What is a 401(k) rollover?

401(k) Plan

Today, 401(k) plans are the primary retirement savings vehicle for most Americans. It offers significant tax benefits, especially when compared with traditional savings plans like IRAs.

401(k) accounts allow participants to reduce their taxable income by deferring taxes on income that would have otherwise been subject to income tax. It also allows contribution on a pre-tax basis. 401(k) contributions must be counted as income only when 401(k) distributions are taken.

Wages are generally included in employees’ taxable income, but 401(k) contributions are deducted from wages for all participants. 401(k) contributions are not counted as income, meaning that 401(k) contributions reduce taxable income.

Contributions are deducted from gross wages before taxes are calculated, so 401(k) deferrals have no impact on an individual's taxable income or tax liability.

401(k) Rollover

A 401(k) rollover is moving assets from one account to another. When a 401(k) participant retires or separates from the company, they have a choice of what to make with their 401(k) savings.

401(k) Portability

These plans are portable, meaning that 401(k) participants can take their 401(k) plans when they change jobs. Here are options you can choose from when changing jobs before retirement:

• Keep your plan with your former employer
• Transfer your plan to your new employer
• Rollover your plan into Individual Retirement Account (IRA)
• Cash out from your plan
  
  

The first three options do not entail losing a portion of your savings; however, you will be subject to a mandatory 20% withholding rate plus early withdrawal penalties for the last option.

How It Works

Rolling over a 401(k) means transferring all or part of these plans into an IRA or another employer-sponsored plan such as a qualified pension, profit-sharing, simplified employee pension (SEP), or another 401(k) plan.

You can either have the money sent directly to the new plan or IRA, or take possession of the funds and do the rollover yourself. However, if you choose to do the rollover yourself, you must complete it within 60 days of receiving the distribution.

Direct Rollover

A direct rollover is when the money goes straight from your old account to your new account without touching your hands. This is usually done by your former employer sending the money directly to your new 401(k) plan or IRA account.

The advantage of this method is that there are no tax consequences since the money never hits your wallet. You will still have to pay taxes on the funds once you withdraw, but you will not incur a penalty from the IRS since you did not receive a distribution from your old 401(k) account.

Indirect or 60-Day Rollover

A 60-day rollover is when you take possession of the funds and then redeposit it into an IRA or new employer plan within sixty days. The benefit of taking possession of the assets yourself is that this gives you enough time to determine whether a direct rollover is allowed.

For instance, if your new employer's plan does not accept incoming rollovers, there would be no reason for them to complete a direct rollover; so instead, they may send the funds to you, and you would have to do a 60-day rollover.

The downside of this option is that if the funds are not deposited back into an IRA or new employer plan within 60 days, the money will be treated as a taxable distribution. You will likely have to pay a 10% penalty for withdrawing funds before retirement.

Keeping Your 401(k) Plan with Your Former Employer

This option is like keeping your account in the same 401(k) plan or retirement home. You will continue to defer income taxes on 401(k) contributions, but 401(k) contribution limits are now applied to your account.

You can keep your 401(k) account with your former employer's plan by notifying the company's administrator. This request should be made in writing, either by mail or e-mail, and this option is not always available.

Your plan administrator must approve 401(k) rollovers.

Transferring Your 401(K) To Your New Employer

This 401(k) rollover option allows plan participants to transfer assets from their 401(k) account to a new employer's 401(k) plan. This  rollover is subject to 401(k) rules, so contribution limits apply when transferring assets.

If you have decided to transfer your 401(k) plan to your new employer's plan, you have to do these things:

1. Arrange the rollover with your new 401(k) plan administrator. You may want to choose the investment you would like beforehand or transfer the lump sum and gradually allocate it to the investment vehicle you want to complete the rollover.
2. Ensure that all forms required to rollover your previous employer’s plan are complete.
3. Ask your previous plan administrator to send a check or transmit your account value electronically to your new plan administrator.

Rolling 401(k) Assets Into An IRA

Rolling over your 401(k) Plan into an IRA is also an option when you retire or switch a job for any reason. Here are several direct rollover options:

Traditional 401(k) To A Traditional IRA

You can roll your traditional 401(k) assets into a new or existing traditional IRA. If you have decided to move your 401(k) funds into a traditional IRA, income taxes will be deferred until the money is taken out of the account in retirement.

The money is moved directly, either electronically or by check. No taxes are due on the assets you move, and any new earnings accumulate tax deferred.

When rolling over 401(k) assets to an IRA, the 401(k) plan administrator will send your 401(k) account balance to your IRA custodian. Depending on the financial institution where you have established your IRA, you may be required to establish an inherited IRA if you have inherited a 401(k).

You will need to complete Form 1040 and Form 4972 if you are under 59.5 and have elected to take a 401(k) distribution as a lump sum instead of annuity or installments.

Traditional 401(k) to a Roth IRA

You may also roll 401(k) assets into a Roth IRA. If your traditional 401(k) plan permits direct rollovers to a Roth IRA, you can rollover assets in your traditional 401(k) to a new or existing Roth IRA; however, you will have to pay taxes on the rollover amount you convert.

The 401(k) funds must be in a qualified plan to be eligible for this option. A traditional 401(k) is taxed when taken out of the account, while a Roth 401(k) is not.

When rolling over 401(k) assets to a 401(k) IRA, the 401(k) plan administrator will pay your 401(k) account balance to your IRA custodian.

Roth 401(k) to a Roth IRA

One of the most popular 401(k) rollover options is to convert Roth 401(k) assets into a Roth IRA.

The benefit of rolling over your Roth 401(k) to a Roth IRA is that earnings are no longer taxed when you take withdrawals in retirement.

Another advantage of rolling over 401(k) funds to a Roth IRA is that you can contribute Roth 401(k) funds to a Roth IRA, and the annual contribution limits apply.

Cash Out 401(K)

This 401(k) rollover option allows 401(k) plan participants to cash out 401(k) assets. 401(k) money is distributed as a lump sum and is subject to tax withholding and early withdrawal penalties if the participant has not reached the retirement age of 59 1/2.

Reasons to Do a 401(k) Rollover

There are several factors that you would want to consider when doing a rollover of your 401(k) plan.

Consolidate Assets Into One Account

When you choose 401(k) rollover options, 401(k) assets will be consolidated into one account. You will then have just one plan administrator and one 401(k) custodian to deal with if you want to change your 401(k).

Reduce Management Fees

Rolling 401(k) assets into an IRA or 401(k) can lower your management fees by reducing the number of different 401(k)s and IRAs you have.

Avoid Penalties and Taxes

401(k) rollovers allow you to avoid the 10% penalty for early withdrawal, and possible ordinary income taxes if you have not yet reached age 59 1/2.

Access More Investment Choices

When 401(k) funds are rolled over to an IRA, you have the flexibility of choosing from several different 401(k) providers and additional investing options.

The Bottom Line

A 401(k) rollover is the process of moving assets from one retirement account to another. It is a great way to consolidate your assets, reduce management fees, avoid penalties and taxes, or access more investment choices.

The different 401(k) rollover options are as follows:

Direct rollover is when the money goes straight from your old account to your new account without touching your hands:

• Direct rollover is when the money goes straight from your old account to your new account without touching your hands.
• Indirect or 60-Day Rollover is when you take possession of the funds and then redeposit it into an IRA or new employer plan within sixty days.
• You can also opt to let your former employer keep the money in the plan for you.
• Another option is transferring your 401(K) to your new employer's plan.
• With the traditional 401(k) to a traditional IRA rollover, income taxes will be deferred until the money is taken out of the account in retirement
• Roth 401(k) to a Roth IRA Rollover allows your earnings to no longer be taxed when you take withdrawals in retirement.
• Traditional 401(k) to a Roth IRA Rollover is possible but you’ll have to pay taxes on the rollover amount you convert
• Cash Out is when you receive a distribution of the money in your account and will be subject to income taxes and possible penalties.
  
  

With several 401(k) rollover options to choose from, be sure to consult with a financial advisor to find the best option for you.

FAQs

1. What is a 401(k) rollover?

A 401(k) rollover is the process of conducting a 401(k) transfer, moving 401(k) assets from your 401(k) plan to another investment account.

2. Why would you want to Do a 401(k) rollover?

The benefits of 401(k) rollovers are that they give participants access to 401(k) assets without early withdrawal penalties and allow 401(k) plan participants to consolidate 401(k) assets into one 401(k) account.

3. What is a direct rollover?

Direct 401(k) rollover refers to 401(k) plan assets being immediately moved from 401(k) plans into 401(k) accounts with new 401(k) providers. 401(k) direct rollovers are initiated through your 401(k) service provider.

4. What is an indirect rollover?

An indirect 401(k) rollover, also known as a 60-day rollover, occurs when 401(k) assets are distributed to 401(k) plan participants, and only then the participants deposit the 401(k) assets into another 401(k).

5. How do you do a 401(k) rollover?

There are two ways to move 401(k) assets into IRAs or 401(k)s with new providers through a direct or indirect rollover.