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How to Roll Over a 401(k) to an IRA

How to Roll Over a 401(k) to an IRA

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Lee Huffman
Updated August 30, 2022
7 Min Read

When you leave a job, don't forget one of your most important assets – your retirement account savings. Every year you save a portion of your paycheck into your 401(k) so that you can have a more fulfilling retirement. Many people also receive a company match to boost their savings. While there are a few advantages to keeping your company retirement account where it's at, there are often even more reasons to roll over your 401(k) to an IRA.

What is a 401(k) rollover?

A 401(k) rollover is the process of transferring money from a former employer's retirement plan to another retirement plan. Usually, employees transfer their savings to an Individual Retirement Account (IRA), but some investors roll over the balance to their new employer's retirement plan.

When you perform a rollover correctly, there are no penalties or tax implications. If mistakes are made, you may incur a penalty and your entire balance could become taxable.

There are several common reasons why people request a 401(k) rollover. Some companies require ex-employees to transfer the money, especially if the balance is relatively low. Many investors roll over their retirement savings to expand their investment options or to use lower-cost investment options. While others prefer the simplification of having fewer accounts to manage.

How to rollover a 401(k) to a Traditional IRA

When you want to roll over your 401(k) to an IRA, there are certain steps that you must follow to avoid penalties and to ensure that you don't trigger a tax event.

Many companies proactively send out a letter informing an ex-employee of their retirement plan options, but not all do this. After you have left the company, you can request a rollover from the company's retirement plan to your desired retirement plan.

There are three ways to complete a rollover:

  • Direct rollover. The company retirement account will transfer the 401(k) balances to the investment company of your choice. A check may be sent to you, but it will be made payable to your new retirement account and you'll need to forward the check to them. No taxes will be withheld, so the full amount of your balance will be sent to your new retirement account. This is the best option for most investors.
  • Trustee-to-trustee transfer. If your new retirement account allows it, you can transfer all of your current investments directly into your new account. This avoids liquidating the investments into cash and reinvesting the cash into investments offered by your new investment company. Some 401(k) accounts offer share classes that are not available to IRAs, so this may not be an option for many investors.
  • 60-day rollover. A check is paid directly to you for the balance of your retirement account minus withholding for taxes. The typical withholding amount is 20% of the balance, which can be a significant amount depending on your retirement savings. To avoid taxes and potential penalties, you must deposit the full balance into your new retirement account within 60 days, which means you have to cover the taxes withheld out of your personal funds.

Investors who transfer cash into their new retirement account must choose how to allocate their investments. Most IRA accounts offer a much greater variety of investment choices than a 401(k), so the process can be overwhelming for some investors. Many investors decide to choose investments on their own, while others benefit from having professional advice.

What are the pros & cons of rolling over a 401(k) to an IRA?

When considering rolling over your 401(k) balance to an IRA, it pays to know the pros and cons of this decision. While it is generally considered a smart financial move, it doesn't make sense for every investor.

Pros

  • More investment choices. Most IRA accounts have a wider array of investment options than the average of 28 in a 401(k). Investors can also transfer funds into a self-directed IRA to invest in real estate and other non-traditional investments.
  • Lower cost options. An IRA has access to lower-cost options, such as ETFs and index funds, that can reduce the expenses of investing through a company retirement account.
  • Convenience. When all of your investment accounts are with one company, it is easier to keep track of your investments and reduces the number of statements that you'll receive.
  • Future contributions are allowed. As long as your income allows, you may continue to contribute to an IRA. Once you have left your previous employer, you may not make additional contributions to their company retirement account.

Cons

  • No loan provisions. When you transfer your previous 401(k) to your new company retirement plan, you may be able to borrow against the balance. IRAs do not allow investors to borrow from their accounts.
  • Early retirement options. Company retirement accounts allow for penalty-free withdrawals if you retire the year you turn 55 or older. Owners of IRAs can start early retirement withdrawals, but the process is more complex.
  • Protection from creditors. Company retirement plan assets are generally protected from judgments by creditors. The protection of IRAs varies by state and there may be a cap as to what is protected.

What about 401(k) to Roth IRA conversions?

A 401(k) is an excellent way to save for retirement through tax deductions today and tax-deferred growth until you start making withdrawals in retirement. However, with tax rates at historical lows today, many people want to take advantage of the current tax rules and convert their traditional 401(k) into a Roth IRA to have tax-free growth and withdrawals in the future.

While tax-free income is appealing, you will have to pay taxes on the amount you convert, and converting your 401(k) to a Roth IRA requires extra steps.

Tax implications

Any amount that you convert today will be taxed at today's income tax rates. If you're in a high tax bracket or nearing the top of your current tax bracket, a conversion could result in a large tax bill that you aren't ready for.

You do not have to convert all of your balance at once. Your retirement savings can be converted a little at a time if that makes it easier for you to handle the income taxes that are due on the conversion.

2-step Process: From 401(k) to Traditional IRA to Roth IRA

To make the conversion happen, first, you'll need to roll over your traditional 401(k) to a traditional IRA, otherwise known as a rollover IRA. This brings the money out of your company's 401(k) plan and moves it to the investment company of your choice. Now that the money is in the rollover IRA, you can convert it to a Roth IRA.

How to reduce the tax hit when converting to a Roth IRA

When you convert your 401(k) to a Roth IRA, you will owe taxes on the balance that is converted. There are some steps that you can take to reduce the tax bill.

Wait until your income is lower

By timing the conversion to years when your income is lower, you'll benefit from lower tax brackets. This is an excellent opportunity for people who are taking a sabbatical, are laid off from work, or a salesperson or business owner whose income fluctuates.

Maximize your tax brackets by converting a portion at a time

Most people's incomes allow them to make more money before being taxed at a higher income bracket. You can take advantage of this capacity for additional income by converting a portion of your income at a time. If your income is $20,000 less than the current tax bracket ceiling, you can convert $20,000 to a Roth IRA without paying a higher percentage in taxes. It is best to consult with a CPA or tax preparer in the 4th quarter of the year to discuss this opportunity and calculate how much you can reasonably convert.

Avoid the Net Investment Income Tax

When your modified adjusted gross income (MAGI) exceeds $200,000 ($250,000 for married filing jointly), you'll pay a 3.8% Medicare tax on regular and investment income over that amount. If you convert a large portion of your 401(k) into a Roth IRA all at once, your income could exceed this threshold and you'll owe additional taxes on regular income, dividends, interest, passive income, annuities, royalties, and capital gains.

Move to a low-tax state

In addition to being taxed by the federal government, state governments want their share of taxes too. If you live in a high-state income tax area, consider moving to a low-tax state. This avoids state taxes on the conversion to a Roth IRA.

Many retirees move to no state tax states, like Florida, Nevada, and Tennessee. This reduces their cost of living and avoids paying state income taxes on their retirement income.

The Five-Year Rule

One of the advantages of Roth IRA investing is that you can withdraw your contributions without penalty before retirement age as long as your account has been open for at least five years. This is known as the Five-Year Rule.

This strategy is used by many early retirees to supplement their income before they reach 59 1/2. They can continue to let the rest of their contributions and earnings grow tax-free, yet have access to their contributions to fund their lifestyle today. Once they reach 59 1/2, investors can withdraw from Traditional and Roth IRAs without paying the 10% early withdrawal penalty.

FAQ

Can you roll over 401k to an IRA without penalty?

When you roll over your 401(k) directly from your company retirement account to an Individual Retirement Account (IRA), there is no penalty and there are no taxes owed.

Can I move my 401k to a Roth IRA?

Yes, you can move a traditional 401(k) to a Roth IRA, but this is usually a two-step process. First, you'll roll over your traditional 401(k) to a traditional IRA. Then, you'll convert your traditional IRA into a Roth IRA. When you do this, the amount converted is considered taxable income. Many people convert only a portion of their IRA balance each year to avoid going into a higher tax bracket.

Should I convert my 401k to a Roth IRA?

There are many reasons why investors choose to convert their retirement accounts into a Roth IRA. Roth IRA balances grow tax-deferred and all withdrawals in retirement are tax-free. Additionally, there are no minimum withdrawal requirements, so retirees can let the money continue to grow in a tax-advantaged account. Traditional IRAs have required minimum withdrawals starting at 72 years of age, whether you need the money or not.

How do I avoid taxes on a Roth IRA conversion?

Because traditional 401(k) balances were contributed pre-tax, when the money is withdrawn or converted to a Roth IRA, taxes are due. While you cannot avoid these taxes, you can minimize the taxes owed in a few ways. The first is to make conversions in years where you have a low income. Another way is to convert only enough to stay within your current tax bracket. Reducing your income through tax deductions and tax credits provides more capacity to convert your retirement accounts into a Roth IRA.

How much money can I roll over from 401k to Roth IRA?

There is no limit to how much you can roll over from your 401(k) to a Roth IRA. The only limit is how much you are willing to pay in taxes on the conversion. Because taxes are owed on the amount converted, most investors choose to convert a portion at a time. This avoids going into the next tax bracket and paying a higher income tax rate.

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