By Justin Pritchard, CFP® in Montrose, CO
When you change jobs or retire, you have several options for the money in your 401(k). You can typically transfer that money to an IRA, leave it in the plan, move it to your new job’s retirement plan, or cash out. In many (but not all) cases, it’s smart to move your savings into an IRA. We’ll cover the pros and cons here so you can decide what’s best.
The process can be confusing and intimidating, so it’s easy to do nothing. But that might result in leaving your savings with an employer that you no longer have any connection to, and one you might even dislike or distrust.
Why Transfer Your 401(k) to an IRA?
Why would you move savings from an old 401(k) plan to an IRA? The main reason is to keep control of your money. In an IRA, you get to decide what happens with the funds: You choose where to invest and how much you pay in fees, and you don’t need anybody’s permission to take money out of the account.
Cost and providers: In your 401(k), your employer controls almost everything. Employers choose vendors for the plan, which determines the investment lineup available. Those might not be investments you like, and they might be more expensive than you want. If you want to practice socially-responsible (or ESG) investing, the 401(k) may lack options for that.
Timing: 401(k) plans also require extra steps when you want to withdraw funds: An administrator needs to verify that you are eligible to access your money before you’re allowed to take a distribution. Plus, some 401(k) plans don’t allow partial withdrawals—you might need to take your full balance.
Easy (and Fast) Withdrawals
If you need access to your 401(k) savings for any reason, it’s easier when the money is in an IRA. In most cases, you call your IRA provider or request a withdrawal online. Depending on what you own in your account, the funds might go out as soon as the next business day. But 401(k) plans might need a few extra days (or more) for everybody to sign off on the distribution.
In addition to maintaining control of your money, there are several other situations in which you might want to transfer from a 401(k) to an IRA. The possibilities are too numerous to cover here, so it’s important to research and understand how your 401(k) compares to an IRA. A few examples include:
- Options at death: You might be interested in what happens to your retirement savings after you die. Sometimes IRAs have more flexible beneficiary options than 401(k) plans. Familiarize yourself with the rules governing these accounts and do what’s best for you and your family.
- Frozen plans: If your company is involved in a merger or certain types of investigations, the 401(k) plan might be frozen. If that happens, even for a short time, you may have to wait to access your money.
- Missing signers: Sometimes, especially with small companies, a company goes out of business, and it’s hard to find the person who can authorize your withdrawal.
- Simplify RMDs: If you need to take Required Minimum Distributions (RMDs) after age 72, using an IRA may be easiest. With IRAs, you can take your annual required amount from a single account—even with multiple IRAs. But with 401(k) plans, you can’t “aggregate” those accounts, so you’d need to take a distribution from each plan you have a balance in.
Control Tax Withholding
When you get a distribution of taxable money from your 401(k), the plan may be required to withhold 20% in taxes. That means you have less to spend, and you might not pay 20% in federal taxes (most retirees pay less than that).
How to Transfer From Your 401(k) to an IRA
When you’re ready to make the transfer, you need to do three things:
- Verify that this is really the best option. Review the examples below describing potential pitfalls, and evaluate the pros and cons.
- Gather information about your IRA. If you don’t already have one, we’ll discuss opening one below. You need your IRA custodian’s name (Vanguard, for example), your account number, and a delivery address.
- Request the transfer. Contact your former employer to provide instructions. You can use this sample text: “I’d like to roll my 401(k) over to an IRA. Please provide instructions on how to proceed.”
Unfortunately, you typically have to go through your former employer or a vendor they use. With many 401(k) plans, you cannot request a transfer using paperwork from the receiving IRA custodian.
Who to Contact
If you work for a large company, you can most likely contact your 401(k) provider directly. For example, contact Fidelity, Vanguard, or whatever website you use to manage your account. Alternatively, call whoever prints your 401(k) statements. If you work for a small company, you may need to contact the human resources “department,” which might just be the person who hired you. Either way, you eventually need one of the following:
- A distribution request form, or
- A phone number for providing your instructions, or
- A website that can take instructions
A financial advisor like me can guide you through the process if you have questions.
What to Say
It’s critical to include the following details as you provide instructions:
- You want to do a “direct rollover” to an IRA.
- The check should not be payable to you personally.
During the rollover process, you provide instructions on who the check should be payable to. In most cases, that would be your IRA provider (a brokerage house, mutual fund company, or bank). It is best to provide an account number, when available, but that might not be required. If the check is mailed to your home, you can write your IRA account number on the check before forwarding it to your IRA provider.
Tip: If a phone representative asks about tax withholding, that’s a bad sign. Double-check that you’re doing a direct rollover to an IRA.
Eventually, the retirement plan should process a payment for your entire vested balance in the plan. In many cases, you receive a check (yes, even in the modern age, you’ll get a paper check).
Where to Deposit
If you don’t already have an IRA, you need to open one. You can start by opening an “empty” IRA, which you will fund with your 401(k) rollover. You have numerous options when it comes to opening an IRA. If you want to keep your money as safe as possible, a bank or credit union can offer savings accounts and certificates of deposit (CDs) with a government guarantee. If you want to invest with the potential for more growth, any mutual fund company, online broker, or financial planner (like me) can open an IRA for you. Just ask for instructions on opening an account.
It’s fine to open an account before you have a rollover check. In fact, that’s an excellent idea. That way, when you receive the funds, the account is ready to accept your deposit. Forward the check to your new IRA provider, and follow any instructions they have. It’s smart to ask about any requirements early in the process:
- Ask for a mailing address and prepare an envelope (with postage).
- You might need to include a deposit slip or a note with instructions to deposit as a “rollover contribution.”
- Be sure your account number is on a deposit slip, note, or the check itself.
- You typically don’t endorse these checks, as they are often made payable to your new IRA (not you).
Roth (and other) funds: If you have Roth money and pre-tax money in your 401(k), expect to receive two checks—one for each “money type.” You typically deposit the Roth 401(k) funds into your Roth IRA when completing a rollover, while the pre-tax money goes into a pre-tax account. You might have additional money types as well (such as voluntary after-tax money), so check your statements carefully.
Indirect vs. Direct Rollovers
As mentioned above, it’s usually best to request a direct rollover. With that approach, your former employer provides a check payable directly to your next retirement account (whether that’s an IRA or your next job’s retirement plan). As a result, you don’t take possession of the funds, and there should not be tax consequences in most cases.
The alternative is an indirect rollover, which you might do as a 60-day rollover. With that method, you receive funds—sent to your bank account or with a check payable to you. Then, you forward the money to another retirement account, which you must complete within 60 days.
Indirect rollovers can be problematic. Your employer is generally required to withhold 20% of pre-tax amounts that are paid directly to you. If you only get 80% of your account balance, you’ll need to replace those funds somehow to complete the rollover (and you might pay unnecessary taxes). But if you can’t come up with that money, it’s treated as a distribution, which may result in income taxes and additional tax penalties.
Try to go with a direct rollover over the 60-day rollover unless you have a good reason not to.
When Not to Transfer to an IRA
You now know some of the benefits of moving your 401(k) to an IRA. But control over your money isn’t the only thing that matters, and you may have other priorities. It’s impossible to list every potential pitfall, but a few examples may offer food for thought.
Between age 55 and 59.5
When you’re at least 55 years old—but not yet 59 1/2 years old—you might want to leave at least some of your money in the 401(k) plan. 401(k)s allow you to pull money out without penalty after age 55 (for most employees, but not everybody—speak with a CPA to verify your details). IRAs, on the other hand, require that you wait until age 59 ½ to avoid an early-withdrawal penalty of 10% on certain distributions. There are always exceptions and workarounds, but those are the basic rules. If you intend to spend your 401(k) savings between the ages of 55 and 59 1/2, keep this in mind before making a transfer.
Note: Some public safety workers can avoid early withdrawal penalties from a retirement plan as early as age 50. If you worked for a federal, state, or local government, be sure to explore your options.
Depending on state laws, money in IRAs might be treated differently, and a 401(k) might offer more protection (or less). Federal law often applies to ERISA-covered 401(k) plans, while state laws cover IRAs. However, there is some federal protection for IRAs in bankruptcy. When you owe federal tax debts or assets are due to an ex-spouse, protection is usually limited.
If you plan to convert Traditional savings to Roth IRA holdings, keeping funds in a 401(k) might simplify your life. Doing so could minimize the amount of pre-tax money that goes into pro-rata calculations when you convert. Money in your 401(k) might be excluded from those calculations, but verify your plans with a CPA.
RMD While Working
If you’re over age 72 and still working, it may be possible to delay your required minimum distributions (RMDs). But that only applies to jobs where you are not involved as an owner in the company (owners may still be required to take RMDs). Moving funds out of the 401(k) to an IRA could require you to take distributions from the assets. Once you stop working, you need to take RMDs regardless of whether the money is in an IRA or a 401(k).
Stable Value Offerings
If you’re a conservative investor and your plan offers an attractive stable value or fixed account offering, it could make sense to continue using your 401(k). Those investment options are most readily available in workplace retirement plans, and they pay attractive rates with very little risk. However, there may be a possibility of a market value adjustment (MVA) resulting in a loss of principal. That can happen at any time, but it’s especially likely after interest rates rise, so be sure to review the rules carefully before making a decision.
Fees and Expenses
This one can go either way. Some 401(k) plans are inexpensive, while others (especially from small companies) can be pricy. But the same is true for IRAs. Ultimately, it depends on how you manage your funds. Evaluate the investment expenses in each type of account as well as additional charges you might pay. Then, with the big picture in mind, you can decide if the price you pay (or will be paying) is worth it. Cheaper isn’t always better, but you need a good reason to opt into higher costs.
Transferring Your 401(k) to Your Bank Account
You can also skip the IRA and just transfer your 401(k) savings to a bank account. For example, you might prefer to move funds directly to a checking or savings account with your bank or credit union. That’s typically an option when you stop working, but be aware that moving money to your checking or savings account may be considered a taxable distribution. As a result, you could owe income taxes, additional penalty taxes, and other complications could arise.
IRA first? If you need to spend all of the money soon, transferring from your 401(k) to a bank account could make sense. But there’s another option: Move the funds to an IRA, and then transfer only what you need to your bank account. The transfer to an IRA is generally not a taxable event, and banks often offer IRAs, although the investment options may be limited. If you only need to spend a portion of your savings, you can leave the rest of your retirement money in the IRA, and you only pay taxes on the amount you distribute (to checking or savings, for example).
Again, moving funds directly to a checking or savings account typically means you pay 20% mandatory tax withholding. That might be more than you need or want. Most IRAs, even if they’re not at your bank, allow you to establish an electronic link and transfer funds to your bank easily.
Where Should You Transfer Your 401(k)?
You have several options on what to do with your 401(k) savings after retirement or when you change jobs. For example, you can:
- Transfer funds to an IRA to maximize control.
- Leave the money with your former employer, at least temporarily (this option may not be available in all cases).
- Cash out by transferring to a bank account, for example (again, this may result in taxes).
- Transfer assets to your new job’s 401(k) plan, if allowed.
The right choice depends on your needs, and that’s a choice everybody needs to make after evaluating all of the options.
Important: The different rules that apply to 401(k) and IRA accounts are confusing. Discuss any transfers with a professional advisor before you make any decisions. This article is not tax advice, and you need to verify details with a CPA and your employer’s plan administrator. Likewise, only an attorney authorized to work in your state can provide guidance on legal matters. Approach Financial, Inc. does not provide tax or legal services. This information might not be applicable to your situation, it may be out of date, and it may contain errors and omissions.