How to Rollover 401(k) Funds and Maximize Your Savings

Younger baby boomers (those born between 1957-1964) held an average of 12.3 jobs during their working lives, according to a study by the Bureau of Labor Statistics   PDF opens in new window. If you diligently contribute to a 401(k) at just half of the jobs you hold over several decades, you could end up with five or more dispersed 401(k) accounts. While you no longer have access to a former employer's retirement plan, the funds in the account belong to you — and it's wise to take them along with you.

For most people, the best option is a 401(k) rollover, which means you roll the funds from an employer-sponsored retirement account into a new account that allows you to continue making contributions and managing your funds.

Why It's Important to Rollover 401(k) Funds

When you leave a job, you may have the option to leave your 401(k) funds in your former company's plan, but doing so means you can no longer contribute to the account and have limited authority over it. In some cases, employers discontinue your plan, or they may open an individual retirement account in your name to deposit your 401(k) funds. And this can happen without you even knowing about it.

To ensure you have full control over your 401(k) funds, it's a good idea to close the account sponsored by your former employer and move the funds into an account that you can manage. While you could just cash out the 401(k) and move the money into a regular bank account or brokerage account, you'll be responsible for paying federal and state income tax on the amount you've earned; if you're younger than 59 1/2, you'll also have to pay a 10% penalty for early withdrawal.

Instead, you can avoid paying taxes or penalties and maintain all the tax advantages of an employer-sponsored account by rolling the retirement funds you've accumulated into another qualified retirement account.

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.

How to Rollover 401(k) Funds

If you've made the decision to roll the funds from your 401(k) into a new retirement account, now you just need to know how to make it happen. The first step is to actually leave your job at the company that sponsors your 401(k), as most plans don't let you move funds from your 401(k) while you're still employed by the plan sponsor.

Once you've left your job, the next course of action is to open a new traditional IRA or to designate a traditional IRA that you already own as the rollover account. To have the funds rolled over, you'll need to complete paperwork provided by both your former employer and the bank where your IRA is housed. Your former employer's human resources department and a customer service representative at your bank should be able to provide you with the necessary paperwork and help you complete the rollover.

If you decide that a Roth IRA is the best fit for your needs, you'll actually have to complete two rollovers. First, because the 401(k) and the traditional IRA have the same income tax structure, you'll have to roll your 401(k) funds into a traditional IRA. Once that's complete, you can then either convert it to a new Roth IRA or designate one that you already own. Your bank should be able to help you with this second rollover as well.

When you do a Roth IRA conversion, you'll pay taxes on the contributions you're converting — unless your 401(k) is a Roth 401(k). In that case, you can roll the funds directly into a Roth IRA without the extra step and without incurring any tax liability.

Report Your Rollover to the IRS

Once the rollover is complete, you're responsible for reporting the transaction on your tax return. Note that while you won't incur any tax liability if you move funds from a 401(k) to a traditional IRA, you're still required to report the transaction.

You should receive a Form 1099-R from the 401(k) plan sponsor, which will show the amount that was distributed from your 401(k). When completing your tax return, enter the amount from your 1099-R, Box 1 on Form 1040, Line 16a. If you deposited the full amount into a qualified IRA or 401(k), you won't owe anything. However, if you rolled any or all of your funds into a Roth IRA (and your 401(k) wasn't a Roth 401(k)), you'll have to pay taxes on the rollover amount. Once you have had your Roth account open for five tax years, the earnings post-rollover can be withdrawn income tax free as long as you are 59 ½, disabled or deceased at the time of distribution or you are a first time homebuyer ($10,000 lifetime limit).

If you're leaving your job, don't leave your 401(k) behind. Consider which account would work best for your situation, then take control of your retirement funds. It can be the key to creating a brighter future.

Please consult your tax and legal advisors for advice pertaining to your particular circumstances.

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