401K Rollover: Understanding The Truth and Options

A 401k is, by definition, a retirement plan sponsored by your employer. These plans are designed to encourage employees to put away a portion of their earning for their retirement. Many 401K plans even offer an amount of percentage match of contribution, at the discretion of the employer. There are annual limits set each year regarding a maximum amount you can contribute.

401K plans enable you to earn tax-deferred interest on your money, meaning that you are not taxed until you withdraw the money from the 401K at age 65 or older. In the 401K, you’re able to invest in various stocks, mutual funds, bonds and other short-term and long-term investments.

Leaving Your Job

Now, picture this: you’ve been at the company awhile, taken the first step in saving for your retirement, and actually saved a good amount. You feel like you’ve finally hit your stride in managing debt as well as understanding and strengthening your financial fitness. Your 401K is looking good, and your investments are performing well. Then, the unexpected happens, and you are suddenly offered a dream job at another company. You’re going to take the job, as it’s an opportunity you can’t pass up, but what happens to your 401K at your current company?

Don’t worry—your 401K retirement account is yours, and it will remain active for your lifetime. You can leave the 401K at your current company, but note that you will no longer be able to contribute to it. Furthermore, some companies do charge an administration fee to maintain your 401k retirement account after you have left their company.

Your other option is to move your 401K account, which is called a 401K rollover.

What Exactly Is a 401K Rollover?

You have a couple of options for moving your 401K from your previous employer. First, you can move the 401K account to a financial institution. This will change the account from a 401K to an individual retirement account (IRA) because the employer is no longer sponsoring it.

The other option is to move your 401K account to your new company. Both of these are different forms of rollovers. A 401K rollover means a transfer of assets from an existing 401K retirement savings plan to a new account, whether that be a new 401K or an IRA. It is a common misconception that you can’t rollover your 401K until you reach retirement age. This is not true; you can rollover your 401K at any age that you change jobs.

New 401K or IRA?

There are advantages and disadvantages to both options. Rolling into a new 401k plan means that your earnings will still be tax-deferred. It also means that your assets are protected from creditor claims in most cases. Some new 401K plans may let you borrow against the funds.

New 401Ks are just like your old 401K in that they might have limited investment options. That may hinder you or benefit you; it depends on your circumstances. Check the fees on the new 401K plan; they might be higher than on your previous plan.

With an IRA, your money continues to grow either tax-deferred or tax-free depending on the type of IRA you choose. IRAs typically offer broader investment options, and if you have several old 401Ks, you can consolidate all of them into one IRA.

You definitely won’t be able to borrow money against your IRA, and there may be tax implications for rolling over your company’s specific stock into an IRA. Finally, IRAs offer less creditor protection; they are only protected in the case of bankruptcy.

Opening an IRA

To start an IRA, you of course first need an existing 401K retirement account from a previous employer. IRAs are similar to 401Ks in that they are also tax-deferred until you withdraw the money at retirement age. Likewise, an IRA allows for all sorts of investments as well–stocks, bonds, mutual funds and other investments like annuities and exchange-traded funds (ETF).

When you choose the IRA option, a financial advisor can open the account for you. It is essential that the financial advisor and the benefits coordinator at your previous employer work together. The company will provide the proper forms required to transfer your 401K to a new IRA. A financial advisor can help you navigate the waters and understand all the rules regarding rollovers. For example, you have an option to move your 401K to another trustee other than yourself.

Make sure the financial advisor and benefits coordinator are talking because there is a right way – and a wrong way – to do a 401K rollover. A common mistake that can be made is that a 401K check is cut to you. You don’t want to do this. This action means that you are cashing out of your fund, and the IRS may penalize you by up to one-third of your balance for an early withdrawal penalty. Don’t make this mistake and give your money to the IRS. Keep it for yourself. Instead, make sure both individuals know that you are asking for a direct 401K rollover, meaning that the 401K plan check will be cut directly to the new IRA account rather than cut to you personally. This is a critical distinction.

Choosing a Financial Advisor

Choose a financial advisor that meets your needs. When your 401K check comes into the IRA, it is cash, so you need to invest the money then. Perhaps the most significant consideration when making this choice is determining how much you want to be involved. Do you want an active role in the management of your IRA or do you want to be completely hands-off and leave it to the financial advisor?

If you want an active role in managing and building your portfolio, an excellent choice is an online broker. With this option, you will be able to buy and sell your investments. When choosing an online broker, consider the funds they have access to, and look at their transaction fees. For example, many brokers have no-transaction-fee mutual funds in which you can invest. Also be sure to look for things like account dollar minimums.

If you don’t want the hassle of researching and investing on your own, choose a financial advisor who can create a balanced and diverse investment portfolio for you. You want to make sure that you have a portfolio that runs on its own so that you don’t incur substantial transaction fees. One option that many investors use is a robo-advisor, which is an automated investment management service. These robo-advisors can build your portfolio based on your preferences, then periodically rebalance your funds to stay on track. The robo option typically has much lower fees than a conventional financial advisor.

Roth Vs. Traditional IRA

Also before you transfer the funds, you need to decide whether you want a traditional IRA or a Roth IRA. When you roll into a Roth IRA, you are taxed on the rollover amount, which is not the case with a traditional IRA. Traditional IRAs offer tax-deferred growth while Roth IRAs offer tax-free growth. You can make tax-free withdrawals from a Roth IRA, as long as they meet the qualifications of approved withdrawals. Both have penalties for early withdrawal, which makes sense because the whole point of both funds is to save for retirement.

There are other differences between the two as well, such as contribution age. With a traditional IRA, you can only contribute until age 70, but you can contribute to a Roth IRA at any age. Income affects how much you can set aside in a Roth IRA, but income does not factor in with a traditional IRA.

Benefits of a Rollover

401K rollovers have several advantages. First and foremost, the rollover allows you to consolidate your old retirement account or accounts in one place, making it much easier to manage. When your accounts are merged, you get a much better picture of where you stand financially. It is also easier to position your investments where you want them, and easier to make investment decisions.

IRAs offer more investment options than 401K plans, so by moving your assets out of a 401k plan and into an IRA, you have much more ability to invest. 401K plans typically have a fixed set of investment options that make plans more straightforward to manage. On the other hand, an IRA allows you to invest in a wide variety of investments as mentioned above. You also have more freedom to choose your mutual funds, perhaps with lower fees than the ones in the 401K plan.

You Have Options

Let your money work for you, not for someone else. Consider a 401K rollover when you’re leaving a job. Also, consider a rollover if you are close to retirement; it pays to explore your financial options, even though you might leave your money there. Finally, a rollover is a great option if you need to consolidate several 401K accounts.

Whatever you decide, remember that you have many options that offer the freedom to make your own wise financial decisions. Be sure to consult your financial advisor with questions and ask his or her advice. Never feel like you are stuck at a job in which you are unhappy or cannot take an opportunity due to concerns over your current 401k plan – you have options!