Everything You Need to Know About 401(k) Rollovers

Everything You Need to Know About 401(k) Rollovers

When you leave a job, you may leave behind your stapler and your computer ... but in most cases, you shouldn't leave your 401(k).

Since it doesn't exactly fit into a cardboard box, bringing your company-sponsored retirement fund with you is a little more complicated. The process is called a "rollover," and it means moving money from one retirement account into another.

How do you do this? And why should you bother?

What Are My 401(k) Rollover Options?

As we know, a 401(k) is a company-sponsored retirement fund that your employer provides, and your 401(k) contributions are automatically withdrawn from your paycheck before it hits your bank account. Sometimes companies will also provide a company match, which means that if you contribute to your account, they'll pitch in some money to give you an added incentive to save.

When you're leaving a company, you have four options for your 401(k):

  1. "Cash out" or withdraw the money from the account (not a good plan)
  2. Roll the money over into an IRA (individual retirement account, which isn't employer-sponsored)
  3. Roll the money over into a new 401(k)
  4. Leave the money in that account

Why You Shouldn't Cash Out

A 401(k) is a retirement fund, so if you withdraw funds before the age of 59 ½, you'll pay an early withdrawal penalty and the funds will be taxed as regular income. The penalty is 10%, plus taxes on any investment gains. If you cash out, not only will your money stop growing, but you'll end up with less money after paying all of the taxes and fees.

Also, while the nature of the stock market means that no one can guarantee investment growth, it stands to reason that a larger fund would earn you more investment gains over a long time horizon.

For example, imagine that you had a 401(k) totaling $10,000 in funds when you leave your job at Alpha Corp for another opportunity at Beta Corp. You "cash out" your 401(k) when you leave Alpha. A few years later, you have a 401(k) with Beta Corp of $20,000, which earns a 7% annual return on its investments ($1,400) after 12 months.* Had you rolled the $10,000 from your Alpha fund into the Beta fund, bringing your total to $30,000, you'd have earned $2,100 in investment gains in the same 12-month period. While that may not seem like a big difference, five years later, assuming that the fund continued to earn 7% a year, the account that started with $30,000 would have about $3,500 more than the account that started with $20,000.

When You Should Roll Over Your Old 401(k) Into a New 401(k)

Mistakenly, some people think that the money from their 401(k) has to stay with the company that established the account. In fact, you're allowed to take it with you by converting or "rolling over" that money into a 401(k) at your new place of employment (or into an IRA, the benefits of which are described below).

By rolling over your old 401(k) into your current account, and consolidating these accounts, it means that you only need to monitor the activity for one account, rather than track multiple retirement accounts from different stages in your life. If you don't have a new 401(k), you can also consolidate accounts by rolling the money into an IRA.

When You Should Roll Over Your Old 401(k) to an IRA

There are a few instances in which you should consider doing a rollover to an IRA.

  1. When you're paying high fees just to keep your old 401(k) open. Most companies pay a brokerage firm to manage the investments of their 401(k)s, which is a cost known as management fees. It can be high--usually about 1% to 2%. Some companies will charge a maintenance fee to cover the cost of management, so by rolling your 401(k) into an IRA and managing the portfolio yourself, you will save money. In addition, by choosing mutual funds with lower expense ratios (think 0.5% or lower), you can save even more. To figure out which funds have lower expense ratios, check Morningstar.com.
  2. When you don't like the investment options in your 401(k) plan. Putting the money in an IRA will give you hundreds, if not thousands, of more investment options. For example, if you want to have a portion of your retirement account invested in alternative investments, such as real estate or commodities, and your 401(k) provider doesn't offer an alternative investment option in your 401(k), then you might want to do a rollover so you can put a portion of your retirement account in this asset class.
  3. When you are in a low tax bracket or early in your career, and you can roll your 401(k) money into your Roth IRA. This is called a Roth Conversion, and you will have to pay taxes on the amount that you convert, but this could save you a lot in taxes later on because you'll be able to withdraw your money tax-free after age 59 ½--this means that you won't pay taxes on the investment gains. (A rollover of this type was prohibited until recently, but most brokerages now allow you to roll a 401(k) into a Roth IRA. Just make a point to call your brokerage firm first.)

When You Should Leave Your 401(k) Where It Is

You don't have to roll over your 401(k) now or ever. You can leave it with your company when you move on--and still be permitted to roll it over a few years down the line. Why would you want to wait? Well, there are a few reasons:

  • You want to recoup losses. 401(k)s are invested, whether in stocks, ETFs or mutual funds, so there's a possibility that you could lose money when you withdraw if the balance is less than what you initially put in. The only way to remedy this situation is to leave the money in your 401(k) and let time smooth over the damages. Once you've earned back the money you lost, you can roll over the money in your old fund into your current account. The current investments must be sold in order to do a rollover to a new retirement account.
  • You like the investments. Since your employer controls your 401(k), your employer chooses which investments you can select from when making elections. When you enroll in a new company's 401(k), you're limited to the investments that the employer offers. If you like the selection that you have at Alpha Corp more than what's offered through Beta Corp, you can leave your money in the Alpha fund. Or you can roll over your 401(k) into an IRA, investing it where you see fit.

How Do I Get Started?

If you choose to roll over your 401(k), start by contacting your company's HR department and request "distribution paperwork," which you need to fill out in order to roll over your account. (Note: The process is a little different at every company.) You can also reach out directly to the brokerage firm hosting your new retirement account--the one you're "rolling into." Remember that they field 401(k) questions every day, so they're happy to help.

If you want to roll over your 401(k) into an IRA instead, look into discount brokerage firms to set one up. And be aware that there is no such thing as a joint IRA--whether or not you're married, your retirement savings can be in one name only. You can use this handy checklist to establish your IRA.

*Figures calculated here.

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