How to Rollover a 401(k)

Rolling over your 401(k) after leaving a job is not mandatory—but it can be incredibly beneficial in the long term.

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Updated January 08, 2022

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Do you have a 401(k) and you’re wondering how to roll it over?

Let’s clarify one important thing first: 👇

One should ideally never take financial advice from Limp Bizkit, but when it comes to your old 401(k), you should keep rolling, rolling, rolling.

If you’re planning to switch jobs or are in the process of switching jobs, you probably have a few questions in mind. For example, will the new job be challenging enough, will you get along with the new colleagues, and what will happen to your old 401(k) account once you leave? 🤔

While we cannot answer the first two questions, we can undoubtedly provide an in-depth answer to the last one. 

It might not seem like a big deal but more than two-thirds (64%) of working-age people do not have adequate retirement savings. Furthermore, only one-third of them have an IRA (Individual Retirement Account) that opens up a wide range of assets to invest in compared to a 401(k).

By managing your retirement funds properly today, you’re helping your future self not deal with heavy penalties or taxes at the time of withdrawing.

So, in this article, we cover why you should consider rolling over your old 401(k), the differences between rolling over to a new 401(k) and an IRA, the tax implications that can arise during the process, why rolling over to an IRA is often the best option, and precisely how you can roll over your 401(k).

What you’ll learn
  • Why Do a 401(k) Rollover?
  • Rollover Your 401(k) in 4 Steps
  • 401(k) Rollover Alternatives
  • Keep in Mind Before You Rollover Your 401(k)
  • Direct vs. Indirect Rollover
  • Net Unrealized Appreciation (NUA)
  • Conclusion
  • Get Started with a Broker

Why Do a 401(k) Rollover? 🙋

A 401(k) rollover is the transfer of funds from an old 401(k) account to a new one or to an IRA. There are several reasons for rolling over your 401(k) after leaving an old jobfor example:

  1. Your old employer might not communicate with you effectively regarding your 401(k) after you leave the company, leaving you particularly vulnerable if something were to go wrong at the company. It can also be challenging to reach an administrator or advisor.
  2. Rolling over a 401(k) into an IRA opens up more investment options that can lead to potentially better returns. So if you are interested in what an IRA can offer, It’s the ideal time to make the switch.
  3. The fee charged by an IRA is usually lower than a 401(k). While fees might seem small, a 1% annual fee on an initial investment of $100,000 adds up to $28,000 over 20 years, assuming a yearly return of 4%.
This image illustrates the 4 ways investors can change the status of their 401(k).
Your 401(k) is likely the biggest asset you possess, so make sure to avoid unnecessary taxation and missed investing opportunities.

While an IRA provides several advantages over a 401(k) (which we will cover in detail later), you don’t necessarily have to roll over to an IRA. Instead, you have four options for what you want to do with your 401(k) after leaving an old job.

Let’s take a deeper look at the four options you have for an old 401(k):

Keeping the Old 401(k) 📊

Some employers will let you keep your funds in the old 401(k) even after quitting the job. Keeping your old 401(k) might seem like the most convenient option, but there are several drawbacks, and it might not make sense other than for some particular circumstances.

For example, your old 401(k) could be performing really well, and you do not want to mess with a winning formula. It can also be a good idea to stick with your old 401(k) if you’re going to be self-employed in the future or if you hold the old company’s stock to get a favorable tax treatment (due to the NUA rule) on the stock’s profit.

We would highly recommend rolling over your 401(k) in most cases as there are several benefits to doing sosuch as taking advantage of a better 401(k) at your new job or having more investment opportunities with an IRA.

Rolling Over to an IRA/Roth IRA 📈

Rolling over to an IRA is preferred the most as an IRA is generally an upgrade over a 401(k). The primary benefit of using an IRA instead of a 401(k) is that it gives you more control over your funds than the generic 401(k) plan would. Additionally, the fees associated with an IRA are much lower than the fees charged by a 401(k).

You can also invest in almost every asset class like bonds, stocks, mutual funds, and ETFs with an IRA. Furthermore, motivated investors also can set up a self-directed IRA, which covers even more asset classes.

However, there are a few things to consider before rolling over to an IRA, like choosing the type of account you want to open.

The two most common options are a traditional IRA and a Roth IRA. The difference between a traditional and a Roth IRA is that both have different taxation policies for the funds. We have covered the differences between a traditional IRA and a Roth IRA further in this article.

While rolling over to an IRA might make sense for most, it certainly isn’t the best option for everyone. In some situations, it might be better to just roll over your funds from the old 401(k) to your new one.

Rolling Over to a New 401(k) 🏛️

If you think your new employer’s 401(k) is exceptional, you can also consolidate your funds and roll over your previous 401(k) into the new one. It is easy to do so since an administrator would handle the transfer, and you can take a hands-free approach.

A direct 401(k) rollover gives you the option to transfer funds from your old plan directly into your new employer’s 401(k) plan without incurring taxes or penalties.

However, we recommend doing your due diligence with the new 401(k) plan before going through with the rollover. Some important things to look at include fees charged, how much the company is willing to match, and available investment options.

It is also possible to have multiple 401(k) accounts as an individual, but it is better to rollover your funds since it allows you to plan and manage your retirement funds more efficiently. Additionally, you cannot invest any more into the old 401(k) and it may only allow you to make one lump sum withdrawal at the end.

Cashing Out 💰

Lastly, you can also cash out your 401(k), but it is not a good idea in most cases. Not only will the income be taxed at your ordinary tax rate, but you’ll also have to pay a 10% penalty if you are younger than fifty-five years old and are no longer going to be employed.

Therefore, cashing out a 401(k) should only be reserved for emergencies. However, do note that if your old 401(k) balance is less than $5,000, it can be cashed out automatically by the company

Rollover Your 401(k) in 4 Steps 💸

If you have decided you want to rollover your 401(k) into a new 401(k) or an IRA, that’s good, but you need to be aware of the many pitfalls that can slow down this process. Here’s a quick guide that will cover everything and walk you through the process in just five steps:

1. Decide if You Want to Rollover to an IRA or a New 401(k) 💵

The first thing you need to do is figure out which of the following is the better path for you rolling over into a new 401(k) or an IRA. Both have their pros and cons, and it is worth looking at both options and what they offer. Here’s a quick table that summarizes the differences between the two:

DescriptionRolling over to new 401(k)Rolling over to an IRA
Investment ChoicesIf you roll over to a new 401(k), your choices will depend on the new company’s policy and generally be more limited than an IRA.An IRA will generally provide a much more comprehensive range of investment options.
Ease of the rolloverRolling over to the new 401(k) is generally easier to handle since the 401(k) administrator will handle the transfer. The administrator can be an employee of the company, a union, or your employer.Rolling over to an IRA will require a bit more effort as you will need to select a brokerage, open the account, and start the rollover process if you do not already have an IRA.
Fees401(k) usually have higher fees compared to IRAs.In general, IRAs will offer more favorable fees.

When you roll over your old 401(k) into a new 401(k), the process is relatively straightforward, and all you need to do is follow the instructions provided by the 401(k) sponsor. There is a fair bit of paperwork involved but the process is usually smooth.

However, if you’re thinking of rolling over to an IRA, some additional steps are involved, like selecting the type of account you want to open and finding a bank/brokerage to open your IRA.

2. Decide If You Want to Rollover to an IRA or a New 401(k) 💳

The most common types of IRA are the traditional IRA and Roth IRA. There are other types available like SEP IRA, SIMPLE IRA, and self-directed IRA. However, we will mainly focus on the traditional IRA and the Roth IRA.

A traditional IRA is the most popular option for investors. It’s easy to see why there are no income restrictions to open an IRA, the contributions are tax-deductible (based on income level) with a maximum of $6,000 ($7,000 if you’re older than 55), and withdrawals are taxed at your tax rate at the time of withdrawal.

It might make sense to go with a traditional IRA if you assume your current tax rate will be higher than at your time of retirement.

On the other hand, a Roth IRA works a bit differently. With a Roth IRA, your contributions are not tax-deductible; instead, the withdrawals are tax-free. Therefore, it makes sense to go with a Roth IRA if one assumes that their tax rate will be higher at their retirement age than what it currently is.

IRA and Roth IRA taxation rules compared
The only key difference between the two types of IRAs is when your money gets taxed.

The top brokers for investing in a Roth IRA usually offer a combination of low fees and more options. You can open a Roth IRA only if your Modified Adjusted Gross Income (MAGI), as a single filer, is less than $140,00 for 2021.

However, you can still use a “Backdoor Roth IRA” which is a legal strategy of rolling over funds from a regular IRA to a Roth IRA well beyond the annual limit. While the transfer will be taxed, the funds will still enjoy the tax-free withdrawal offered by the Roth IRA.

Once you have decided whether you want to open a traditional IRA or a Roth IRA, the next step is to find a bank/brokerage.

3. Find the Right Brokerage for the IRA 💶

If you do not have an IRA, you’ll need to open one before you can rollover your 401(k) to it. Fortunately, the process only takes a few minutes and can be completed quickly.

It is a good idea to compare the leading IRA brokerages based on factors like fees, investment options, and account minimums before making your decision. You might also want to decide if you prefer using a robo-advisor that automatically manages your investment.

You can also open an IRA at a bank, but it is better to go with a brokerage since bank IRAs do not offer stocks or other securities as investment options.

4. Open the Account and Start the Rollover Process 👤

After you find the right brokerage for your needs, the next step is to open a brokerage account and begin the rollover process. The exact steps will be dependent on the broker, but you will receive clear instructions on how to proceed with the rollover from the brokerage.

You will need to deal with some paperwork during the process. At this stage, you should also decide how you would want the funds to be transferred. The ideal option is a direct transfer, which prevents any potential tax liability since you never actually touch the funds.

401(k) Rollover Alternatives 📉

There are two alternatives other than rolling over to a new 401(k) or an IRA – keeping the old 401(k) or cashing it out. The former sounds really easy, and the latter very practical but in truth, these two are the less popular options because of the problems they carry with them.

Keeping the Old 401(k) 💴

If the company allows it, you can just leave the 401(k) with your ex-employer. While it might seem like the path of least resistance and can be the right choice in some particular cases, it is generally not advised.

Since individuals can have multiple 401(k) accounts, it is perfectly okay to start fresh with the new 401(k) while still retaining your older accounts. However, you will not be able to contribute further to the old 401(k).

📋 Note: If your 401(k) balance is less than $5,000, the company has the right to automatically cash it out or transfer it to an IRA for you.

In only a few rare cases keeping the old 401(k) might make sensefor example, if your 401(k) account holds your old employer’s publicly traded stock. If you are thinking of keeping your old 401(k), here’s quick pros and cons list to look at:

The Good and the Bad with Keeping Your Old 401(k)

Pros

  • Penalty-free withdrawals (age 55+).
  • Federal law protects you against creditors
  • Allows you to retain favourable capital gains tax treatment on the company’s stock.

Cons

  • No further investments can be made.
  • Cannot use for a 401(k) loan.
  • May have problems with withdrawals.
  • Multiple 401(k) accounts are harder to track and manage.

Cashing it Out 💸

Ideally, you should never cash out your 401(k). Cashing out will lead to a 10% early withdrawal penalty if you are younger than 59 and a half years or do not qualify for one of the other exceptions to the 10% early withdrawal penalty by the IRS. The withdrawal would be considered income and taxed at your ordinary tax rate. 

Thus, even in an emergency, we would recommend trying to withdraw partially if possible instead of draining the whole amount.

Pros and Cons of Cashing Out Your 401(k)

Pros

  • It can be a source of funds if you need it urgently and have no other sources.

Cons

  • 10% penalty and additional income tax.
  • It is a step backward for your retirement funds and forfeits long-term, tax-deferred growth.

Things to Keep in Mind Before Rolling Over Your 401(k) 💲

Unfortunately, the fun of rolling over retirement money doesn’t end here. Now you know the main avenues you can take with your rollover, but there are still a few more retirement options that might be ideal for some investors.

Direct vs. Indirect Rollover 🎯

You have two options for transferring funds from your 401(k)a direct transfer or an indirect transfer. As implied, a direct transfer ensures the funds go from the old 401(k) to the new account directly, and in an indirect transfer, the money is transferred to you first.

It is better to opt for a direct transfer as they allow you to avoid any potential tax implications. However, if you opt for an indirect transfer, you have to transfer the funds within 60 days into the new retirement plan, or you will have to deal with withdrawal penalties and additional taxes.

Net Unrealized Appreciation (NUA) 🥅

If your 401(k) contains your company’s publicly traded stock, you might want to consider the implications of a rollover on them. Net unrealized appreciation (NUA) is the difference between the value of the company’s stock when transferred into your 401(k) account and its value when moved out of it.

If you keep your old 401(k), the NUA will be taxed at the capital gains tax rate, while the cost basis of the shares is taxed at the higher ordinary income tax rate. If you rollover to an IRA, you’ll incur no taxes on the transfer, but you will not receive the favorable tax treatment for the NUA.

Instead of being charged at the lower capital gains tax rate, the entire value of the stock would be charged at the higher ordinary income tax rate. 

Not Rolling Over to an IRA

Income tax on $100,00 (35%)Capital Gains tax on $700,000 (15%)Total Tax Liability
$35,000$105,000$140,000

Rolling Over to an IRA

Income tax on $800,000 (35%)Total Tax Liability
$280,000$280,000

Here’s an example to understand how taxes would be affected – let’s say the value of your company’s stock was $100,000 on a cost-basis, and at the time of withdrawal, the fair market value of those shares was $800,000. Assuming the income tax rate to be 35%, the results will be as follows:

Conclusion 🎬

In general, a 401(k) rollover is not a complicated or time-consuming process. However, you need to be careful with a few things to ensure that you are not hit with any penalties or taxes. We recommend keeping things simple and transferring the funds directly, whether to a new 401(k) or an IRA. 

In some specific cases, especially if you hold your old company’s stock, it might be beneficial just to keep the old 401(k) instead of rolling it over. Now that you’ve made it to the end of the article, we hope you are equipped with all the knowledge you need to rollover your old 401(k) to a new one or an IRA. 

401k Rollover FAQs

  • Is it Worth it to Rollover a 401(k)?

    Rolling over a 401(k) in most cases is worth it. While one can have as many 401(k) accounts as they like, having your funds consolidated is usually better for management and tracking. In addition, if you are rolling over to an IRA, you also have the opportunity to invest in more asset classes.

  • What Happens if You Don't Rollover 401(k) Within 60 Days?

    If you don’t roll over your 401(k) within 60 days, in the case of indirect transfer, you will be hit with a 10% early withdrawal penalty and will incur taxes for the entire transfer amount. Because of this, a direct transfer is preferable.

  • How Many Times Can You Rollover a 401(k)?

    You can rollover a 401(k) usually only once unless the plan allows for partial rollovers. However, it is possible to rollover multiple 401(k) accounts into a single IRA.

  • Can I Transfer My 401(k) to My Bank Account?

    You can transfer your 401(k) to your bank account if you choose to rollover your 401(k) via the indirect transfer method. In this method, the money will be first sent to your bank account. Then you are responsible for transferring it into your new retirement account within 60 days, lest you will have to pay a 10% early withdrawal penalty and taxes on the amount transferred.

  • Can I Move My 401(k) to an IRA Without Penalty?

    You can move your 401(k) to an IRA without penalty. The best way to avoid penalties during a 401(k) rollover is to opt-in for the direct transfer method, as the funds are transferred directly from one retirement account to another.

  • What Happens if My Old 401(k) Balance is Less than $5,000?

    If your 401(k) is valued at less than $5,000, your old company has the right to cash it out automatically or transfer it to an IRA. If the company cashes it out and sends you the cheque, you will have to pay taxes on the income.

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