How to Move Your 401(k) into a Rollover IRA

January 26, 2022

Leaving behind an old employer? That doesn’t mean you have to leave behind your old retirement plan. In fact, if you handle the transition correctly, you can keep your tax-deferred status on that money

It’s all thanks to a rollover IRA.

But in order to keep the benefits of your old retirement plan, you have to know how to move your 401(k) into a rollover IRA. Here’s what you should know before you make the transition.

What is a Rollover IRA?

A rollover IRA is a type of individual retirement account (IRA) that allows the transfer of assets from an employer-sponsored retirement account into a traditional IRA (a type of IRA where you contribute pre-tax dollars, grow your money tax-deferred, and pay taxes once you make withdrawals).

These plans are most often used to hold assets from a former employer’s sponsored retirement account. A rollover IRA does not cap the amount of money you can rollover. Some people also make the switch to a rollover IRA because it offers wider investment options and lower fees, especially when compared with a 401(k).

Why Move Your 401(k) into a Rollover IRA?

There are several reasons why you might choose to move your 401(k) into a rollover IRA.

One of the most common is transferring away from your former employer’s sponsored plan. When you leave an employer, you have three options for your retirement assets: cash them out and pay taxes, transfer it to your new employer’s plan (if they have one), or roll it over into an IRA. A rollover IRA allows you to retain all of your previous assets without triggering taxes, which makes it highly popular.

Some people also prefer to transition to a rollover IRA because it has much broader investment options than a 401(k). Most 401(k) plans have a limited investment pool curated by the plan provider, which usually means mutual funds. An IRA, on the other hand, is basically a tax-protected box to store almost any investment you’d like—the only thing the IRA changes is how those assets are taxed.

Plus, a rollover IRA gives you the option to convert to a Roth IRA (an IRA allowing withdrawals on a tax-free basis as long as certain conditions are met). In fact, if you’re rolling over from a Roth 401(k), a rollover Roth IRA is the preferred option.

Steps to Move Your 401(k) into a Rollover IRA

Here’s the good news: once you know how to move your 401(k) into a rollover IRA, the steps are pretty straightforward. Here’s a quick look at how the process works.

Choose Your IRA

First, you need to choose your IRA. Remember, a rollover IRA isn’t a unique type of IRA per se—you have to choose between the different types of IRA as your rollover. For most people, that means the choice between a traditional IRA and a Roth IRA.

The difference between a traditional IRA and a Roth IRA is basically where the contributions come from. Traditional IRAs get contributions from pre-tax dollars, while Roth IRAs get contributions from post-tax dollars. Because of this, you don’t pay taxes on traditional IRA contributions now (and can even get a tax write-off for your contributions) but you’ll have to pay taxes once you start withdrawals. Since you’ve already paid taxes on Roth IRA contributions, you don’t pay taxes on withdrawals as long as they meet certain conditions.

In general, a traditional IRA is better if you think you’ll be in a lower tax bracket in retirement, while a Roth IRA is better if you’ll be in a higher tax bracket. However, most people don’t have the discipline to make up the difference in benefits on a traditional IRA, which means most people are better served by a Roth IRA. Plus, Roth IRAs are the preferred choice if you convert from a Roth 401(k) or similar plan.

Open Your Account

Next, you have to decide who to open your account with. You have two choices: a broker or a robo-advisor. This basically comes down to whether or not you want to choose your own investments.

If you don’t want to choose your own investments, a robo-advisor can do that for you. If you do want to choose your own investments, you’re better served by a broker. Look for a broker that doesn’t charge account fees and offers a wide range of low-cost investment options.

Direct Rollover or 60-Day Rule

After that, you have to move your money. A rollover IRA allows you to move your money through a direct rollover or indirect rollover.

A direct rollover is when some or all of your retirement assets are transferred directly from one retirement account to another. This is handled entirely by the plan administrator (your former employer). The benefit is that a direct rollover is not considered a taxable event—which is a big deal, because if it were, 20% of your transferred assets would be withheld by the IRS.

An indirect rollover is when you take possession of the plan assets and deposit them into a new eligible retirement account within 60 days. Basically, you cash out your old plan to take control of the assets and pay the assets into a new one. Here’s the catch: this is a taxable event, which means the IRS will withhold 20% of your cashed out assets and you can’t recover them until you file your annual tax return.

Indirect rollovers are also known as the 60-day rule. That’s important because you only have 60 days to transfer the assets to a new account. If you miss the deadline, the IRS will treat your cash out as an early withdrawal, and you’ll incur a 10% early withdrawal penalty on top of income tax.

Most people are best served by a direct rollover. Basically, your plan administrator cuts a check to your IRA instead of to you.

Select Your Investments

Last but not least, you’re ready to select your investments.

If you opted for a robo-advisor, the algorithm selects investments for you based on your questionnaire, though you can update your preferences later. If you’re selecting investments yourself, low-cost exchange-traded funds or index funds are usually the best place to start.

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