Start Rolling Over Your 401K to an IRA

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When it comes to a 401K, you can take it with you from job to job, and in fact, you should, and it should be in the form of a 401K 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 rollover a 401K 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.

What are 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 alone. If your previous employer allows, you can leave the plan right where it is. However, it 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 401K fees as an ex-employee. So really, 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 it out. But be cautious with this option, because not only can 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 401K — even the fresh, shiny one at your new employer — which often has tightly curated investment options and administrative fees.

Should you 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, and which type of IRA you want, a traditional IRA or a Roth.

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 401K, a type of 401K that mimics the tax treatment of a Roth IRA. You cannot roll a Roth 401K into a traditional IRA, but you can roll it over into a Roth IRA tax-free)

Once it’s 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.

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