What are 401(k) rollovers?
401(k) rollovers are the transfer of funds contained in a 401(k) plan to either another 401(k) or other retirement accounts. 401(k) rollovers are carried out for a variety of reasons. For example, a rollover might provide an investor with more investment choices or tax benefits. Per existing regulations, you can only perform one 401(k) rollover to a retirement account per calendar year. However, there is no limit on rollovers between different 401(k) accounts. 401(k) rollovers should be analyzed before being implemented.
Basics of 401(k) Rollover
There are several reasons why an individual might be interested in a 401(k) rollover. Some of them are outlined below:
- Change of jobs: This is the most common reason for carrying out a 401(k) rollover. Each employer has different 401(k) providers and a change of jobs might require you to migrate funds from a previous plan to the new one.
- More investment choices and lower fees: As compared to traditional IRAs, most 401(k) plans offer fewer choices for investing your life’s savings. 401(k) plans are also expensive. They pass on management fees from providers to account holders and those costs can add up over a period of time, eating into the gains made by funds in the accounts. Retirement accounts like traditional IRAs are relatively cheaper in comparison.
- Tax benefits: Depending on the type of instrument that the funds are rolled over to, moving funds from a 401(k) account to another account comes with tax benefits. For example, rolling over funds from a 401(k) account to a Roth IRA provides tax-free retirement income because Roth accounts are funded with after-tax income. Distributions from 401(k) are also taxed at a higher rate as compared to retirement account distributions, making it sensible to rollover funds from a 401(k) account to retirement accounts.
- Consolidation of accounts: Most job changes are accompanied with the creation of new 401(k) accounts. The balance in each of these accounts can build up. 401(k) rollovers simplify account and funds management by enabling you to consolidate multiple accounts into a few or, possibly, a single entity.
You must complete a 401(k) rollover to a traditional IRA within 60 days. The IRS will waive the time period, if the financial institution responsible for the waiver received funds before the end of 60-day period and failed to deposit them into the new IRA, in spite of your instructions. The fee for requesting an automatic waiver is $10,000.
Steps to a 401(k) Rollover
Broadly, there are four steps to a 401(k) rollover. They are outlined below.
- Determine your goals with a 401(k) rollover: Before actually implementing a 401(k) rollover, you must analyze your goals with the rollover. This is an important step as it will determine your plan of action and the steps you will take to accomplish that goal. For example, if you are interested in tax benefits then it makes sense to rollover your funds into a Roth IRA instead of a traditional IRA. Similarly, if your 401(k) rollover goal is to boost your retirement account holdings through trading, then you might want to opt for a retirement account with a brokerage. Generally, these accounts charge very less fees and are designed to maximize trading opportunities for account holders.
- Determine the type of account for your 401(k) rollover funds: Depending on your comfort level with trading, you can opt for self-directed accounts, in which the account holder is responsible for making investment decisions. The alternative to such accounts are managed accounts, in which the plan administrator makes decisions relating to investment and charges a fee for it. In recent times, the growth of index funds has led to robo-advisors becoming popular within retirement accounts. Robo-advisors simplify investing decisions by setting aside a certain amount of money to be invested in funds periodically, depending on criteria specified by the investor. For example, an investor may specify monthly contributions to an ETF of his or her choice.
- Select the type of 401(k) Rollover: There are two types of 401(k) rollovers: Direct and Indirect. In a direct rollover, funds are transferred between retirement accounts without being touched by the account holder. The funds are transferred between retirement accounts based simply on instructions (and the completion of a couple of forms) by the account holder. The direct rollover is considered easy and convenient and is generally recommended for transfers by financial planners. However, certain circumstances may necessitate the use of indirect transfers. For example, indirect rollovers are a good option during times when you need cash urgently. In an indirect rollover, the retirement account agency cuts a check directly to you and withholds 20% tax, as required by law, on the funds. Thereafter, you have a 60-day period during which you must deposit the withdrawn funds to the new account. The funds must be made whole again, meaning the balance in your new account must equal that of the old. For example, an indirect rollover of $100,000 from a 401(k) account incurs 20% tax, equaling to $20,000. Therefore, the 401(k) provider will give you a check for $80,000. You must add another $20,000 before depositing it into the new account within the 60-day period. If the funds are not deposited in 60 days, then the IRS slaps a 10% penalty plus income tax on the funds.
- Select your investments: Once you have decided on the type of rollover, it is time to execute the rollover and select the investments. Similar to step 1, this step ties back to your investment goals. Most 401(k) plans and retirement accounts offer a menu of low cost ETFs, index funds, and bonds for trading. At some brokerages and funds, you can also trade stocks. There are no fees if you trade online but using a phone brokerage generally incurs fees. Accounts that offer robo-advisors generally ask a set of questions related to your retirement goals to offer a custom menu of options.