- When you change jobs, there are four paths you can take with your 401(k): you can leave it with your previous employer, roll it over to your new 401(k), roll it over to an IRA or Roth IRA, or take a cash distribution
- A rollover is when you move retirement savings from a prior employer 401(k) to either a new 401(k), traditional IRA, or Roth IRA
- To make the right choice, you need to consider plan fees, investment options, the control you want over the account, and even current and future tax consequences
- The rollover process can be confusing and knowing what steps to take can help you avoid costly mistakes and keep your money working hard for you
- The decision shouldn’t be made in a vacuum as it will affect all aspects of your investment strategy and financial plan
Starting a new job comes with many new responsibilities and time-sensitive workplace benefit elections. One of these responsibilities is determining what to do with the 401(k) you left behind at your previous employer.
It’s a decision that many people put off; in fact, there are 24 million forgotten 401(k) accounts out there holding $1.35 trillion in assets. While some of these old 401(k)s are intentionally left behind, there are other, maybe better options that you should consider for yours.
Making the right decision can be confusing and the process can be quite onerous. Do you move the money to your new company, move it to an IRA or Roth IRA, or cash it out? And how do you actually do it? Here’s what you need to know to make the right decision and how to make it happen.
What can you do with your 401(k) when you switch jobs?
Following a job change, you’ll have to decide what to do with your retirement plan from your previous employer. Here are the four options you’ll need to consider when deciding what to do with your retirement savings:
- Leave money in your old 401(k)
- Roll your 401(k) over to your new employer plan
- Roll your 401(k) over to an IRA or Roth IRA
- Take a distribution or cash out your 401(k)
The right choice for you depends on a number of factors including your personal situation, the quality of your prior employer and new employer 401(k), and even your desire to use a backdoor Roth IRA strategy. But first, let’s look at what a rollover is.
What is a 401(k) rollover?
A rollover is when you move money from an employer-sponsored retirement plan, like a 401(k) or 403(b), to another retirement account. The account where you move (or roll) your retirement savings can be either a 401(k) through your new company or an individual account that you set up and manage on your own like a traditional IRA or Roth IRA.
Rollover vs transfer: It’s important to understand the difference between a rollover and a transfer because of tax reporting requirements.
- A rollover involves an employer-sponsored (or qualified) retirement plan. So you roll over one 401(k) to another 401(k) or a 401(k) to an IRA. A transfer is when you move money between two individually owned and controlled (i.e. non-employer controlled) accounts. So you would transfer money from one IRA to another IRA or Roth to Roth.
- Rollovers must always be reported on your tax returns even if they aren’t taxable. Transfers, on the other hand, do not have to be reported on your tax returns.
Direct vs indirect rollovers: there are two types of rollovers you need to know about – direct and indirect.
- With a direct rollover, your money goes directly from one plan to the other or from your prior plan to an IRA or Roth IRA. So Plan A issues a check payable to Plan B and mails that check directly to Plan B.
- With an indirect rollover, you act as the middle person. Plan A issues a check payable to you and then you are responsible for depositing that check into Plan B.
- Indirect rollovers often come with a 20% mandatory tax withholding even if you plan on putting the money back into your new plan or an IRA. And, if 20% is withheld, you have to put 100% of your account balance back into a new plan or IRA before you can get the 20% back (so you must have that extra 20% lying around).
A direct rollover is almost always the way to go. Let’s take a look at your options and which direction may be best for you.
Option 1: Leave money in your old 401(k)
Leaving money in your prior employer 401(k) is the easiest option, at least upfront. You simply leave the money where it is – no paperwork and no tax reporting required. However, while easier upfront, you should consider both the short-term and long-term impact on your investments and your overall plan.
When does this make sense?
- Your old 401(k) is quite good: When your old retirement plan has low administrative fees and a good list of low-cost investment options from which to choose, leaving your money in your old plan could be a good option.
- You want to use a backdoor Roth IRA strategy: If you are currently using or thinking about using a backdoor Roth IRA strategy, you may want to leave your 401(k) where it is. If you roll over your account, especially if it has before-tax contributions (and most do), you could jeopardize your ability to make a backdoor Roth IRA contribution or run afoul of the pro-rata rule.
- You want a simple solution: Simply put, it’s the easiest option for now. There’s nothing you have to do when you leave the company. However, while it’s the easiest thing to do today, it can make things more complicated down the road.
- You want extra asset protection: Qualified retirement plans are offered a greater level of protection against creditors and some lawsuits compared to IRAs and Roth IRAs. The laws are quite nuanced and can vary from state to state. If greater asset protection is important, be sure to talk to a qualified professional or attorney to make the right call.
Is there a downside?
- Lack of control: When your money is left in an old 401(k), your former employer controls everything from administrative fees to the plan’s investment options. The only thing you can control is what you invest in.
- Higher costs and fees: If you aren't careful or if your prior employer changes plan costs and fees (which they have the right to do), you may end up paying higher fees in the plan and possibly with your investments as well.
- Increased complexity: An extra account is another thing you need to track and manage over time. You’ll need to track log-in credentials, investment options, your overall allocation, plan fees, and any changes to the plan that your prior employer makes.
- Lack of investment coordination: The more accounts you have, the harder it is to make sure all of your investments are working well together. With an extra 401(k), often with limited investment options, you may find it harder to put all of the pieces of your accounts together to create a well-allocated and properly diversified portfolio.
How to keep your 401(k) with your previous employer
Leaving your money in your old plan is quite simple as there’s nothing you need to do. It’s recommended that you keep track of your log-in information and that you check your account periodically to make sure you are including the plan in your broader investment strategy, and to see if there have been any investment changes.
Keep in mind, if your plan balance is less than $1,000, your former employer can require you to take a full distribution from the account. If your account is between $1,000 and $5,000, your employer can require you to move it to an IRA or a Roth IRA. They have to help you set up the accounts, but you have to move the money.
Option 2: Roll your 401(k) over to your new employer
Instead of leaving your money behind, you may be eligible to roll your money into your new employer-sponsored retirement plan. Here’s how to decide if rolling over the money to your new plan could be right for you.
When does this make sense?
- Your new plan allows it: To be eligible to roll your money into your new 401(k), the plan must allow it. Not all plans accept incoming rollovers so you need to check with your new employer or plan administrator.
- Your new plan is worth it: You only want to move money into your new plan if the administrative fees are low, it has a good variety of investment options, and those investments come with low expenses as well.
- You value simplicity: Consolidating accounts can be a great option as it reduces the number of accounts you have to keep track of and it allows you to more easily monitor what you own (your asset allocation) and the overall risk of your investments.
- You want to use a backdoor Roth IRA strategy: Similar to keeping money in your old plan, moving it to your new plan could help you avoid issues if you are looking to take advantage of a backdoor Roth IRA.
- You want the flexibility to take a loan: Active participants in a 401(k) plan can take loans against their account balances. They are typically limited to the lesser of 50% of your vested account balance or $50,000. Keep in mind that loans must be repaid through payroll deductions and they come with administrative fees and interest costs.
Is there a downside?
- You don’t have full control: Your new employer controls the plan and they can change overall plan fees and/or the investment options available to you. They can also change the plan administrator which means your entire plan could move to a new platform with a new fee structure and different investments without your consent.
- Limited investment flexibility: 401(k) plans have limited investment options, on average around 15 choices, in most cases. On the other hand, a traditional or Roth IRA can give you access to thousands of options from individual stocks to mutual funds and exchange-traded funds (ETFs).
How to roll over your 401(k) to your new employer
Rollovers aren’t always the easiest things to accomplish which is why so many accounts are left behind. To properly complete a rollover, follow these steps:
- Review your most recent statement for your old 401(k) to see what you contributed over time. You want to look for different contribution types like before-tax, Roth, and after-tax contributions. You want to know this before you process the rollover so you can ensure the information is captured properly within your new plan.
- Contact the company that oversees the administration of your new plan, also called the plan administrator. You need to confirm:
- That they accept deposits from outside 401(k) plans. Not all plans do.
- The mailing address for your plan administrator plus instructions on how to make the check payable. You want the check made payable to your new account with the new plan (e.g. XYZ Plan for Your Name) so it is treated as a direct rollover. You do not want a check made payable to you directly.
- Contact the plan administrator for your old 401(k) and tell them that you would like to request a full rollover of your plan to a new 401(k) plan. They will walk you through the process of how best to do this (over the phone, online, or a physical form that must be mailed).
- Complete the request based on step 4 and have the check made payable to and mailed directly to your new plan administrator.
- Confirm the funds are deposited into your new account, that all contribution types are accounted for, and that the funds are invested appropriately. As a quick tip, you may have to provide separate investment instructions for your rollover funds.
- Report the rollover on your tax return for the year in which the funds were disbursed from your old plan and deposited to your new one. It is not a taxable event, but you need to report it on your tax return for the year in which the rollover was completed.
Once the rollover is complete, it becomes part of your new 401(k) balance, and you can manage it and invest it as one account.
Option 3: Roll your 401(k) over to an IRA or Roth IRA
If you want more control over your account, your fees, and your investment options, you might want to consider rolling over your old 401(k) to an IRA or Roth IRA. Here’s what you need to know:
When does this make sense?
- You want more control and flexibility: Moving the money to an IRA or a Roth IRA puts you in control of where the money is held, what investments you choose, and what fees you pay. In short, you have full control and aren’t limited to what’s offered in a 401(k) plan.
- You want to separate before-tax and Roth contributions: When you complete a rollover of a 401(k) with both before-tax and Roth contributions, you can have the money separated and deposited into an IRA and Roth IRA, respectively. This allows you to manage and invest the accounts differently should you want to.
- You have after-tax contributions in your 401(k): When after-tax contributions are made to a 401(k), the earnings or growth on those contributions will be taxed when eventually pulled out. However, if you roll over your after-tax contributions to a Roth IRA, the earnings and growth can be tax free as long as you follow Roth IRA withdrawal rules.
Is there a downside?
- It could affect a backdoor Roth IRA strategy: The backdoor Roth IRA strategy works best when you have little to no before-tax money in your IRAs. If you rollover a 401(k) with significant before-tax contributions to an IRA, it could eliminate the benefits of using a backdoor Roth IRA strategy.
- You can no longer take a loan: While you cannot take a loan from a prior employer 401(k), you could take one if you moved it into your new employer’s 401(k). If you move your money to an IRA, you cannot take a loan as they are not allowed from individual retirement accounts.
- You may have less asset protection: For the most part, employer-sponsored plans offer greater asset protection against creditors and certain lawsuits. Asset protection laws vary by state so you need to talk to a qualified professional or an attorney to make the right decision.
How to roll over our 401(k) to an IRA or Roth IRA
A rollover can be a cumbersome process and, if done incorrectly, can lead to some undesirable tax consequences. It’s important to know how the process works, every step of the way, to get it right. Keep in mind that a CFP® professional can help you through the process. Here are the steps to follow to roll over your prior employer plan to an IRA or Roth IRA:
- Review your 401(k) account statement to determine what kind of contributions you have made. This will either be before-tax, Roth, or after-tax contributions.
- Based on the contributions from step 1, you will need to establish a traditional IRA or Roth IRA if you don’t already have one or both established. Your before-tax contributions will go to an IRA and your Roth (plus earnings) and after-tax contributions (not including earnings) will go to a Roth IRA.
- Contact the financial institution where your IRA or Roth IRA is set up (also called the custodian) to determine how the rollover check should be made payable and where it should be mailed.
- Contact the plan administrator for your old 401(k) and tell them that you would like to request a full rollover of your plan to an IRA or Roth IRA. They will walk you through the process of how best to do this (over the phone, online, or a physical form that must be mailed).
- Complete the request based on step 4 and have the check made payable to and mailed directly to the custodian where you hold your IRA or Roth IRA.
- Confirm the funds are deposited into your IRA or Roth IRA and that all amounts were properly accounted for. It is your responsibility to make sure before-tax money goes to your IRA and Roth or after-tax contributions go to your Roth IRA.
- Once the rollover is complete, it’s up to you to decide how to invest the money (unless you work with a financial advisor).
- Report the rollover on your tax return(s) for the year in which the funds were disbursed from your old plan and deposited to your individual retirement account. It is not a taxable event, but you need to report it.
Option 4: Take a distribution or cash out your 401(k)
The last, and least utilized, option is to take a full distribution and to cash out your retirement plan. It isn’t recommended in the majority of cases, but here’s what you need to know:
When does this make sense?
Taxable distributions should almost never be considered as they are subject to taxes and early withdrawal penalties, with very few exceptions. This should be a solution of last resort, and you should talk to a financial planner to understand if this is the right solution or if there are other options available. Here’s when it could make sense:
- You want or need access to your money and have no other options: If you need the money, this is the only option that allows you to get access to it (without taking a loan). However, there are downsides to pulling the money out, which are laid out below.
- If you are over 59 ½: Once you reach age 59 ½, you are no longer subject to the 10% early withdrawal penalty. Some plans allow you to take money out after age 55 without penalty, but you have to check with your prior employer or plan administrator to see if this is allowed as it is plan specific.
Is there a downside?
- A penalty will apply in most cases: Unless you are over 59 ½, you will likely pay a 10% penalty on the amount you pull out of the plan. There are exceptions, but they are few and far between.
- Distributions are fully taxable: Any before-tax money you pull out will be subject to federal and state income taxes. Pulling money out of a retirement account while you are still working is almost never a good idea as you will likely end up paying more in taxes today than waiting until retirement.
- Missing out on tax-favored growth: When your money is in a retirement plan, all growth is tax-free. If you pull the money out early, you will miss years of potential growth without paying taxes (called tax-deferred growth). Taking money out now can cost you a lot over time.
How to cash out your 401(k)
If you are considering cashing out your 401(k), it’s recommended that you speak with a financial advisor, ideally a CFP® Professional, before doing so. Working with an advisor may help you see options you didn’t know existed and avoid making a decision that can cost you a lot of money.
Here are the steps you need to follow to cash out your 401(k):
- Contact the plan administrator and let them know you want to take a full distribution from your account. They will provide you with the steps required to make the request.
- Before taking the distribution, you need to notify the plan administrator of how much you want withheld for taxes. Keep in mind there are standard withholding rates (often 20% for federal taxes), and they may not be appropriate for your situation. Don’t assume that standard withholding rates will be sufficient. Without proper planning, you could end up owing money come tax time.
- Report the full amount of the distribution on your tax return for the year in which the distribution was completed. If you have any Roth or after-tax contributions, you still have to report it even though you may not owe taxes on this portion of the money you pull out.
Making the right decision for you
A rollover is often seen and planned for as a one-time event. Request the rollover to a new account, invest the money once deposited, and move on with your to-do list. However, any decision regarding a prior employer 401(k) can impact the fees you pay on your investments, the level of control you have over your accounts, your overall investment strategy, and even your ability to effectively use a backdoor Roth IRA strategy. With so much on the line, it’s critical to make the right call.
With the right strategy in place, you’ll make a more informed decision and keep your money working hard for you for years to come.