How to Roll Over a 401(k) to an IRA

When it comes to a 401(k), you can take it with you.

In fact, you probably should, in the form of a 401(k) rollover. But making the most of the money you’ve built up means performing the rollover correctly. Here’s the four-step process for how to roll over a 401(k) to an IRA. As with any big decision, it’s always good to know your options before you go all in, so let’s start there.

1. Evaluate your choices

If you’re leaving a job, you have three basic options — none of which allows you to continue contributing to the plan, but all of which ensure that the money you’ve already contributed remains yours:

• Leave it be. If your ex-employer lets you, you can leave the plan right where it is. This isn’t ideal, for a couple of reasons: You’ll no longer have an HR team at your disposal to help you with plan questions, and you may be charged higher 401(k) fees as an ex-employee. (Want to see just how much your 401(k) is costing you? Check out NerdWallet’s 401(k) Fee Analyzer.) In short, leaving your account behind is kind of like leaving money in a savings account at a small-town bank when you’re moving to another state — you can do it, but life will be easier if you don’t.
• Cash out. We hesitate to list this as an option. Not only does cashing out sabotage your retirement — you’ll lose the power of compound interest, especially if you’re early in your career — but it comes with some brutal penalties and taxes levied by the IRS. You’ll pay a 10% early withdrawal fee, plus ordinary income taxes on the amount distributed. That means you might hand over up to 40% of that money right off the top. Bottom line: Bad idea, if you can avoid it.
• Roll it over. This is the best choice for many people: You can roll your money into either your current employer’s retirement plan or into an IRA, and in most cases, the IRA is the destination of choice. There, you’ll have a wide variety of investment options and low fees, particularly compared with a 401(k) — even the fresh shiny one at your new employer — which often has tightly curated investment options and administrative fees. The 401(k)-to-IRA rollover is what we’re going to focus on in this post.

2. Open an IRA

If you have an existing IRA, you can just roll your balance into that. If you don’t, you’ll need to make two decisions: where to open that account — which means selecting an online broker or robo-advisor — and which type of IRA you want, a traditional IRA or a Roth.

The main difference between an online broker and a robo-advisor is that a robo-advisor will provide account management, for an annual fee of around 0.25%. If you want to manage your investments yourself, you may want to go with a broker. Look for an account provider that charges no account fees, offers a wide investment selection with low investment fees, and has good customer service.

» MORE: How and where to open an IRA

The main difference between a traditional IRA and a Roth IRA is their tax treatment:

• Traditional IRAs net you a tax deduction on contributions in the year they are made, but withdrawals in retirement are taxed.
• Roth IRAs don’t include an immediate tax deduction, but withdrawals in retirement are tax-free.

The difference between these accounts always matters, but it matters a lot on a rollover: Although you can choose to roll it over to either account, rolling to a Roth means you’ll pay taxes on the rolled amount because it will be treated like a Roth conversion. (The exception is if you’re rolling over a Roth 401(k), a type of 401(k) that mimics the tax treatment of a Roth IRA. You cannot roll a Roth 401(k) into a traditional IRA, but you can roll it over into a Roth IRA tax-free).

Once it is in the Roth IRA, the money — and any additional contributions you make, plus investment earnings — will be available for tax-free withdrawals once you hit age 59½. It’s a good deal, and will get you around Roth IRA eligibility if your income is too high to otherwise contribute. But you shouldn’t do this if you need to use cash from the rollover to foot the tax bill.

3. Initiate a direct rollover from your old 401(k) plan

The IRA provider will offer ample support to help you do this — many have “rollover specialists” — but the basics are simple: You’ll contact your former employer’s plan administrator, complete a few forms, and ask it to send a check for your account balance to your new account provider. (The new account provider should give you pretty explicit instructions for how the check should be made out, what sort of information should be included — like your new IRA account number — and where it should be sent.) Some providers allow you to wire the funds instead.

The key to all of the above is the phrase “direct rollover”; in other words, the money never touches your hands. You can also opt for an indirect rollover, which essentially means you’re withdrawing the money and moving it to the IRA provider yourself, a process that needs to be complete within 60 days.

On its face, an indirect rollover can feel like a short-term loan. But before you go rolling around on your mattress of money, consider: Your employer will withhold 20% of the distribution as a safeguard for the IRS, in case you get too comfortable in your riches and decide to keep that cash.

If the full balance — including that 20% — is deposited into the new IRA within 60 days, you’ll get the amount withheld back … but not until you file your tax return. That means if you want to make your 401(k) balance whole, you’ll need to come up with that 20% elsewhere. If you can’t, you may owe taxes and a 10% penalty on it, as it will be counted as an early distribution.

Sound confusing? Let’s look at an example: Say you have $30,000 in a 401(k) and you want to do an indirect rollover into an IRA. Your employer will send you a check for $24,000 and withhold $6,000 for taxes. Within 60 days, you’ll need to deposit $30,000 into the new IRA to avoid a penalty. The problem: Your employer is holding on to that $6,000 for the IRS.

You have two choices: You can come up with that $6,000 out of pocket, from a savings or other account, and deposit the full $30,000 into your new IRA. The $6,000 that was withheld will be reported as taxes paid. You won’t owe any taxes or penalties on the rollover, so that $6,000 will be credited back to you when you file taxes the following April.

If you don’t have that $6,000 available to make your account whole, you can deposit only the $24,000 that you have on hand. The missing $6,000 will be reported as taxable income as well as taxes paid. You’ll likely owe a 10% penalty on that amount.

And if you miss the 60-day deadline altogether? The entire amount will be counted as an early distribution. Bottom line here: It’s much easier on your wallet — not to mention your accounting skills, or lack thereof — to do a direct rollover.

4. Invest your funds

Once the money lands in your new IRA account, you can get down to the fun part: selecting your investments.

If this is your first IRA, you’ll probably be surprised at the world of investments available at your doorstep, especially compared with the measly selection of 10 to 20 funds in your 401(k): You can invest in mutual funds — a much wider selection of them, including index funds and exchange-traded funds — as well as trade stocks and options.

But for most people, the best choice is to select a few low-cost index funds or ETFs, based on the asset allocation — shortly defined as the way you divide your money among stocks, bonds and cash — that makes sense for your age and risk tolerance.

If you’re not up for that, there are more hands-off options: If you were invested in a target-date fund in your 401(k), you can find a similar (and perhaps less expensive) fund through an IRA. And if you opened your new account at a robo-advisor, as discussed above, that company’s computer algorithms will take care of selecting and rebalancing your investments. That’s not to say you can turn a blind eye — we’d never recommend that — but there’s something to be said for turning over the bulk of the dirty work to someone (or, in the case of a robo-advisor, something) else.

Best rollover IRA options: NerdWallet’s picks

TD AMERITRADE: AMONG BEST OVERALL

TD Ameritrade is one of our picks for best overall IRA providers. The popular online broker has wide customer appeal for IRA account holders and beginner investors alike for several reasons: helpful customer service, a $0 minimum balance requirement, and a large selection of commission-free ETFs and no-transaction-fee mutual funds. Advanced, active traders also gravitate to the company because of its two top-notch trading platforms — including widely renowned thinkorswim — and its research and data. The downside: The company’s trade commissions are on the high side at $9.99.

E-TRADE: NO ACCOUNT MINIMUM

E-Trade is one of our picks for best providers with no account minimum for IRA accounts. One of the best-known online brokers, the company is loved by investors because of its user-friendly online experience on both its website and mobile app. E-Trade has a large selection of no-transaction-fee mutual funds and commission-free ETFs. Research and data are free, and E-Trade’s tiered commission structure means frequent traders can keep costs down.

WEALTHFRONT: GOOD FOR HANDS-OFF INVESTORS

Wealthfront, one of our top picks for hands-off IRA investors, was one of the first robo-advisors in the game. It remains one of the largest, and it regularly adds new features and tools for its investors. The company is a great option for IRA account holders who are looking for investment management, particularly beginners, because it waives its 0.25% account management fee on balances of $10,000 or less. Wealthfront has a $500 account minimum and invests its clients in a portfolio of ETFs with expense ratios that average a modest 0.12%.

BETTERMENT: NO MINIMUM, TIERED FEES

Betterment, our other top pick for hands-off investors, has carved out a place as the largest independent robo-advisor. It caters to the retirement market with innovative goal-based tools to help investors save more. The company requires no minimum investment and offers a tiered management fee that starts at 0.35% for balances under $10,000 (with auto-deposits of at least $100 a month). The fee drops to 0.25% on balances between $10,000 and $100,000; balances over $100,000 pay just 0.15%. Betterment’s portfolio of ETFs has expense ratios that range from 0.09% to 0.17%.

» MORE: See our full lists of top IRA providers and top Roth IRA providers

Arielle O’Shea is a staff writer at NerdWallet, a personal finance website. Email: aoshea@nerdwallet.com. Twitter: @arioshea.

from NerdWallet
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