You’ve moved on from your old job, and now your 401(k) is in transition. Instead of letting your hard-earned savings sit under your former employer’s plan, it’s time to take control and make your money work for you. With this new chapter come several options for managing your retirement funds.
One of the most common choices is a 401(k) rollover into an IRA. Since there are both traditional and Roth IRAs, it’s important to evaluate which one aligns best with your goals and financial situation. In this article, we break down the details so you can make an informed decision about your next steps.
401(k) Rollover Options
Before diving into the IRA options, let’s first review the choices available when you leave an employer. Depending on your specific circumstances, there are generally four main options available, each with its own set of advantages and disadvantages.
- Leave the money in your former employer’s retirement plan: Not every employer will allow this, so be sure to check with your company before making a rollover decision. If you are able to leave the money in the plan, this option allows you to enjoy the tax-deferred growth of the assets until you are ready to withdraw them. The downside is that you may have limited investment options and less control over your funds. It’s also not uncommon for employees to forget about their old 401(k) accounts when they are left with a previous employer’s plan.
- Roll over into a new employer’s plan: You can also transfer the assets to a new employer’s plan, if one is available and rollovers are permitted. This option allows you to consolidate your retirement savings into a single account. If you don’t have access to a new employer’s plan, or if there is a delay in eligibility, this option becomes less feasible.
- Roll over into an IRA: This option allows the participant to maintain control over their retirement savings and may offer a wider range of investment options. There are two types of IRAs available, as discussed in greater detail below.
- Cash out the account balance: This option allows you to receive the full amount of your retirement savings in cash, but it comes with significant tax consequences. You will be subject to income taxes on the full amount of the pre-tax contribution and earnings. If you are under age 59½, you will also be subject to a 10% early withdrawal penalty. This option gives you full control of your retirement funds, but you may significantly reduce the account value when taxes are considered.
IRA Rollover Options
When looking at the rollover IRA option specifically, there are several considerations to keep in mind. First you’ll have to decide which IRA makes the most sense for your financial situation.
Traditional IRA
Prior to 1997, there was only one kind of IRA, which is now referred to as a traditional IRA. It is a tax-deferred retirement account in which the contributions may be tax deductible in the contribution year and the taxes are paid when the money is withdrawn in retirement. Also, if you are in a lower tax bracket in retirement, you’ll end up paying less in taxes than you would have originally.
IRAs can be invested in just about everything except life insurance or collectibles, so there is a much broader range of investment options available. Unlike employer-sponsored retirement plans, with an IRA you are the complete owner and the plan is in no way tied to your employment. You can change jobs as frequently as you want and it does not impact your account or your ability to contribute to it (as long as you have earned income). You can even withdraw money penalty-free before age 59½ if it’s for a qualified first-time home purchase or education expenses.
Roth IRA
Out of the Taxpayer Relief Act of 1997, a new kind of IRA was born, named after Senator William Roth of Delaware, who was the chief legislative sponsor of the act. Roth IRAs differ from traditional ones in a few key ways. The biggest difference is the tax treatment. Whereas traditional IRAs are tax-deferred, with a Roth you pay all taxes up front. The key, though, that makes Roths so popular, is that you don’t have to pay taxes on any of the growth. Everything generated by compounding interest is yours, and the government doesn’t take any of it if you follow the rules.
Roths also differ from traditional IRAs in that there are no required minimum distributions. So, you can leave your money in the account to grow for perpetuity, instead of being required to take withdrawals (and stop contributions) at age 73 like with a traditional account. Some people even utilize Roth IRAs as a way to provide tax-free income for their children or grandchildren. In addition to the traditional IRAs allowances for special withdrawals, contributions (not growth) can be taken out at any time for any reason without penalty.
There are income limitations on who is allowed to open a Roth IRA outright, but anyone can rollover a 401(k) to a Roth IRA as long as they pay the associated tax liability.
Roth Rollover Considerations
Because of the different tax treatment of the two types of IRAs, there are tax consequences depending on the type of account you roll your 401(k) into. A traditional 401(k) can be rolled into a traditional IRA without paying taxes. A Roth 401(k) can be rolled into a Roth IRA without paying taxes. However, to roll a traditional 401(k) into a Roth IRA creates a tax liability. Since most 401(k)s are pre-tax and a Roth IRA is after-tax, you will have to pay ordinary income taxes on the money to move it from one to the other. In order to roll a traditional 401(k) into a Roth IRA, you should have sufficient money saved elsewhere to cover the tax bill.
One final thing to keep in mind when rolling over 401(k) funds into an IRA is whether the money is sent to you or directly to your IRA custodian. If your old 401(k) plan writes you a check, they are required to withhold 20% for the IRS. However, if you don’t deposit the full original amount into an IRA within 60 days, it will be considered a withdrawal and you may be penalized. For example, say you have a $100,000 401(k) you want to roll over. Your previous employer writes you a check for $80,000 because they are required to withhold $20,000, or 20%. You, however, are required to deposit $100,000 into your new IRA in order to avoid the penalty, so you have to find the remaining $20,000 somewhere else in order to complete the transaction. It is much easier to do a direct rollover, or trustee-to-trustee transfer, where your previous employer sends the money directly to the IRA custodian and nothing is withheld for taxes.
Traditional vs. Roth IRA: Which Works Best for Your 401(k) Rollover?
A Roth IRA often works well for younger investors who have time to let their savings grow and take full advantage of compounding, thanks to its favorable tax treatment. On the other hand, those closer to retirement who may need earlier access to funds might find a traditional IRA more practical. Some individuals choose a Roth IRA regardless of age to avoid required minimum distributions and leave a legacy for their loved ones.
If you’re considering an IRA rollover from your 401(k), selecting the right type of IRA can have a lasting impact on your financial future. Your personal goals, time horizon, and priorities should all factor into this decision. Our team at Premier Planning Group can provide clarity and help you make a confident choice.
Ready to roll over your 401(k) into an IRA? Call our office at (443) 837-2520 or email my executive assistant, Talia Grover, at taliagrover@premierplanninggroup.com to set up a complimentary consultation.
About Brion
Brion Harris is the CEO, founder, and managing partner of Premier Planning Group, an independent financial firm specializing in working with pre-retirees and retirees, helping them create customized wealth preservation and retirement distribution strategies. With over 20 years of experience, Brion has developed deep knowledge and skill in helping his clients simplify their finances and find confidence in their financial future. Brion and the Premier Planning team are known for their unparalleled client service and their dedication building long-lasting relationships with their clients. As a result, Brion has been the recipient of the #1 Advisor Leadership Award* at Summit Brokerage Services for eight years running and has a reputation as one of the top retirement advisors in the business.
Brion is a proud 20-year resident of the Annapolis community, where he resides with his wife, Elizabeth, their three children, Addison, Jay, and Scarlett, and their two dogs, Pepper and Coco. When he’s not working, you can find him boating, skiing, traveling, and enjoying good food and music with his family. If you want to learn more about Brion, connect with him on LinkedIn.
*The #1 Advisor and Leadership Award is based on production data while at Summit Brokerage Services, Inc. Brion Harris received the award in 2014, 2015, 2016, 2017, 2018, 2019, 2020 and 2021. This award is not a guarantee of future investment success. This recognition should not be construed as an endorsement of the advisor by any client.