Should I Roll Over My 401(k) Into an IRA?

13 MIN READEditorial Policy

When you separate from an employer, you have a lot of decisions to take care of. Depending on the reason of separation, you have to choose between jumping on COBRA Continuation Health Coverage, joining your spouse’s health plan, enrolling on 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).

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 $5,000 and under. Leaving your 401(k) untouched may work against you. According to a Plan Sponsor Council of America survey of 613 plans with 8 million participants, 57% of 401(k) plans with balances between $1,000 and $5,000 are forcefully transferred to an IRA of the plan’s choosing when the owner of the 401(k) doesn’t indicate what to do after separation from employment.

Even worse, the investment return on those forced-transfer IRAs ranges from 0.01% to 2.05%, according to a 2014 report from the U.S. Government Accountability Office (GAO). A mix of high annual fees, including loading fees and administrative fees for searching a missing account holder, and low annual returns made accounts with small balances decrease to $0 within a period of 30 years, according to the same report.

Advantages of rolling over to an IRA

There are three main advantages to rolling over a 401(k) into a traditional IRA or a Roth IRA.

Simplicity: The main advantage of rolling over a 401(k) to an IRA is that most IRAs accept rollovers, unlike some new and existing 401(k) plans and employer qualified 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.

More 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 that 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 a Roth IRA you’re allowed to choose your investing house so you can chase top-performing portfolio managers or very low-fee passive funds. More detail on the traditional vs. Roth IRA chose in the section below!

Relatively easy withdrawal: With an IRA, you’re able to take early distributions without penalty for several reasons. With a 401(k), it’s much more limited.

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 so you can withdraw your contributions any time tax free without penalty. However, earnings are only eligible for tax- and penalty-free withdrawal after the account has been open at least for 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. Taking a loan from your 401(k) doesn’t make sense. Knowing that you have a last-resort plan for several situations can be helpful for individuals just starting to build their credit history.

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 still liable for applicable income taxes, including capital gains, with a traditional IRA.

  • Upside potential of income: Single tax filers with an adjusted gross income (AGI) over $161,000 per year in 2024 (over $240,000 for joint tax filers) should choose a traditional IRA over a Roth IRA so that their permissible contributions aren’t reduced or prohibited.

  • Start age for required minimum distributions (RMDs): Unlike a traditional IRA, a Roth IRA doesn’t require you to start taking RMDs at age 70 ½, 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 in to 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 judgements. 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 up 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: You can contribute less per year to an IRA. In 2024, you can only contribute up to $7,000 ($1,000 in catch-up contributions for those age 50 and over) to traditional and Roth IRAs. This is significantly less than the $23,000 contribution limit by 401(k) plans ($7,500 in catch-up contributions for those age 50 and over). Depending on your AGI, you may only be able to contribute a reduced amount or nothing at all to a Roth IRA.

Additionally, only companies with 100 or fewer employees are eligible to make matching contributions to an employee’s traditional IRA through a SIMPLE IRA. It’s virtually impossible for an employer to contribute to the Roth IRA of an employee.

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. 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.

You only get one per year: You have to follow the IRS’s IRA one-rollover-per-year rule. Since 2015, the IRS only allows you to make only one rollover to another (or the same) IRA in any 12-month period, regardless of the number of IRAs you own.

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) can provide you an advantage over a traditional 401(k).

Roll over to a traditional 401(k) or qualified employer plan: Those planning to max out their contributions to retirement accounts year after year would benefit more from a traditional 401(k) because of the higher contribution limit ($23,000 in 2024; $30,500 if past the age of 50). Most qualified employer plans operate with the same rules as 401(k)’s, so check the rules of any qualified employer plan that you receive.

Leave the 401(k) as is: This can be an option for those 401(k) holders with balances well over $5,000 or that hold company shares with very restrictive portability rules. Contact your plan administrator or tax accountant for more details on tax scenarios.

Do an indirect rollover: With an account balance under $1,000, your employer can opt to cash out your 401(k) without your input and mail you a check, withholding the mandatory 20%. Don’t spend that check because you have 60 days to roll over to a retirement account and get back that 20% in next year’s tax return.

Choose a mix of options: As long as the plan administrators allow it, you could rollover a portion of the 401(k) into an IRA and the remaining portion to a new 401(k). Or cash out a small portion (taking a 20% tax hit and 10% penalty when under age 59 ½) for living expenses during your job search and rollover the rest to a new retirement account.

In sum, rolling your 401(k) into an IRA can be a smart move as long as you have weighed in all of the advantages and disadvantages that come with such a move . Don’t rush into a decision and make sure to shop around to take stock of all available rollover options for your 401(k).

If you do decide to begin the rollover process, you may find this article helpful, which does into detail about the logistics of actually transferring funds: How to Roll Over Your 401(k).

Damian Davila is a Honolulu-based writer with an MBA from the University of Hawaii. He enjoys helping people save money and writes about retirement, taxes, debt, and more.

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