How to rollover an old 401(k)
Executive Summary
Do you have a 401(k) from an old job? At any point in your law career you may switch jobs. Maybe it’s to focus on a specialty or move to a firm with a better work-life balance. When you leave, you’ll have to decide what to do with that employer’s 401(k). This post dives into the 401(k) itself and also answers 6 of the most common questions around a 401(k) rollover including:
- What is a rollover?
- How do you rollover to an IRA?
- Can you rollover to a new 401(k)?
- Can you leave your 401(k) with your former employer?
- Can you cash out your 401(k)?
- Which type of rollover is right for me?
It’s not uncommon for lawyers to switch employers in their careers. This can be an exciting time because you’re taking another step in your career path. A new employer is an opportunity to advance your career in the direction you want it to go in. While it may be the beginning of something new, you may be leaving some things behind at your old employer. One of those things may be your former employer’s 401(k).
The 401(k)
Your 401(k) is a special investment account. It is special because unlike a typical investment account you may have with your bank or a brokerage, a 401(k)’s investments are tax-deferred. If you receive a dividend or make a sale, those would be taxable in a brokerage investment account. In a 401(k), those are not taxed while in the 401(k) account.
There are generally two types of 401(k)’s: Traditional and Roth. A Traditional 401(k) also known as a pre-tax 401(k) takes your payroll contribution and direct deposits it into your 401(k). No taxes are paid on your contribution. If you earn $100,000 and contribute 10%, then at the end of the year you contributed $10,000. When you pay your taxes, you won’t have a taxable income of $100,000. Since you contributed 10% to a Traditional 401(k) your taxable income is only $90,000.
A Roth 401(k) will have taxes owed for the amount contributed. If you earn $100,000 and contribute 10% then at the end of the year you will contribute $10,000. When you pay taxes, you will have a taxable income of $100,000. (Want to learn more? Check out our blog post on choosing between a Roth and Pre-tax 401(k).)
It’s also special because 401(k)’s are only available through an employer. So what do you do if you change jobs? One of the options is a rollover. It’s not just a command to teach your dog. A rollover can be beneficial to you when changing employers.
To help you decide on what to do, here are a few common questions regarding a rollover and other options:
1. What is a 401(k) rollover? Are there different ways to do a rollover?
There are 2 types of 401(k) rollovers: direct rollovers and 60-day rollovers.
A direct rollover will be made from a 401(k) to either a new 401(k) or an IRA. The former 401(k) administrator will do a direct rollover by sending a check directly to the new 401(k) or IRA.
A 60-day rollover results in the 401(k) plan sending you personally a check for the 401(k) amount minus 20% for tax withholdings. It is then up to you to deposit the whole distributed 401(k) amount into a new 401(k) or IRA. Note: Even though your check is only for 80% of the former 401(k)'s amount, you will still need to deposit 100% of the former 401(k)'s amount or you will be subject to additional penalties and taxes.
If you choose a 60-day rollover you’ll need to find 20% of the rollover amount in cash. If you had $100,000 in your 401(k) and opted for a 60-day rollover, you would receive a check for $80,000. You would then have to deposit an extra $20,000 into the new 401(k) or IRA so your new account balance is also $100,000. Once you file your taxes you would be able to claim a refund for the withheld $20,000. 60-day rollovers are to be avoided in most situations because you have to finance the 20% of the 401(k) value in cash or by selling some asset to have enough cash. Meanwhile, you lend the government that 20% of your 401(k) balance at a 0% interest rate until you file your taxes.
2. How can someone roll their 401(k) over into an Individual Retirement Arrangements (IRA)? How does it differ for different types of IRAs?
If you don’t have an IRA, you can usually set one up with your bank or a brokerage company. Unlike a 401(k) you don’t need an employer to have one. These are personal accounts. While an IRA has a limit on how much you can contribute (2021: $6,000) it does not have a limit on the amount you can rollover.
When you rollover a 401(k) into an IRA, the options available to you differ depending on the type of 401(k) you have and the type of IRA you are depositing into. Here is a list of your options:
1. Traditional 401(k) to a Traditional IRA.
2. Traditional 401(k) to a Roth IRA. Since a Roth IRA and a Roth 401(k) require you to pay taxes on contributions, you also have to pay taxes on a Traditional 401(k) to a Roth IRA rollover. If you earned $100,000 in a year and rolled over a $40,000 Traditional 401(k) into a Roth IRA, you would have to include $40,000 extra dollars in your annual taxable income. Your total taxable income for the year would be $140,000.
3. Roth 401(k) to a Roth IRA.
If the rollover is a Traditional to a Traditional or a Roth to a Roth, no additional taxes are owed in the year of a rollover. Since money in a Roth is taxed, a Roth 401(k) cannot be rolled over into a Traditional IRA because a Traditional IRA is pre-tax.
3. How can someone roll their 401(k) over into a new 401(k)?
Similar to a 401(k) rollover to an IRA, a 401(k) to a new 401(k) has the same two options: direct rollover and a 60-day rollover. It's important to know that a new 401(k) plan does not have to accept your rollover contributions. You should check with your new 401(k) plan's administrator to see if they accept rollover contributions.
Your options for rolling over a 401(k) into a new 401(k) are:
1. Traditional 401(k) to a new Traditional 401(k)
2. Traditional 401(k) to a Roth 401(k): This can only be done for a rollover within the same company's plan. Taxes will also apply.
3. Roth 401(k) to a Roth 401(k): This must be done with a direct rollover. A 60-day rollover will result in the contributions to the former Roth 401(k) being ineligible for the new Roth 401(k). Those ineligible amounts would have to be rolled over into a Roth IRA.
Once again, you cannot rollover a Roth 401(k) into a Traditional 401(k).
4. Can someone keep their 401(k) with their former employer? When is this a good idea? What do investors need to know?
Yes. Once you leave a company, you are allowed to keep your 401(k) in the former employer's plan unless the plan administrator informs you that they intend to distribute your account's balance to you. In most circumstances, the plan administrator must provide you with a notice of your rights regarding a rollover.
Some investors may choose to leave their 401(k) with a former employer if the investment options are better than their current plan offers. They may also maintain the old 401(k) if the expenses and fees are lower than their new 401(k) plan or an IRA. Investors should know that they may leave the plan with a former employer but they are not allowed to contribute to that plan anymore.
If you do leave your 401(k) with your former employer’s plan, do not forget about it! A study found that Americans have $1.35 Trillion in old employer 401(k) plans. That’s a lot of money to forget about.
5. Should investors consider cashing out their 401(k) when they leave a job?
Investors have the option to cash out their 401(k) when they leave a job but there are potential consequences to this:
1. Any untaxed amount distributed from the 401(k) will be taxable in the year of the cash-out.
2. If you are younger than 55 when you cash out, you may have to pay an additional 10% penalty on the amount cashed out.
These reasons may deter you from cashing out but if you still decide to cash out, you have 60 days after the distribution to roll over the cash amount into a new employer 401(k) or an IRA.
6. Which type of rollover is right for me? Roth to Roth, Traditional to Traditional, or Traditional to Roth?
In most cases, a direct rollover is a better choice than a 60-day rollover due to the complexities of a 60-day rollover and the need for additional funds to cover the 20% tax withholding amount.
When deciding what account to rollover to, you should keep these considerations in mind:
1. What type of account do I have? A Roth 401(k) must either rollover to another Roth 401(k) or a Roth IRA. A Traditional 401(k) can either be rolled over into a Roth or a Traditional 401(k)/IRA.
2. Will my new 401(k) allow rollover contributions? If “no”, then rolling over to an IRA is probably the best option.
3. What investment options does the new 401(k) plan have? IRA's have more investment options than 401(k)'s. For many investors, this is a compelling reason to rollover to an IRA.
4. Can I afford the taxes of a Roth conversion? If you are rolling over a Traditional 401(k) to a Roth 401(k) or a Roth IRA, the rolled-over amount will be included in your taxable income. A substantial Roth conversion amount can increase your annual income to a higher tax bracket for the year.
An investor who anticipates having a lower annual income than in future years may decide that a Roth rollover would be a good time to convert these Traditional 401(k) amounts at a lower tax rate than the investor expects to pay in the future.
Example: A lawyer earns $120,000 per year or $10,000 per month. After working for 4 months, the lawyer quits their job to travel the world. When they return in December, they decide to rollover their Traditional 401(k) of $80,000 into a Roth IRA. When they files their taxes, they will have a taxable income of $40,000 (4 months of work X $10,000 per month) + $80,000 Roth rollover which equals $120,000 of taxable money. You should be aware that they will have to pay the taxes on $120,000 even though they only made $40,000. I hope they saved some travel money for this tax bill.
5. Do I want more control of my distributions in retirement? A Roth IRA is the only retirement account that is not currently subject to required minimum distributions of 401(k) & IRA amounts, after age 72. Being able to control their distribution schedule is valuable to a lot of investors.
A rollover is a typical financial decision that almost everyone will face in their career. Hopefully, this answered some of the questions you might have. Please consult with a tax professional and/or a financial planner if you have any additional questions. Developing Financial will perform a rollover analysis for you as part of the Developing Financial Process. Schedule a Meet & Confer meeting today!
Disclaimer: Nothing in this blog should be considered financial advice or recommendations. Your questions are unique to you and your own personal financial circumstances. You should consult with a financial professional before making a financial decision. See full blog disclaimer.