How to Roll Over Your 401(k)
When you leave a job, you have to decide what to do with your 401(k). Your choices: Leave it where it is (this makes sense if you like the investment options offered by the plan), roll it over to a qualified retirement plan at a new employer (if you get a new job and the new employer accepts rollovers and you like the investment options in the new plan), or roll it over to your own IRA (if you want maximum control over your investment options). If you want to transfer funds from your 401(k) to a qualified plan of a new employer or to your IRA, you have two options, each with its pros and cons, and some wrinkles to consider.
If your retirement plan is making a distribution to you, ask the plan’s trustee to make the payment to another qualified retirement plan or IRA, which is a direct rollover. You usually have to complete some paperwork verifying that you want the plan administrator or trustee (the person in charge of the plan) to make this transfer. You can roll over all or only part of the funds eligible for a distribution.
Pros. Usually, distributions from a qualified retirement plan are subject to an automatic 20% withholding tax, but a direct rollover avoids withholding. Even if the plan sends you a check, as long as it is payable to the new plan or IRA, it is treated as a direct rollover and there is no withholding.
Cons. It may take time for the trustee to process your paperwork and send the funds to the new plan.
Special consideration for company stock: If your account includes employer stock, a rollover that includes the stock may not be a good move; a partial rollover may be better. Here’s why: The stock has net unrealized appreciation (NUA), which is the difference between the original cost and its current fair market value. If you roll over the stock, you forfeit the potential tax benefit of converting ordinary income into preferentially taxed capital gains. With a rollover, the eventual distribution stemming from the stock will be taxed as ordinary income. In contrast, if you take a current distribution of the stock (called an in-kind distribution), you’ll pay ordinary income (and a 10% penalty if under age 59½) on the original cost to you of the stock but position yourself for favorable tax treatment later on. The NUA, plus all future appreciation, will be taxed as capital gains when you eventually sell the stock.
You can make a rollover by depositing funds you receive as a distribution from your 401(k) into another qualified retirement plan or IRA. The rollover can be completed by endorsing a check that has been made out to you from the 401(k) or by depositing the funds in your own (non-IRA) account and then writing on a check on that account payable to the new plan or IRA. You have 60 days from the date you receive the distribution to complete the rollover.
Pros. You have control over the funds for the short term and can use them before completing your rollover. For example, if you need funds for a specific purpose (e.g., paying your tax bill for the year), you can use the distribution and won’t incur any income tax as long as you come up with other funds to complete the rollover within the 60-day period.
Cons. The distribution is subject to the automatic 20% withholding tax. If you take a distribution and then decide to make a full rollover, you’ll have to come up with the 20% amount from your own pocket to complete the rollover; you’ll recoup this amount when you file your tax return. For example, say you have $50,000 in your 401(k) and want to take a complete distribution. The plan will send you $40,000 ($50,000 – 20% of $50,000). To make a full rollover so that you won’t owe any current tax on the distribution, you’ll have to use the $40,000 you received plus $10,000 of your own money to complete the rollover. When you file your return, the $10,000 withheld is a tax credit that you can receive as a refund. Another drawback is that it’s all too easy to miss the 60-day rollover deadline, despite good intentions. If you do this and can’t get an extension from the IRS, you’ll owe income tax on the distribution. What’s more, if you’re under age 59½, you’ll owe a 10% early distribution penalty unless you can show that you used the funds for a purpose that’s exempt from the penalty (e.g., you’re disabled). Note: If the distribution includes after-tax contributions you made to a designated account (a Roth IRA–like feature that employers add onto 401(k)s), only the earnings on these contributions are taxable and subject to penalty if you don’t complete a rollover on time.
Transfer to a Roth IRA
Roth IRAs enable you to build up funds that will be tax-free to you in the future. You can transfer some or all your 401(k) to a Roth IRA. However, this rollover won’t avoid current tax. You’ll be currently taxed on the portion going into a Roth IRA. It’s considered a Roth IRA conversion (in the same manner as if you’d converted a traditional IRA to a Roth IRA).
The Bottom Line
If the value of your 401(k) account is under $1,000, the trustee may decide to disburse the funds to you, regardless of your preferences; the funds will be subject to the 20% withholding tax. If the value is between $1,000 and $5,000, the trustee may deposit the money in an IRA under your name unless you opt for a distribution. For larger accounts, it’s up to you to make a decision. When in doubt, consult with a financial advisor.
For further reading, see Using Age-Based Funds in Your 401(k) and I Maxed Out My 401(k)! Now What?
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