your tax bill. 

Why Do a 401(k) Rollover?

Sometimes it makes sense to leave your money in your old employer’s 401(k) plan. In fact, if you have over $5,000 in the account, your employer has to give you the option to keep the money in the account. 

More likely than not, while you were working for them, they were also paying for the administrative fees associated with the account upkeep. They may no longer be willing to do that, even if you keep your money in their plan. 

If you have anywhere from $1,000-$5,000 in your account, your employer is legally obligated to send you a letter and document in writing the options that you have. It is then up to you to inform them what you want to do. If you choose not to respond, they can roll the money over to an IRA on your behalf which is called an involuntary cash-out. 

For accounts with $1,000 or less, many employers will write you a check. Just be sure to deposit that check in a new 401(k) or IRA within 60 days to avoid the tax penalty.

What Accounts Can You Roll the Money Into?

Now that you know what a 401(k) rollover is, understand how it is done, and the rules to keep in mind, it’s time to take a look at the specific accounts you can use to give your retirement savings a new home. 

Today, we are going to look at two options, transferring the money into your new 401(k) or moving it into an IRA.

Rollover Into a New 401(k)

Your new 401(k) is an excellent option for your rollover. The 2020 contribution limit is $19,500 or $26,000 for those over 50. The good news? Your rollover won’t count toward that contribution limit. 

Take some time to evaluate your new company’s 401(k) policy. Are you happy with your investment choices? Is there enough diversity in the type of investment options you have? Does the company offer a competitive match program? Understanding what you will get from the new employer should be an important factor in deciding if you want to roll the money over. 

If you have an incredible employer match and good investment opportunities, rolling it over into this new account might make a lot of sense for you. 401(k) accounts are also generally quite safe from creditors and lawsuits, providing extra protection than the looser lines of an IRA. 

Another important factor is the required minimum distributions (RMDs) in retirement. Your 401(k) will have you take your RMDs once you turn 72, thanks to the SECURE Act. You will need to pay ordinary income tax on those distributions, so be sure to factor that into your tax plan. 

Rollover Into an IRA

An Individual Retirement Account (IRA) is another great choice for investors to consider. In general IRAs have more flexibility and customization in your investment choices which can allow you to allocate your money as you see fit. 401(k) accounts are often quite stringent and strict with how you diversify your investments but an IRA gives you more flexibility and freedom in that department. 

An IRA can also help you consolidate your financial picture and give you a better sense of where you are in your financial journey. Having multiple accounts can get tricky to forecast where you really are and how close you are to reaching your savings goals. 

You also have more flexibility on what fees you pay with an IRA. Since you can decide where you want to open your account, you have more control over the type and amount of fees that you pay. With a 401(k) you have little control over administrative and other fees since the program is set up through your employer. 

IRAs also have more wiggle room when it comes to distributions. The government will allow you to take money out of your IRA early without penalty for things like college costs and that can’t happen with a 401(k).

You will still need to factor in distribution requirements. A Traditional IRA operates in the same way as the 401(k), where all distributions are taxed at your ordinary-income rate. Whereas a Roth IRA doesn’t have taxes upon distribution since the money contributed is after-tax.

The Bottom Line

401(k) rollovers are an excellent strategy for you to bring your money with you as you change jobs and advance in your career. It is important to know the options that you have in order to make the best decision for you and your financial future. 

Are you ready to initiate a 401(k) rollover but want to talk through your specific situation? Give us a call today.