Types of Qualified Retirement Accounts
To preserve all the tax advantages of an employer-sponsored account, you can roll the funds into one of two types of qualified retirement accounts: another 401(k) account (or other employer plan) or an IRA.
If you have a new job that also offers a 401(k), you can roll the funds from your former employer's 401(k) into your new account, consolidating the two. Not all employer-based plans allow this, so check with your human resources department to find out whether it's an option. If it is, your current employer's 401(k) service provider will manage all the funds.
For most people, however, a better option is to roll the funds from a former 401(k) into an IRA. This is because an IRA lets you choose from a wide variety of investment options, compared to the limited menu of investments offered by most 401(k) plans. An IRA may also offer lower fees. And if you have a financial advisor, they can monitor and rebalance an IRA for you — something they wouldn't be able to do with a company-sponsored 401(k).
You can roll your funds into one of two types of IRAs: a traditional IRA or a Roth IRA. A traditional IRA is a tax-deferred account, meaning you don't owe income taxes on the funds you deposit in the year they're deposited. You will, however, pay income taxes on your contributions when you withdraw them in retirement. But the account grows tax-free, so you'll only have to pay taxes on the amount you contribute, not on the increase.
While a Roth IRA also grows tax-free, it differs from a traditional IRA in that you pay taxes on your contributions in the year you deposited them but not when you make withdrawals in retirement. Unlike a traditional IRA, a Roth IRA can also be used to pay for college expenses for yourself or your child. Because you've already paid taxes on your contributions, you can make withdrawals without penalty or tax liability, as long as you've had the account for at least five years.
Choosing a Rollover Account
For most people, rolling 401(k) funds into a new IRA makes the most sense; it offers greater control and more options than rolling into a new 401(k) account. But the right type of IRA depends on your individual situation and plans.
The first thing to consider is your tax liability in retirement. It's important to make sure that you'll be able to use as much of your 401(k) money as possible in retirement, and that you'll pay as little as possible in taxes. If you expect your income tax rate in retirement will be lower than it is now, a traditional IRA is probably the way to go. This is because you pay taxes on traditional IRA contributions when you withdraw funds, so they'll be taxed at your post-retirement rate if you wait to withdraw after you quit working.
However, if you expect your income tax rate in retirement will be higher than it currently is, a Roth IRA is probably a smarter option. With a Roth IRA, your contributions are made after taxes, so you won't owe any income taxes on the funds you withdraw. If you're still in the early stages of your career or if you expect to make more money down the road, which will increase your income tax rate accordingly, a Roth IRA may be the best choice for your 401(k) rollover. Another reason to rollover to a Roth IRA is if you expect to need the funds from your previous 401(k) account before retirement, since you can make early withdrawals from a Roth IRA without paying a penalty.