How to Roll Over Your 401(k) to an IRA, and Why (2024)

When you change jobs, you generally have four options for your 401(k) plan. One of the best options is doing a 401(k) rollover to an individual retirement account (IRA). The other options include cashing it out and paying the taxes and a withdrawal penalty, leaving it where it is if your ex-employer allows this, or transferring it into your new employer's 401(k) plan—if one exists.

How to Roll Over Your 401(k) to an IRA

Your plan administrator can guide you through the process, and the financial institution where your money is going will be more than happy to assist. Fundamentally, though, you have two choices.

1. Choose a Direct Rollover

The easiest and safest way to roll over your 401(k) into an IRA is with a direct rollover from the financial institution that manages your 401(k) plan to the one that will be holding your IRA.

Note there are three key types of rollovers from a 401(k) to an IRA:

1. Rolling over a traditional 401(k) to a traditional IRA. Here the taxes are deferred and you won't owe anything.
2. A rollover from a Roth 401(k) to a Roth IRA. You won't owe taxes.
3. Rolling over from a traditional 401(k) to a Roth IRA. You'll owe income taxes on the amount you roll over.

In many cases, your plan administrator will give you a check made out to your new IRA custodian for you to deposit there. Thus, open your new IRA first, then contact the plan administrator for your former employer.

2. Choose an Indirect Rollover

Another option—but a far riskier one—is to have the check made out to you and take possession of the money yourself.

If you do that, you typically have just 60 days from the date you received it to roll it over into an IRA. If you fail to meet that deadline, the distribution will be treated as a withdrawal, and you'll be subject to income taxes and possibly penalties on the full amount.

A further complication of receiving the distribution yourself is that your ex-employer will be required to withhold 20% of it for taxes. If you then want to deposit your full balance into an IRA, you'll have to come up with other money to make up for the 20% that's been withheld.

The important thing to remember is, don't touch that money. Complications can ensue, meaning the IRS could claim that the money was disbursed to you, not rolled over.

Benefits to Rolling Over a 401(k) to an IRA

For most people, rolling over a 401(k) (or a 403(b) for those in the public or nonprofit sector) to an IRA is the best choice. That's because a rollover to an IRA offers:

• More control over your portfolio and more personalized investment choices
• Easier to get up-to-date information about changes
• Lower fees
• Possible Roth IRA options
• Possible incentives such as cash or free stock trades
• Fewer and clearer rules
• Better for your beneficiaries later

1. More Investment Choices

Most 401(k) plans have limited investment choices, selected by the employer and the financial provider it chooses. You'll probably choose among a number of mutual funds from one particular provider.

There is a near-infinite variety of IRA plans out there, and many of them offer a wide variety of choices. You can choose from many types of investments, too, including individual stocks, bonds, and ETFs, to name a few.

You can also buy and sell holdings any time you want. Most 401(k) plans limit the number of times per year that you can rebalance your portfolio, as the pros put it, or restrict you to certain times of the year.

2. Better Communication

If you leave your account with your old employer, you might be treated as a second-class citizen, though not deliberately. It could be harder to get communications regarding the plan, as news is generally distributed through company email, or to get in touch with an advisor or administrator.

There's also the off chance that something will go south at your old workplace and that line of information will get cut off for good.

3. Lower Fees and Costs

Rolling your money over into an IRA can reduce the management and administrative fees you've been paying, which eat into your investment returns over time. The funds offered by the 401(k) plan may be more expensive than the norm for their asset class.

On top of that, there is the overall annual fee that the financial institution managing the plan charges. The bigger 401(k) plans with millions to invest have access to institutional-class funds that charge lower fees than their retail counterparts.

Of course, your IRA won't be free of fees either. But you'll have more choices and more control over how you'll invest, where you'll invest, and what you'll pay.

4. The Option to Convert to a Roth

An IRA rollover gives you a good reason to consider switching to a Roth account. (In fact, if yours is one of the increasingly common Roth 401(k)s, a Roth IRA is the preferred rollover option.)

With a Roth IRA, you pay income taxes on the money you contribute in the year during which you contribute it, but there is no tax due when you withdraw money. That's the opposite of a traditional IRA. Nor do you have to take required minimum distributions (RMDs) at age 73 or ever from a Roth IRA. You've already paid the income taxes due.

If you believe that you will be in a higher tax bracket or that tax rates will be generally higher when you start needing your IRA money, switching to a Roth from a traditional account—and taking the tax hit now—might be in your best interest.

If you're under the age of 59½, it's also a lot easier to withdraw funds from a Roth IRA than from a traditional one. In most cases, there are no early withdrawal penalties for your contributions, but there are penalties if you take out any investment earnings.

Roth Rollover Rules

Your 401(k) plan rules may only permit rollovers to a traditional IRA. If so, you'll have to do that first and then convert the traditional IRA into a Roth.

There are a number of strategies for when and how to convert your traditional IRA to a Roth that can minimize your tax burden. Should the market experience a significant downturn, converting a traditional IRA that is down, say 20% or more, to a Roth will result in substantially less tax due at the time of the conversion. If you plan to hold the investments until they recover, that could be an attractive strategy.

This can be tricky, so if a serious amount of money is involved, it's probably best to consult with a financial advisor to weigh your options.

5. Cash or Other Incentives

Financial institutions are eager for your business. To entice you to bring them your retirement money, they may throw some cash your way. If it's not cash, free stock trades can be part of the package at some companies.

A one-time incentive shouldn't be your sole reason for choosing an IRA provider, but if it's the cherry on top, go for it.

6. Fewer (and Clearer) Rules

Understanding a 401(k)'s rules can be no easy task because employers have a lot of leeway in how they set up their plans.

In contrast, IRA regulations are standardized by the Internal Revenue Service (IRS). An IRA at one financial institution follows substantially the same rules as one at any other.

An often-overlooked difference between a 401(k) and an IRA has to do with IRS rules regarding taxes on distributions. The IRS requires that 20% of distributions from a 401(k) be withheld for federal taxes. When you take a distribution from an IRA, you can elect to have no tax withheld.

It's probably wise to have some tax withheld rather than winding up with a big tax bill at the end of the year and possibly owing interest and penalties for underpayment. However, you can choose how much to have withheld to more accurately reflect the actual amount you'll owe, rather than an automatic 20%.

The benefit is that you're not depleting your retirement account faster than you need to, and you're allowing that money to continue compounding on a tax-deferred basis.

7. Estate Planning Advantages

Upon your death, there's a good chance that your 401(k) will be paid in one lump sum to your beneficiary, which could cause income and inheritance tax headaches.

Rules vary depending on the particular plan, but most companies prefer to distribute the cash quickly so they don't have to maintain the account.

Inheriting an IRA has tax implications too, but IRAs offer more payout options.

The Bottom Line

For most people switching jobs, there are many advantages to rolling over a 401(k) into an IRA. But shop around for an IRA provider with low expenses. That can make a big difference in how much money you'll have at your disposal when you retire.