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How to Do a 401(k) Rollover to an IRA

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Did you know that your 401k is tied to the stock market and is in risk of a stock market crash? It offers no diversity, no opportunity to invest in other assets like precious metals or real estate, and very risky when it comes to losing all of your hard earned savings. Fortunately for you, this article will cover the ways that you can rollover this account to an IRA.

401k to IRA Rollover

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Every year millions of people change jobs.

And many who do are faced with the decision of what to do with the 401(k) plan they have with the (soon to be) previous employer.

It’s a potentially hazardous decision too. 

Do you cash out the plan, and take the money?

Do you attempt to roll the old employer plan over to the new employer plan?

Or do you do a 401(k) rollover into an IRA?

The stakes are high, not only because of the potential income tax consequences, but also because the decision you make today may have a material affect on your retirement, including whether or not you’ll be able to retire at all.

How much money you have in your 401(k) often has an affect on which option you choose.

For example, if it’s only a few thousand dollars, you may decide to cash out the plan, and use the funds for other purposes, like paying off debt or buying a new car.

If it’s a large balance, particular well into six figures, cashing out the plan won’t be practical due to the income tax implications.

And in some cases, a new employer won’t allow the rollover of a 401(k) plan from an old employer.

That’s why doing a 401(k) rollover to an IRA is such a popular choice.

Even if you’re not sure if it’s the absolute right strategy right now, it preserves your options for a later date.

With that in mind, let’s do a deep dive into how to do a 401(k) rollover to an IRA.

Ultimate 401k Rollover Guide

What Are the Choices with a 401(k) Distribution?

When you have a 401(k) with an employer and you decide to leave the company, you have four basic options:

Cash Out the Plan

If you choose this option, you simply direct the plan trustee to liquidate the account and send you a check.

The account will be closed out, and no further action is necessary.

Advantages: If the balance in the plan is relatively small, like a few thousand dollars, you may decide the money would be better used to pay off debt.

This can make sense if the tax liability on the distribution isn’t too high, and the interest you’re paying on the debt you intend to pay off is much higher than the investment return in the 401(k).

Disadvantages: You’ll have to pay ordinary income tax on the amount of the distribution, which won’t make sense if you’re in anything higher than the 12% tax bracket.

But if you’re under 59 ½ you’ll also have to pay the IRS 10% penalty on early distributions.

Keep the 401(k) with the Previous Employer

This is the simplest choice of all. You decide to do nothing, and leave the account where it is.

Unless the employer has some sort of rule requiring disposition of the account following separation, you can literally leave the money in the plan for the rest of your life.

Advantages: No action is required on your part. If you’re satisfied with the investment options in the plan, as well as the plan performance, there’s no need to move the money.

Disadvantages: Not a good idea if you’re not happy with the investment options or with the performance of the plan.

The plan may also have high fees, including an annual account maintenance fee, that will further hurt your investment performance.

And if you tend to change jobs often, you may accumulate several previous employer 401(k) plans, each with it's own set of fees.

Roll the Previous Employer 401(k) into the New Employer’s Plan

This is where you transfer the 401(k) from your previous employer to the new one.

Once the transfer is complete, you’ll have access to all the investment options of the new plan.

Advantages: Good strategy if the new employer plan has either greater investment options, lower fees, or both, compared to the old plan.

Disadvantages: The new employer may not permit rollovers, or it may not even offer a plan to roll the previous 401(k) into.

Also a bad strategy if the new employer plan has more limited investment options and/or higher fees than the previous employer plan.

Do a 401(k) Rollover to an IRA

Instead of rolling over the old 401(k) to a new employer plan, you choose instead to do a 401(k) rollover to an IRA.

Advantages: You can transfer the funds from the old 401(k) to a self-directed IRA.

This will give you potentially unlimited investment options and lower fees, since you will choose the trustee for the plan.

This can be a diversified investment broker where you can trade any investments you like, or a managed plan, like a robo-advisor.

Disadvantages: Not a good idea if you’re not comfortable making your own investment decisions.

But then you always have the option to have your account fully managed at very low cost by a robo-advisor.

Also be aware you may lose certain legal protections by moving the funds from an employer sponsored plan to a self-directed plan (more on that under The Disadvantages of a 401(k) Rollover into an IRA.)

Advantages of a 401(k) Rollover to an IRA

Rollover to an IRA

The main advantage of a 401(k) rollover to an IRA can be summed up in one word: control.

The control factor with an IRA can be broken down as follows:

  • You choose the plan trustee. You can hold the account with any investment platform you feel most comfortable with. That may be because it offers 24/7 customer service, top-notch investment tools and research, or even local branch offices.
  • Invest your way. Some employer plans limit you to a few funds. With an IRA, you can invest in an unlimited number of funds, as well as stocks, bonds, options, real estate, precious metals, and even options. You can also choose a managed option with a robo-advisor.
  • Control over fees. With most major investment brokers now charging no trading fees, and robo-advisors managing portfolios for just a fraction of 1%, you can reduce your investment fees very close to zero.
  • Access to your funds. To avoid tax consequences, you should refrain from taking early distributions from a retirement plan. But if you absolutely need to access the funds, that’s far easier to do with an IRA than with an employer sponsored plan.
  • Roth IRA option. You can convert some or all of your IRA balance to a Roth IRA whenever you choose. A Roth IRA has the advantage of distributions being tax-free in retirement, and also having no required minimum distributions (RMDs) after age 70 1/2 . Though some employer plans offer a Roth 401(k) option, most don’t.
  • Disadvantages of a 401(k) Rollover into an IRA

    Rolling over a 401(k) into an IRA does have some disadvantages, so you’ll have to weigh these against the advantages.

  • Early separation from service. All retirement plans discourage you from taking withdrawals before reaching the age of 59 ½. That’s what the 10% early withdrawal penalty is all about. But the penalty is waived on distributions taken from a 401(k) plan as early as 55 under the separation from service exemption. This exemption does not apply to IRA accounts.
  • Greater legal protections for employer plans. As ERISA plans, 401(k) plans are generally protected from creditors, civil judgments and bankruptcy proceedings. However, under federal bankruptcy laws, up to $1,362,800 in traditional and Roth IRAs are protected in bankruptcy proceedings. And in most states (but not all), IRAs are also protected from creditors.
  • Convertibility to a future employer plan. While you can generally roll over a previous employer 401(k) to a new employer plan, the same is not generally true with an IRA.
  • You’re happy with the investment performance of your existing plan. If you don’t have much investment experience, and you’re satisfied with the returns on your old 401(k), moving the money to an IRA may not be in your best interest.
  • Traditional IRA vs. Roth IRA

    Traditional IRA vs. Roth IRA

    Let’s say that after evaluating the advantages and disadvantages of doing a 401(k) rollover to an IRA, you decide to move forward with the rollover.

    Now you have a second choice: traditional IRA or Roth IRA.

    Let’s look at both.

    Traditional IRA

    The traditional IRA has all the advantages and disadvantages we’ve discussed so far.

    The main advantage to doing a 401(k) rollover to a traditional IRA (compared to a Roth IRA) is that there are no tax consequences as a result of the rollover.

    You’ll move the old 401(k) to your traditional IRA, report it on your tax return as a full rollover, and there will be no ordinary income tax due, and no 10% early withdrawal penalty.

    You’ll be able to keep the money in the traditional IRA, building up tax-deferred investment income.

    After age 59 ½ you can begin taking withdrawals from the plan.

    As you do, the amount of the withdrawals will be subject to ordinary income.

    If you take withdrawals before reaching 59 ½, you’ll not only have to pay ordinary income tax, but also the 10% early withdrawal penalty (unless you qualify for one of the penalty exemptions).

    Beginning at age 70 ½ you’ll be required to begin taking RMDs, based on your life expectancy, which will be calculated for each age a withdrawal is required.

    Roth IRA

    If you do a rollover of a 401(k) to a Roth IRA, you’ll experience financial pain at the time of the rollover, but you’ll gain many benefits in the future.

    That’s because a rollover from a 401(k) to a Roth IRA creates a tax liability.

    The full amount of the 401(k) - less any after-tax contributions - will be subject to ordinary income tax, but not the 10% early withdrawal penalty.

    Let’s say you’re in a combined federal and state marginal income tax rate of 30%.

    You do a rollover of a 401(k) to a Roth IRA of $100,000.

    Since the entire amount of the rollover is taxable, you’ll pay $30,000 ($100,000 X 30%) in combined federal and state income tax on the rollover.

    That’s the bad news. But here’s the good news…

    Once you reach age 59 ½, and as long as you’ve been in the Roth for at least five years, you’ll be able to take distributions from the plan tax-free.

    It’s a perfect strategy if you expect to be in a relatively high tax bracket in retirement, or if you expect tax rates to go significantly higher in the future.

    What’s more, Roth IRAs are the only retirement plans not subject to RMDs.

    While you’ll be required to begin taking distributions at age 70 ½ from all other plans, including traditional IRAs, you won’t have to with a Roth IRA.

    It’s an excellent strategy if you’re concerned about outliving your money.

    You can let your Roth IRA continue to grow, and only begin tapping it when all other retirement plans have been exhausted.

    IRA Fees to be Aware Of

    If you do opt for a self-directed IRA account, there may be some fees to be aware of.

    However, self-directed IRA fees are almost always lower than 401(k) fees.

    Examples include:

  • Annual fee. This may go by different names, such as an administrative fee, and may be something like $50 per year. But most IRA trustees don’t charge this fee.
  • Trading commissions. Most major brokerages have waived these fees on trades of stocks, exchange traded funds (ETFs) and options. But many still charge trading fees on mutual funds and some other investments.
  • Load fees. These are sales charges on mutual funds, and they can be as high as 3%. However, many mutual funds are no-load, and you can avoid the fee by holding these funds.
  • Management fees. These apply to managed funds, like robo-advisors. They generally charge an annual fee to manage your portfolio, ranging from 0.25% to 0.50%. For example, if you have $100,000 in the plan, and the robo-advisor fee is 0.25%, you’ll pay $250 per year, which is usually pro-rated on a monthly basis.
  • Expense ratios. These are the fees charged by funds for administrative and marketing expenses. Called 12b-1 fees they can be as high as 1% annually. But you can find many funds that charge less than 0.20%. You don’t pay this fee separately. Rather it’s an internal fee, charged within the fund, thus reducing it’s net return.
  • What Are Your Investment Options with a Rollover IRA?

    Once you’ve made the decision to do a 401(k) Rollover into an IRA, the next decision is how you want to invest your account.

    If you plan to engage in self-directed investing, buying and selling individual stocks, options, funds, bonds, real estate investment trusts (REITs) and other securities, it will come down to selecting the broker to hold your IRA with.

    Popular investment brokers that offer nearly unlimited investments and charge no trading fees on many of them include:

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    Noble Gold Investments Logo

    Noble Gold Investments

    $2,000

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    on Noble Gold website

    If you prefer to invest in mutual funds or ETFs, Vanguard may be the broker of choice.

    They offer trading in stocks and other securities but they do charge trading fees on those.

    However, they offer thousands of fee-free ETFs and mutual funds for you to invest in.

    Given that Vanguard funds are found in most professionally managed portfolios, you can take that as a hint of how good their funds are.

    Choosing a Managed Option: Robo-advisors

    If you want a fully managed IRA account, you can opt for a robo-advisor.

    They’ll create a portfolio of stocks, bonds and other asset classes for you, based on your risk tolerance, investment goals and time horizon. 

    After that, they’ll fully manage the portfolio for you, including reinvestment of dividends, and periodic rebalancing to make sure your portfolio maintains its target allocations.

    Popular robo-advisors include:

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    Betterment and Wealthfront will manage your IRA for a fee of just 0.25% per year (again, as in $250 per year for a $100,000 account).

    M1 Finance charges no management fee at all. And they’ll allow you to either select pre-built portfolios, or to create your own. 

    Either type of portfolio will be managed for you, giving you a mix of self-directed investing (security selection) and robo-advisor management once your portfolios are in place.

    How to Do a 401(k) Rollover to an IRA

    There are two ways to do a 401(k) rollover to an IRA.

    The first is a direct rollover.

    This is where the funds from your 401(k) plan are transferred directly to your account with the new IRA trustee.

    The second is an indirect rollover.

    This is where the funds from the 401(k) are sent to you personally, then you transfer them into your IRA account.

    Under IRS rules, you have up to 60 days to complete the transfer, otherwise the funds transferred to you will be considered a distribution of the 401(k) plan funds.

    The best option is the direct rollover method.

    It completely avoids the possibility you’ll miss the 60 rollover window and be subject to a plan distribution and the income tax consequences that will invite.

    Contact your new IRA trustee, and direct them to handle the rollover for you.

    They have experience in this capacity, and know exactly what to do.

    They’ll contact the appropriate party with your 401(k), and arrange for the transfer to take place smoothly.

    Should You Do a 401(k) Rollover to an IRA?

    The 401(k) rollover to an IRA has become very popular, and for good reason.

    Today’s retirement plans are designed to be portable, and none are more so than an IRA.

    Once you complete the rollover, you’ll have more choices than you ever had with your 401(k).

    That will include the choice of the plan trustee, the type of investing you’ll do, and even the fees you’ll pay.

    Complete flexibility is usually a big advantage when it comes to investing, especially for retirement.

    And while you’re managing your new rollover IRA account, you’ll be building a whole new 401(k) plan with your new employer. It’ll be the best of both worlds.


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