Should I roll over my 401(k) into an IRA?

Separating from an employer often presents you with several decisions. Depending on the reason, you may have to choose between jumping on COBRA Continuation Health Coverage, joining your spouse’s health plan, enrolling in your new employer’s health plan, or paying for your own coverage. 

Another important choice is whether or not to roll over your 401(k) into an IRA. There are advantages and disadvantages to choosing a traditional IRA or Roth IRA over a 401(k). Let’s review your options.

Avoid a forced rollover to an IRA

First things first: It’s critical that you make a choice about your rollover, particularly when the total vested balance on your 401(k) is $7,000 and under. Leaving your 401(k) untouched may work against you. 

A 401(k) forceout occurs when a former employer decides what to do with your retirement savings after you've left the job—sometimes without needing your approval. If your 401(k) balance is small (typically under $7,000, after a SECURE 2.0 Act update), the plan may automatically move your money into an IRA. For balances below $1,000, your previous employer may even cash it out and send you a check (after taxes and may be subject to early withdrawal penalties if you are under age 59 1/2). 

This process is designed to save employers the hassle of managing small, inactive accounts—however, it may leave you with a low-performing account or even reduced savings if fees stack up. 

Advantages of rolling over to an IRA

Rolling over a 401(k) into a traditional IRA or a Roth IRA has three main advantages.

1. Simplicity: The main advantage of rolling over a 401(k) to an IRA is that most IRAs accept rollovers, unlike some employer-sponsored qualified plans (including 401(k) and 403(b) plans.) The portability of 401(k) funds into an IRA enables you to avoid ending up with several retirement accounts, which complicates retirement planning and makes it more difficult to track fees and returns.

2. Investment options: You often have more investment options available in an IRA than in a 401(k), since administrators of 401(k) plans select funds that they believe would be the most beneficial to their employees. In an IRA you’re not restrained to only a few pre-selected options and can add ones that better match your unique retirement goals, including money market accounts, stocks, bonds, real estate, and mutual funds. Having more choices could potentially allow you to achieve higher returns with an IRA than with a 401(k).

With an IRA, you’re generally allowed to choose your own investments, so you can pursue top-performing portfolio managers or very low-fee passive funds. The section below provides more detail on the traditional vs. Roth IRA choices.

3. Relatively easy withdrawal: With an IRA, you’re able to take early distributions without penalty for several reasons. With a 401(k), it’s more limited. That’s why it’s a good idea to have a backup plan. The IRS exempts distributions before age 59 ½ from an IRA to a 10% additional tax when those monies are for:

• Qualified higher education expenses

• First-time home purchases or substantial renovations (up to $10,000)

• Out-of-pocket medical expenses greater than 10% of your adjusted gross income (AGI) Health insurance premiums during unemployment for at least 12 continuous weeks

• Other qualified scenarios as described by the IRS

With a Roth IRA, you contribute with post-tax dollars, and you can withdraw your contributions at any time tax-free without penalty. However, earnings are only eligible for tax- and penalty-free withdrawal after the account has been open for at least five years and you’re at least 59 1/2.

Important note about loans: Most 401(k) plans don’t have exemptions for early distributions and, instead, may offer you the option to take out a loan. Before taking a loan, it’s important to weigh your options. You may consider taking a loan on your 401(k) if you need to make a lump-sum cash payment or have an emergency that blocks your normal income flow. Keep in mind that, in most cases, you’ll have to pay back that money, including interest, within five years (be sure to confirm with your plan provider).

Rolling over your 401(k) into a traditional IRA vs. a Roth IRA

The two most common types of IRAs are traditional IRAs and Roth IRAs. Here is a checklist to evaluate which one makes more sense for you:

• Tax rate during retirement: If you expect your tax rate to be lower during retirement, a traditional IRA is more suitable because taxation is deferred until retirement. If you expect to be in a higher tax bracket during retirement, then choose a Roth IRA. Remember that you’re generally liable for applicable income taxes, including capital gains, with a traditional IRA.

Start age for required minimum distributions (RMDs): Unlike a traditional IRA, a Roth IRA doesn’t require you to start taking RMDs at age 73, enabling you to continue contributing to your retirement account.

Disadvantages of rolling over to an IRA

To make an informed decision, consider also the weak points of an IRA.

In case of bankruptcy: If you roll over your funds into an IRA, you lose the level of legal protection against creditors that a 401(k) offers. In a 401(k), your retirement funds are protected from all forms of creditor judgments. Traditional and Roth IRAs aren’t covered by the Employee Retirement Income Security Act of 1974 (ERISA). Still, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCA) does provide protection of up to $1 million for all contributory and Roth IRA assets in the event of bankruptcy. Protection of IRA monies from creditors varies from state, so check with your local plan administrator or tax accountant for more details.

Lower contribution limit: Participants can contribute significantly less per year to an IRA compared to a 401(k). Depending on your AGI, you may only be able to contribute a reduced amount or nothing at all to a Roth IRA. Below are the latest contribution limits for a 401(k):

Now compare this with the contribution limits for an IRA:

Taxes: You have to pay taxes upfront with a Roth IRA. Rolling a traditional 401(k) to a Roth IRA requires paying taxes on the rollover amount. While taxes are not withheld, the rollover is included in your taxable income. Also, you can only fund a Roth IRA with after-tax dollars. Depending on your tax rates now and in retirement, paying taxes now on your contributions may reduce the potential size of your nest egg and create stress on your monthly budget. Still, you could choose a traditional IRA over a Roth IRA to defer taxes until retirement.

Your other rollover options

You aren’t limited to rolling over your 401(k) to an IRA. Consider the following scenarios:

• Roll over to a Roth 401(k): While a traditional 401(k) defers taxes until retirement, a Roth 401(k) only takes after-tax contributions. Depending on your tax bracket now and in the future, a Roth 401(k) may provide you an advantage over a traditional 401(k). Note that rolling pretax funds into a Roth 401(k) results in the entire transaction being taxable in the year you roll over

• Leave the 401(k) as is: This option can be used by 401(k) holders with vested balances over $7,000 or who hold company shares with very restrictive portability rules. Contact your tax accountant for more details on tax scenarios.

• Do an indirect rollover: You have the option to take funds in cash and then within the subsequent 60 days deposit those same funds to an IRA. When you take the cash withdrawal from your employer, they will withhold the mandatory 20%. If you wish, you can make up the withholding that was originally withheld (20%) by contributing that out-of-pocket into your IRA from your available funds. Savers who do this can get a credit on their federal tax return. You can potentially receive that 20% in next year’s tax return (depending on your tax bracket). 

• Choose a mix of options: As long as your plan administrator allows it, you could roll over a portion of the 401(k) into an IRA and the remaining portion to a new 401(k). Or cash out a small portion and rollover the rest to a new retirement account. Note that a 20% tax withholding is standard for all cash distributions. Savers who choose this method who are under age 59 ½ will be subject to a 10% penalty from the IRS for an early cash withdrawal.

Rolling your 401(k) into an IRA can be a smart move as long as you have considered all of the advantages and disadvantages. Don’t rush into a decision; make sure to shop around to take stock of all available rollover options for your 401(k). When you decide to begin the rollover process, refer to how to roll over your 401(k), to learn about the logistics of transferring funds.