How to Roll Over a 401k into an IRA?
If you’re covered under a 401k plan at work, odds are you will do a 401k Rollover sometime during your working career. Why? Most people change jobs at least once during their working years. A lot people change jobs a number of times. Once you change jobs, you will be faced with the decision of doing a 401k rollover into an IRA. Or, you might have the decision made for you by your former employer. Rollovers are easy if you give some thought to setting up the right type of IRA, and doing the transfer correctly.
Why Roll Over Your 401k into an IRA?
There are two main reasons why you should roll your 401k balance when you leave an employer:
1. When you leave a company, and therefore no longer an active participant in the 401k, many plans state that you have to move your 401k plan somewhere else. They do this to save money. If you’re not an employee any more, why should they incur the administrative expense of having to track your 401k balance? While there are rules allowing you to keep to your balance in the plan, most companies do everything possible to encourage you to transfer your account elsewhere. If you join a new Company that has a 401k plan, you can move your balance into the new plan.
2. If your new company has no 401k plan, or if you simply want to, you can move your 401k assets into an IRA. The advantage of doing this is that an IRA gives you much more investment flexibility – you can invest in almost anything you want. In a 401k, you are limited to the funds offered by the plan sponsor.
The theory of income tax is pretty easy. If you earn money, it will be taxed, either now or later – but it will be taxed at some point. There are some loopholes, but in general, the theory holds true.
Regular 401k – Pre Tax
You may have a regular 401k at a former employer to which you contributed and your employer put in matching funds. This is considered a regular Pre-tax 401k plan that most people know about.
Employer Matching Contributions – Tax status is easy. Your employer adds money to your 401k on your behalf, and it doesn’t show up on your W-2. Since you haven’t been taxed on the money yet, you get hit with tax whenever you withdraw funds.
Your contributions – I always hear that people make “tax deductible contributions” to their 401k. This is technically wrong, though the thought is right. The amount you contribute to a 401k reduces the amount of salary shown on your W-2 each year. Since your salary is less, you pay less in income taxes. You don’t “deduct” the contribution from your taxes. The contributions reduce the amount of salary subject to tax – which is a bit different, but has the same general effect.
The bottom line is that your Regular 401k contributions have a tax status of Pre-Tax or “yet to be taxed dollars”. They have not been taxed, and will not be taxed until you withdraw money from the 401k. The IRS is very patient – they will wait for 30-40 years to get their tax cut of your money. But in the end, they always get their cut. Remember this point since it governs everything that happens in IRA rollovers or conversions.
The Roth 401k is the new guy on the block. Starting in 2006, your employer was able to add a Roth option to your 401k plan. Essentially, you were/are given the option of electing how your contributions would be considered for tax purposes. You could continue to put in money, get a tax break and have your money taxed when you withdraw it (Regular 401k – Pre Tax). Or you make contributions after-tax, get no tax break, but have all money come out tax free when you retire (Roth 401k – After-Tax).
Again, remember the tax status of your contributions, either Pre-Tax Regular 401k or After-Tax Roth 401k contributions, as we move on to rolling over your account to an IRA.
What type of IRA Can I Open?
There are two types of IRA’s:
Traditional IRA – this is your normal IRA where you received a tax break on any money you put in, and get taxed when you take the money out at retirement. Tax status of money in a Traditional IRA is similar to a Regular 401k. Your contributions aren’t taxed until you withdraw the money.
Roth IRA – here you put in after-tax dollars, and when you retire, all withdrawals are received tax free. The tax status of your contributions is the same as in a Roth 401k – you put in after tax money and will get withdrawals tax free.
Why do I make a big deal of Tax Status? When you do a rollover of your 401k money into an IRA, the tax status needs to remain the same, unless you are willing to pay taxes as though you made a withdrawal.
If you want to make a tax free rollover:
• A regular Pre-Tax 401k must be rolled into a Traditional IRA
• An After-Tax Roth 401k must be rolled into a Roth IRA
These moves preserve the tax status of the money. Your regular 401k money and your Traditional IRA money will all be taxable when you eventually take the money out. Your Roth 401k money and your Roth IRA money has already been taxed and will eventually come out tax free.
You might have heard about Roth IRA conversions, in which people roll their money form a Regular 401k or a Traditional IRA into a Roth IRA. This is done to change the tax status of money and involves paying income taxes now, at the time of conversion. There are good reasons for doing this, and the subject is discussed in What is a Roth IRA Conversion and How Does it Work?
In this article, I am assuming you want to move your 401k into an IRA and not pay any income taxes until you retire or withdraw your money later on.
How to Move Your 401k into an IRA without it Being Taxable
It’s pretty easy to rollover your 401k into an IRA.
• When you open an IRA account, whether you choose a Roth or Traditional depends upon the tax status of your 401k money. So if you are in a Regular 401k, open a Traditional IRA. If you are in a Roth 401k, open a Roth IRA.
If you are moving Cash from the 401k, you can open the IRA anywhere you want – bank (for a savings account or CDs), Brokerage Firm (if you want to invest in securities), or Mutual Fund Company (to invest in funds).
If you are moving company stock from your 401k, you need to open the IRA at a Brokerage Firm who can accept securities. Read: Choosing the Right Manager for Roth or Traditional IRA Investments
• Fill out the forms at your former employer telling them to move the assets directly into your new IRA.
*** Do NOT have your employer cut you a check so that you can deposit it into the new IRA. Have it sent directly to your IRA account. ***
If your employer makes the check out to you, they are obligated to withhold 20% of the amount, and submit this to the IRS. You would get the money refunded when your income taxes are filed for the year. However, the IRA Withdrawal Rules are strict, and say that IRA funds must be deposited within 60 days or you will have a penalty of 10% plus whatever other taxes are due. So, you will have to make up for the 20% out of your own pocket to fully fund the new IRA within 60 days. If you don’t have this large amount lying around in a savings account, you will be penalized 10% on the 20% that went to the IRS as though you had withdrawn the money early.
So, be sure to tell your former employer to move your 401k assets directly to your new IRA provider so that no tax withholding is necessary. This will prevent the above problem.
If your former employer refuses to make a direct transfer, and will only cut you a check, tell the employer to make out the check to your new IRA provider with the notation “investment for John Doe 401k rollover…” This will stop you from being able to deposit the check in your checking account. Simply send the check to your new IRA provider since it is made out to them.
• Check with your new IRA provider that the funds were received and put in the correct account. Money does get side tracked sometimes, and you don’t want to find out in 6 months that the money never arrived.
A 401k Rollover is easy if…
As you can see, the process is very easy. Your new IRA provider will handle most of the transfer aspects. Your former employer will be glad to get rid of your account.
The process is easy IF you put in the necessary thought before the transfer .Ensure the rollover is going in an account with the same tax status. Make sure you don’t get your hands on the money during the process. Confirm the money ended up in the right place.