Why Would I Roll My 401k into an IRA?

If you’re leaving the job where the 401k sits, rolling it over into an IRA is a good option. Whether it’s the best option depends on what you’re doing after you leave. Retirement plans can and should be re-evaluated over time.  If you’re changing jobs or leaving the job market, there are some 401k basics you need to know.

Quick Facts on a 401k

  • There are 2 types of 401ks:
    • Traditional 401k: A traditional 401K defers income taxes on your contributions. They are funded with pre-tax dollars. Taxes will be paid when the money is withdrawn.
    • Roth 401k: With a Roth 401k, your contributions are not deferred. It is funded with after-tax dollars. The contributions are taxed as part of your income. When you withdraw your money, it’s tax-free.
  • Most companies will allow you to leave your 401k where it is if you change jobs. You can’t make any more contributions to it or take a loan from it.
  • If you have less than $5000 in your 401k when you leave, your employer can transfer the money to an IRA on your behalf.
  • If you’re taking another job, check and see if you can roll your old 401k into their new one. Though most employers do, there are a few that don’t.
  • Most 401ks have some type of employer match. Some have probationary periods for enrollment. The best allow immediate enrollment. These benefits vary by employer. If you’re being recruited for a new job, get the specifics on their 401k plan.
  • Cashing your 401k out can be costly. If you’re in a traditional 401k, there’s an automatic 20% withholding tax. If you cash out $32,000, you’ll get $25,600. If you’re under age 59 1/2, there’s a 10% penalty on top of that. Cashing out a Roth 401, if you meet the eligibility requirements, there’s no tax.  But if you’re under 59 1/2, the same 10% penalty is applied.
  • There are some exceptions for avoiding the penalty. If you rolled it over to another 401K plan within a designated time. If it’s being divvied up in a divorce. There are also hardship exemptions for medical bills or disabilities.
  • You can take loans from your 401k if you need money. They can’t exceed $50,000, offer a reasonable rate and 5-year term.
  • The focus needs to be on how to best handle your retirement account.

retirement accounts

Moving to an IRA

Both 401k plans have rules about withdrawing income. To avoid an early withdrawal penalty, the money must remain in the account until you are 59 1/2. For a Roth 401k, the account must be open for a minimum of 5 years.

(Is a Roth 401k Better than Your Traditional 401K?)

If you intend to roll the account into an IRA, it makes sense to match the type of 401k to the type of IRA. When you roll a traditional 401k to a traditional IRA, there is no tax liability. Both accounts are funded by pre-tax dollars.  If you move a traditional plan to a Roth IRA, tax is owed the entire amount transferred. Once that’s paid, any eligible withdrawals are tax-free.

In 2021, the annual limit contribution limit for either 401k plan is $19,500 or $26,500 for people over 50. Be aware that the annual contribution to an IRA is only $6,000 or $7,000 if you’re over 50.

If your account isn’t well funded, it might be too early to roll it over to an IRA. The contribution limits are drastically different and IRA limits won’t help you build your account.

if you’re well funded and leaving your job, Consider these Benefits:

  1. You control your money. If you leave it sitting in your old employer’s 401k account, you can’t add to it. $6 or 7 thousand a year is better than nothing. It’s best to do it as you’re leaving instead of after you’ve gone. You won’t have access to company systems and communication can dry up.
  1. IRAs allow more diverse portfolios. 401ks are usually built on a few mutual funds. With an IRA, you can invest in stocks, bonds, and exchange-traded funds (EFTs). You can invest in some REITs to incorporate real estate investments.
  1. With an IRA, there is no automatic 20% tax on withdrawals. You can set the amount of tax to pay. But remember to offset end of the year tax liabilities.
  1. Every IRA broker on the block is looking for your business. They’re offering cash incentives to get it.

Roth IRAs

If you have a Roth 401k, a Roth IRA is the logical choice for the transfer. The value of this move increases as you get closer to your seventies. As noted above, eligible withdrawals from any Roth asset are tax-free. But the rules governing the IRA have some added perks.

Every 401K plan, SEP, or traditional IRA is subject to Required Minimum Distribution (RMD). When the account holder turns 72, they’re required to withdraw a percentage of money from their account. If you miss an RMD, there are IRS penalties in addition to the withdrawal amount.

There are no RMDs for a Roth IRA. Rolling your account over to a Roth IRA maintains the tax-free withdrawal. But you decide when to make them.

Traditional to Roth

Anything you pull from a traditional 401k plan or IRA is taxable. That includes a transfer to a Roth IRA. Depending on the amount in your account, the taxes can be substantial. Without factoring in other income or deductions. It rarely makes sense. If you didn’t have access to a Roth 401k plan, talk to your financial advisor about possible rollover solutions.

If you’re self-employed, you can set up a SOLO Roth 401k. It works much the same way as an employer plan.  You and your spouse can contribute, but you can’t go over the contribution limit.  If the account is active for 5 years and you’re over 59 1/2 – you can move your account to a Roth IRA. If you’re still contributing the max, hold off until you get closer to the RMD requirement.

Don’t forget you can take a loan from your 401k for any purpose. The term is 5 years at a reasonable interest rate. You can use one to start and fund a Roth IRA.

How to Do a 401k Rollover

Every brokerage business wants to help you do just that. Vanguard, Fidelity, Ameritrade, and Charles Schwab all offer IRAs. Depending on your financial status, you may be working with wealth managers. If that’s the case, they’ll guide the best options for your account.

If not, here are some questions to ask before transferring a 401K.

What are the fees?

Many brokers have reduced fees on their IRA accounts but shop around. Not just for costs, but incentives abound. Brokers are offering cash incentives to get your business

The possible fees to check:

  • Any annual or quarterly maintenance fees.
  • Expense ratio on mutual funds or ETFs and potential loads.
  • Sales charges
  • Trading commissions for buying stocks.

What investments are available?

A big benefit of an IRA is an expanded menu of investment options. Take a look at what the brokerage is offering. Understand the benefits, any tax liabilities, and risk.

How much support do I need?

Some people like to use tools and data, other investors are hands-off. Most brokers provide access to tools – many have interactive options. If you prefer a passive approach, consider using a robo-adviser to automate your account.

A robo-advisor automates the management of your account based on risk preference. They periodically rebalance the portfolio. Self-managed accounts allow more hands-on investing, including trading stocks.

How personal is the service?

Do you want or need face time with your broker? Ask how communications are structured. Are you looking for guidance? If so, expect additional fees.

Choose Your broker

 examples of IRA account managers


Your due diligence on the questions above will help you choose a brokerage.

Once you have, here are the steps to follow:

  1. Open an IRA account

Choose the type of account you prefer – self-managed or using a robo-advisor.

To rollover any 401k account, you must meet eligibility requirements. You need to be at least 59 1/2. For a Roth 401k, it needs to be open for at least 5 years.

If you have a traditional 401k, open a traditional IRA. If you have a Roth 401k, open a Roth IRA.  You can transfer funds from a traditional 401k to a Roth IRA, but the money is taxable.

  1. Transfer the 401k

Request a direct rollover from your current 401k plan administrator. A direct rollover means that the check for that money goes directly to the new IRA account. That’s important for tax liability.  If the check goes to you – it’s considered a withdrawal. From a traditional 401k, that withdrawal is taxed. If you withdrew $20,000, 20% is automatically withheld.  Only $16,000 makes it to your IRA.

Though there is no tax liability for a transfer from a Roth 401k, it makes sense to directly fund the IRA account. If you aren’t 59 1/2 you can still get hit with a penalty. Large personal checks over $10,000 can put on the IRS’ radar. No one wants that.

  1. Choose your portfolio

In your 401k plan, investments were chosen for you. If you want to self-manage your IRA, you need to pick the assets for your account. Unless you are an experienced investor, EFTs and mutual funds make the most sense. But you can buy stocks and securities if you want. 

Some brokers offer a “targeted retirement” account. The portfolio provides the best return based on your retirement date.  If you’ve chosen a robo-advisor, your investments are picked automatically based on your preference.

Is Rolling a 401k to an IRA the Right Move?

It certainly can be. But much of that depends on the type of account you have and the tax liability you might have to assume.

A traditional 401k and an IRA have the same rules on withdrawals. But they have very distinct differences in what you can contribute. It will be much harder to build wealth for your retirement in an IRA.

If you’re changing jobs, it makes sense to evaluate the 401k plan at your new employer. If there’s a good match and you have plenty of time until requirement – it’s a better option.

If you have a Roth 401k and your new employer doesn’t offer one – things are a little tricker. The benefit of a Roth account is tax-free money in retirement. We’d suggest you contact a financial advisor on the best course of action. The best time to roll over a Roth 401k to a Roth IRA is to avoid RMDs.

It’s seldom a good idea to cash in your 401k. Though there are some hardship exceptions, the tax liability and 10% IRS penalty eats up a lot of your cash. If you need money, you are better served by taking a loan against the account.

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