Once you leave your employer, either by quitting or retiring, you have the right to keep your money in your company’s 401k plan (assuming the balance is above the plan requirements—usually $5,000 or more) or roll it over to an IRA. In most cases, rolling over a 401k to an IRA is your best choice but you need to understand all the variables so you can make an informed decision.
There are many benefits of a 401k rollover to an IRA. First and foremost are fund options. When you roll over your 401k, you should choose a large mutual fund company that offers their own funds as well as access to a network of other fund families where you can purchase a range of funds without a fee. Second, some 401k plans have high administrative fees and expense ratios for the funds available through their plan versus the fees charged by low-cost mutual fund companies like Vanguard and Fidelity. Finally, if you’ve worked at several companies and have a 401k balance at each one, it’s much simpler to have each one transferred to a single IRA where you can easily manage your asset allocation targets.
The best way to do a 401k rollover is a direct transfer to a financial institution that will help you through the entire process. If you decide to have your employer issue your 401k check in your name only, 20% of the account value will be withheld for taxes. Assuming you don’t come up with the money out of your own pocket to make up the 20% when rolling over to an IRA, this amount will be considered a taxable distribution. Furthermore, if you do make up the difference out of your own pocket to make your IRA whole, you won’t get the 20% back until you file your income taxes the following year. And if that isn’t enough discouragement, you have 60 days from when the check was issued to put the money in an IRA, or it will be considered a taxable distribution and subject to a 10% early withdrawal penalty if you’re less than 59 ½ years old. Bottom line: make your life easy and do a direct transfer.
As for the case not to roll over your 401k, the primary reason has to do with when you’ll need the assets to cover your retirement expenses. To explain, if you have an IRA, you essentially can’t take the money out before the age of 59 ½ without a penalty. I say essentially since there is a way to get it out sooner, but it requires equal distributions every year for five consecutive years. On the other hand, if you are 55 or older when you leave your job, you can take distributions from your 401k that will not be subject to the 10% early-withdrawal penalty.
Another benefit of not immediately rolling over your 401k is if you have company stock that has significantly appreciated in value from the time you purchased it. If this is the case, you may be able to take a lump-sum distribution of your 401k account, move the employer stock into a taxable account, and roll the rest of the account into an IRA. This option is available under the net-unrealized-appreciation rules and can minimize the taxes owed on the appreciated stock. To elaborate, if you roll the stock into a taxable account, only the amount you paid for the stock will be taxed as a distribution. As for the appreciated value (current value minus what you paid), it’s treated as a long-term capital gain and taxed at no more than 20% when it’s sold.
Finally, if your 401k plan allows for after-tax contributions, you might want to take advantage of it. For starters, the money will grow tax-deferred until the money is withdrawn where you’ll be taxed on the earnings portion only. Secondly, unlike a nondeductible Traditional IRA, when you decide to roll over your 401k, any after-tax contributions can be paid to you directly. This is a nice feature and gives you the option at rollover to use the after-tax contributions anyway you, such as covering your immediate retirement expenses, want without any tax implications.
Note: Although this entire blog focuses on 401k plans, a rollover from a 403b or 457b plan to an IRA is also allowed and in most cases is your best option. The rules and rollover process for 403b and 457b plans are similar to a 401k. As always, check with your employer’s benefits department and the financial institution you’re transferring to before you execute a rollover.