401k's and what to do!
How to Decide Which Rollover Is Right for You
When you leave an employer for non-retirement reasons, for a new job, or just to be on your own, you have four options for your 401(k) plan:
Roll the assets into an Individual Retirement Account (IRA) or Roth IRA
Keep your 401(k) with your former employer
Consolidate your 401(k) into your new employer’s plan
Cash out your 401(k)
Let's look at each of these strategies to determine which is the best option for you.
Rolling Over Your 401(k) to an IRA
You have the most control and the most choice if you own an IRA. Unless you work for a company with a very high-quality plan—these are usually the big, Fortune 500 firms—IRAs typically offer a much wider array of investment options than 401(k)s.
Individuals with 401(k) plans have several options when leaving an employer: roll the plan to an IRA, cash out the 401(k), keep the plan as is, or consolidate the old 401(k) with a 401(k) at the new employer.
IRA accounts include a wider array of investment options compared to most 401(k) plans. The choice between a Roth IRA and a traditional IRA is a decision about paying taxes on the contributions now or paying them later. If an individual is in a low-income tax bracket now but expects to be a higher one in the future, the Roth IRA conversion might make more sense.
Leaving the 401(k) plan with the old employer is an option in certain situations, such as when the plan offers investment options that are not available in the new plan. Cashing out a 401(k) is typically not the best option because of the penalties for early withdrawals.
Some 401(k) plans have only a half dozen funds to choose from, and some companies strongly encourage participants to invest heavily in the company's stock. Many 401(k) plans are also funded with variable annuity contracts that provide a layer of insurance protection for the assets in the plan at a cost to the participants that often run as much as 3% per year. Depending on which custodian and which investments you choose, IRA fees tend to run cheaper.
With a small handful of exceptions, IRAs allow virtually any type of asset: stocks, bonds, certificates of deposit (CD), mutual funds, exchange traded funds, real estate investment trusts (REITs), and annuities.1 If you're willing to set up a self-directed IRA, even some alternative investments like oil and gas leases, physical property, and commodities can be purchased within these accounts If you opt for an IRA, then your second decision is whether to open a traditional IRA or a Roth IRA. Basically, the choice is between paying income taxes now or later.
The main benefit of a traditional IRA is that your investment, up to a certain amount, is tax-deductible now. You deposit pre-tax money into an IRA, and the amount of those contributions is subtracted from your taxable income.3 If you have a traditional 401(k), the transfer is simple, since those contributions were also made pre-tax.
Tax deferral won’t last forever, however. You must pay taxes on the money and its earnings later when you withdraw the funds.4 And you are required to start withdrawing them at age 72, a rule known as taking required minimum distributions (RMDs), whether if you’re still working or not. (RMDs are also required from most 401(k)s when you reach that age, unless you are still employed—see below.)5
Previously, RMDs began at age 70½, but the age has been bumped up following new retirement legislation passed into law in December 2019—the Setting Every Community Up for Retirement Enhancement (SECURE) Act.
In contrast, if you opt for a Roth IRA rollover, you must treat the entire account as taxable income immediately. You’ll pay tax now on this amount (federal income tax as well as state income taxes, if applicable). What’s more, you’ll need the funds to pay the tax and may have to increase withholding or pay estimated taxes to account for the liability.
However, assuming you maintain the Roth IRA for at least five years and meet other requirements, then all of the funds—your after-tax contribution plus earnings on them—are tax-free.6 7
If you are wondering whether a rollover is allowed or will trigger taxes, remember this basic rule: You're generally safe if you roll over between accounts that are taxed in similar ways (e.g., a traditional 401(k) to a traditional IRA, or a Roth 401(k) to a Roth IRA).
There are no lifetime distribution requirements for Roth IRAs, so funds can stay in the account and continue to grow on a tax-free basis.3 You can also leave this tax-free nest egg to your heirs. But those who inherit the account must draw down the account over the 10-year period following your death, as per new rules outlined in the SECURE Act.5 Previously, they could draw down the account over their life expectancy.8
If your 401(k) plan was a Roth account, then it can only be rolled over to a Roth IRA.9 This makes sense since you already paid taxes on the funds contributed to the designated Roth account. If that's the case, you don’t pay any tax on the rollover to the Roth IRA.7 To do a rollover from a traditional 401(k) to a Roth IRA, however, is a two-step process. First, you roll over the money to an IRA, then you convert it to a Roth IRA.
Keeping the Current 401(k) Plan
If your former employer allows you to keep your funds in its 401(k) after you leave, this may be a good option, but only in certain situations, says Colin F. Smith, president of the Retirement Company in Wilmington, N.C. The primary one is if your new employer doesn't offer a 401(k) or offers one that's less substantially less advantageous. For example, the old plan "may have investment options you can’t get in a new plan,” says Smith.
Additional advantages to keeping your 401(k) with your former employer include:
If your 401(k) plan account has done well for you, substantially outperforming the markets over time, then stick with a winner. The funds are obviously doing something right. Special tax advantages: If you leave your job in or after the year you reach age 55 and think you'll start withdrawing funds before turning 59½; the withdrawals will be penalty-free.11 Legal protection: In case of bankruptcy or lawsuits, 401(k)s are subject to protection from creditors by federal law. IRAs are less well-shielded; it depends on state laws.12
If you are going to be self-employed, you might want to stick to the old plan, too. It's certainly the path of least resistance. But bear in mind, your investment options with the 401(k) are more limited than in an IRA, cumbersome as it might be to set one up. Some things to consider when leaving a 401(k) at a previous employer: Keeping track of several different accounts may become cumbersome. Says Scott Rain, tax senior at Schneider Downs & Co., in Pittsburgh, Pa. “If you leave your 401(k) at each job, it gets really tough trying to keep track of all of that. It’s much easier to consolidate into one 401(k) or into an IRA.” You will no longer be able to contribute to the old plan and receive company matches, one of the big advantages of a 401(k)—and in some cases, may no longer be able to take a loan from the plan. You may not be able to make partial withdrawals, being limited to a lump-sum distribution down the road. Bear in mind that, if your assets are less than $5,000, then you may have to notify your plan administrator or former employer of your intent to stay in the plan; otherwise, they may automatically distribute the funds to you or to a rollover IRA. If the account has less than $1,000, you may not have a choice—many 401(k)s at that level are automatically cashed out.
Rolling Over to a New 401(k)
If your new employer allows immediate rollovers into its 401(k) plan, this move has its merits. You may be used to the ease of having a plan administrator manage your money and to the discipline of automatic payroll contributions. You can also contribute a lot more annually to a 401(k) than you can to an IRA.14 15 In 2020, employees can contribute up to $19,500 to their 401(k) plan. Anyone age 50 or over is eligible for an additional catch-up contribution of $6,500.15
Another reason to take this step: If you plan to continue to work after age 72, you should be able to delay taking RMDs on funds that are in your current employer's 401(k) plan, including that roll over money from your previous account. (Prior to the new law, RMDs began at 70½).5 The benefits should be similar to keeping your 401(k) with your previous employer.
The difference is that you will be able to make further investments in the new plan and receive company matches as long as you remain in your new job. Mainly, though, you should make sure your new plan is excellent. If the investment options are limited or have high fees, or there's no company match, the new 401(k) may not be the best move.
If your new employer is more of a young, entrepreneurial outfit, the company may offer a SEP IRA or SIMPLE IRA—qualified workplace plans that are geared toward small businesses (they are easier and cheaper to administer than 401(k) plans). The IRS does allow rollovers of 401(k)s to these, but there may be waiting periods and other conditions
Cashing out Your 401(k)
Cashing it out is usually a mistake. First, you will be taxed on the money as ordinary income at your current tax rate. In addition, if you’re no longer going to be working, you need to be 55 years old to avoid paying an additional 10% penalty. If you’re still working, you must wait to access the money without a penalty until age 59½.11
So aim to avoid this option except in true emergencies. If you are short of money (perhaps you were laid off), withdraw only what you need and transfer the remaining funds to an IRA.
Don’t Roll Over Employer Stock
There is one big exception to all of this. If you hold your company (or ex-company) stock in your 401(k), it may make sense not to roll over this portion of the account.
The reason is net unrealized appreciation (NUA), which is the difference between the value of the stock when it went into your account and its value when you take the distribution. You’re only taxed on the NUA when you take a distribution of the stock and opt not to defer the NUA. By paying tax on the NUA now, it becomes your tax basis in the stock, so when you sell it—immediately or in the future—your taxable gain is the increase over this amount. Any increase in value over the NUA becomes a capital gain.
You can even sell the stock immediately and get capital gains treatment. (The usual more-than-one year holding period requirement for capital gain treatment does not apply if you don’t defer tax on the NUA when the stock is distributed to you.)16
In contrast, if you roll over the stock to a traditional IRA, you won’t pay tax on the NUA now, but all of the stock’s value to date, plus appreciation, will be treated as ordinary income when distributions are taken
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy. Internal Revenue Service. "IRA FAQs - Investments." Accessed March 29, 2020. Zacks. "Placing an Oil and Gas Royalty in an IRA." Accessed March 30, 2020. Internal Revenue Service. "Traditional and Roth IRAs." Accessed March 29, 2020. Internal Revenue Service. "Topic No. 424 401(k) Plans." Accessed March 29, 2020. Internal Revenue Service. "Retirement Plan and IRA Required Minimum Distributions FAQs." Accessed March 30, 2020. Internal Revenue Service. "Publication 590-B Distributions from Individual Retirement Arrangements (IRAs)," Page 30. Accessed March 30, 2020. Internal Revenue Service. "Rollovers of Retirement Plan and IRA Distributions." Accessed March 30, 2020. AARP. "Did the SECURE Act Kill the Stretch IRA?" Accessed March 30, 2020. Internal Revenue Service. "Rollover Chart." Accessed March 30, 2020. Internal Revenue Service. "Retirement Topics - Exceptions to Tax on Early Distributions." Accessed March 29, 2020. Internal Revenue Service. "Topic No. 558 Additional Tax on Early Distributions from Retirement Plans Other than IRAs." Accessed March 30, 2020. Mesirow Financial. "Retirement Accounts Provide Protection Against Creditors," Page 1-2. Accessed March 30, 2020. Congress.gov. "S.256 - Bankruptcy Abuse Prevention and Consumer Protection Act of 2005." Accessed March 30, 2020. Internal Revenue Service. "IRA FAQs - Contributions." Accessed March 30, 2020. Internal Revenue Service. "401(k) contribution limit increases to $19,500 for 2020; catch-up limit rises to $6,500." Accessed March 30, 2020. Internal Revenue Service. "Topic No. 412 Lump-Sum Distributions." Accessed March 30, 2020. Internal Revenue Service. "Rollovers of Retirement Plan and IRA Distributions." Accessed March 30, 2020. Internal Revenue Service. "Topic No. 413 Rollovers from Retirement Plans." Accessed March 30, 2020.