401(k) rollover options: Here’s what to do if you lose or change your job

6 min read
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Millions of Americans will need to decide what to do with their 401(k), as workers face a coronavirus-driven recession in which top economists expect a long-lasting double-digit unemployment rate to persist. If you’re suddenly unemployed, worrying about your distant financial future may seem unimportant when you have immediate pressing needs now. Still, the decisions that you make today can cost you a lot more in the future, so it’s smart to weigh your 401(k) options.

Below are the key choices for a 401(k) rollover and when each might be right for your situation.

4 key options for a 401(k) rollover

As you’re considering where to roll over your 401(k), you’ll want to consider the advantages of each account type, the drawbacks, your own financial situation and the tax implications.

Depending on how much you have invested in your plan, you may have a limited time to make this decision, and in some cases your former company can make the decision for you:

  • If you have less than $1,000, your ex-employer can just cash you out. You can still roll over the money into another account, but you typically must do so within 60 days.
  • If you have between $1,000 and $5,000, your ex-employer can move the money into an IRA of its choice. If you don’t like that IRA, you can always move it.
  • If you have more than $5,000 in your 401(k), your company must await your instructions on how to proceed. You could continue to leave your money in your old 401(k).

The specific rules vary from employer to employer, and the rules that apply to your old 401(k) can be found in the plan’s documents. So check there first, if you’re unsure how to proceed.

1. Rollover into a new company’s 401(k) plan

A rollover into your new company’s 401(k) plan may be the easiest option for you. You’ll keep all the money in one place, and you may be able to access some professional advice as part of your new plan, too. So a rollover to a new 401(k) is a winner for convenience. It’s a winner from a tax perspective, too, because you won’t incur any new taxes as long as you transfer to the same account type – a traditional 401(k) vs. a Roth 401(k) – that you currently have.

In addition, having all your money in a 401(k) protects you from the pro-rata rule, which could really trip you up and limit the effectiveness of a backdoor Roth IRA.

One downside, however, is that your new plan may not have particularly attractive investment choices, for example, offering expensive funds. So you’ll want to consider your investment options, too.

2. Rollover into a traditional IRA

A rollover into a traditional IRA is another strong choice, because you’ll still enjoy substantial tax benefits. You’ll be able to defer taxes on any gains, and you can continue to add to your IRA, up to $6,000 annually (in 2020) and enjoy the tax breaks on any income you stash there.

Another advantage is that you’re able to invest in whatever you want, so you can pick a top-performing low-cost index fund or opt for a risk-free IRA CD. Some might see the flexibility of a traditional IRA as a disadvantage, because it requires them to make investment decisions, and so many people will need the advice of a financial professional.

But the traditional IRA has disadvantages, too, including required minimum distributions (RMDs) when you reach age 72, meaning you’ll have to withdraw money whether you want to or not.

If you opt for a traditional IRA, you’ll want to be careful that you make the transition exactly how you intended it. Money from a traditional 401(k) can go into a traditional IRA, but it could also go into a Roth IRA (see the next option). If you decide to move from a traditional 401(k) to a traditional IRA, you’ll avoid any immediate tax liability from the rollover. Not so with a Roth IRA.

3. Rollover and convert to a Roth IRA

Another option is to roll over your 401(k) into a Roth IRA. The Roth IRA provides enviable tax advantages such as never paying taxes on gains when the money is withdrawn in retirement. It also offers attractive estate planning advantages and no RMDs. These are some of the reasons that many experts prefer the Roth IRA over the traditional IRA.

If there’s any disadvantage to a rollover into a Roth IRA, it occurs if you have money in a traditional 401(k). If you move from this kind of 401(k) to a Roth IRA, you’ll be hit with taxes to compensate for the taxes you’ve already deferred in the traditional 401(k). This burden, which can be quite high, is one reason that many workers move their money into a traditional IRA.

If you have a Roth 401(k), you can roll over your money to a Roth IRA without creating extra taxes. This is also a popular maneuver as retirees near age 72 when the Roth 401(k) rules say that participants have to begin taking RMDs. By switching to a Roth IRA, you can avoid this requirement entirely.

However, many savers may have a traditional 401(k) that they’re not aware of. If you receive matching contributions from your employer, those contributions are put into a traditional 401(k), regardless of which kind of 401(k) you have. If you have a Roth 401(k) and receive an employer match, you’ll have to figure out how you want to deal with this extra traditional 401(k) account.

This Roth IRA calculator can help you tally up how much tax-free money you can amass.

4. Rollover into an annuity

Another option is to roll your 401(k) into an annuity, which can still be held within the tax-friendly embrace of an IRA, helping you avoid taxes until they’re necessary. The advantages of an annuity are that it can provide stable income with a guaranteed return. When participants tap the annuity, they can receive a regular pension-like income. Many savers like this security, and they don’t need to worry about investing their money, a process that some don’t want to handle.

The downsides for an annuity include the relatively high sales commissions that can sometimes be hidden in the sales contract. The types of annuity contracts can be incredibly complex, with all types of restrictions and caveats, depending on what the annuity company offers. Some annuities can be much more complex than others, depending on the features you need.

Another downside is that once you buy the annuity, the money is typically locked in for some period, so it may not be accessible if you have an emergency and need ready cash.

Annuities divide many financial experts, because of their various pros and cons, in particular their costliness and complexity. If this route appeals to you, speak with a fee-only financial adviser who is a fiduciary in order to access objective advice about whether an annuity is right for your situation. Many “advisers” are actually disguised salespeople, so beware.

Avoid taking the cash

When times get tough, it can be easy to see the cash in your retirement account and consider tapping that to help get you through. In fact, in a recent Bankrate survey, about one in four Americans said that they had hit up their retirement savings or planned to do so as a result of the coronavirus-related economic decline.

Taking an early withdrawal comes with a heavy cost. If you take money out of a 401(k) before retirement age (59 ½), the IRS will hit you with a 10 percent bonus penalty on top of the taxes that you’ll already owe. In addition, you may have to sell investments at low prices, and you’ll lose any potential appreciation over your working years, hitting your nest egg still more.

If you must tap your retirement account, see if your plan allows you to borrow against the money in the account. You’ll have to repay the funds, of course, but you may be able to avoid the taxes, which is a win in itself. You may also see if you can take a hardship withdrawal.

In addition, you may be able to benefit from the CARES Act, which waived RMDs and the 10 percent bonus penalty (as long as the money is withdrawn in 2020) for the year. The law also offers other advantages for those strapped for cash, but remember the potential long-term costs that come with this move.

Bottom line

Workers have a few 401(k) rollover options, but the best decision focuses on your financial situation, and the right rollover will differ from person to person. Also key is avoiding tapping your retirement funds, if at all possible, because you’re stealing from your financial future.

Featured image by tomazl of Getty Images.

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