Updated on February 6, 2023
When you switch your place of employment, your 401(k) plan typically presents you with four potential paths.
One of the most advantageous things to do is a 401(k) rollover into an Individual Retirement Account (IRA). The alternatives include cashing it out and bearing the taxes and a withdrawal penalty, leaving it intact if your previous employer allows, or moving it into your new employer’s 401(k) plan — if such a plan is available.
For the majority of individuals, executing a rollover of a 401(k) (or a 403(b) for those working in the public or non-profit sector) emerges as the optimal option.
At Capitalize, we like to say that taxes and penalties aren’t our friends, so let’s not invite them to this retirement savings party. Nowhere is that more true than if you’re considering a 401(k) withdrawal or a cash-out.
While it’s easy to request a 401(k) withdrawal, the IRS will take a big chunk out of the money you get. Why? Because they want you to keep your money in a long-term retirement account so that you have money to support yourself. And we want that too. Most of the time you’ll pay income tax on the withdrawal in the year that it occurs, plus a 10% penalty on top if you’re under 59 ½.
“Compounding” is just the fancy finance term for what happens when your investments grow exponentially over time. Einstein called compounding the eighth wonder of the world, and let’s face it, he was a pretty smart dude.
The point is that when your money remains in long-term investments it grows much faster than it would if it were in a bank account. That’s because bank interest rates are so much lower than the returns you can get from long-term investments like stocks.
For example, $3,000 invested in stocks today for the next 35 years will turn into over $40,000. That compares to just $4,000 if you leave it in a bank account. Put differently, you’ll make 10x more by staying invested in stocks for the long term.
When you withdraw your money it gets pulled out of these long-term investments and into cash.
If you roll over your 401(k) account balance into an IRA instead, then you’ll continue to benefit from long-term investments that will compound for you over time.
Retirement accounts like 401(k)s and IRAs have special tax advantages. That’s because Congress wanted to encourage people to use them — and grow their wealth in the long term — so that there’s less pressure on the Social Security system.
The biggest tax advantage is that your investments in a 401(k) or IRA can appreciate without you having to pay taxes on them until you withdraw them at retirement. That’s a big deal because you can basically kick the tax can down the road, legally. A dollar of tax paid 30 years from now is less of a burden than a dollar of tax paid today.
When you transfer money from your 401(k) into an IRA, the IRA preserves this tax advantage.
The rollover itself (if transferred to another retirement account with the same tax treatment) also has no tax consequences. In contrast, a 401(k) withdrawal causes you to lose this big tax advantage. If you withdraw your 401(k) savings into cash and put it into a bank account then any interest you earn on that cash will be subject to income tax.
Even if you agree that a 401(k) rollover is better than a withdrawal you might think that the extra work involved isn’t worth it. A lot of people who came to Capitalize thought the same thing. But doing a rollover doesn’t have to be that painful. There’s 3 key steps: 1) pick an IRA provider; 2) open an account at that IRA provider online and 3) transfer your 401(k) into that new IRA. Steps 1 and 2 can be done literally in minutes, and we can help you with it. Step 3 might involve a bit of waiting time once you’ve initiated a transfer, but again the amount of work time for you can be counted in minutes.
That’s not a whole lot of time for what could end up being a large difference in your long-term finances. We get that rollovers don’t sound fun. But it’s often worth the hassle.
Typically, 401(k) plans come with a limited selection of investment options, dictated by your employer and the financial institution they partner with. Usually, you might find yourself picking from a range of mutual funds given to you by a specific provider.
In contrast, the universe of IRA plans is vast, and many offer an extensive array of investment choices. You have the flexibility to choose from a broad spectrum of investment types, including but not limited to individual stocks, bonds, and Exchange-Traded Funds (ETFs).
Furthermore, you have the liberty to buy and sell your holdings at your discretion. This is a significant advantage over most 401(k)s and other qualified plans, which may restrict the frequency of portfolio rebalancing within a year or confine such activities to certain periods.
To compare the two is to compare apples and oranges. The “rollover” title has nothing to do with the tax status of the account; in fact, you could have both a rollover traditional IRA and a rollover Roth IRA as rollover options. This would just mean that you rolled over funds from another tax-advantaged source into either of these accounts.
A traditional IRA, on the other hand, is meant to hold pre-tax dollars. This means you received some tax benefit when you deposited the money, and it’s now growing tax-deferred until you withdraw it on some future date. Only then will you pay tax on any amount withdrawn. Still, as described earlier, you can deposit after-tax contributions to traditional IRAs, but this can be complicated to track.
Your investment options for either account are generally the same since both are IRA accounts. You’ll be able to access single stocks, bonds, ETFs, mutual funds, and in some cases, even more esoteric investments like cryptocurrency.
You’ll often see the terms together, but the words “rollover” and “traditional” aren’t meant for direct comparison. Recall that you can have an IRA that’s both an IRA rollover and a traditional IRA!
Roth 401(k) withdrawals, however, are subject to employer restrictions.
Two types of distributions you may encounter are hardship withdrawals and rollovers, each with distinct rules and potential tax implications.
Hardship withdrawals are early distributions taken from your 401(k) or similar retirement plan due to immediate and significant financial need. This can include distributions to cover expenses like abnormally high medical expenses, funeral expenses, or disability.
However, taking a hardship withdrawal comes with significant consequences. Since this is considered an early withdrawal (taken before age 59.5), you’ll generally have to pay income taxes on the distribution, though you may be able to waive the 10% early withdrawal penalty if you qualify for an IRS exception (see below). This can significantly reduce the amount you’ll receive and impact the growth of your retirement savings.
Also, it’s important to note that a hardship withdrawal doesn’t have to be paid back. Once you take it, those funds are permanently removed from your account.
Check out the IRS (Internal Revenue Service) site on hardship withdrawals for more information.
On the other hand, a rollover is when you move funds from one tax-advantaged retirement account to another, such as from a 401(k) to an IRA, or from a former employer’s 401(k) to a new employer’s plan. The purpose of a rollover is to maintain the tax-advantaged status of your retirement funds, not to use the money for current expenses.
If you do a direct rollover, where the money goes directly from one account to another, there are no taxes or penalties involved. If you do an indirect rollover, you receive the distribution yourself and have 60 days to deposit it into another retirement account.
If you fail to deposit the money within 60 days, the IRS considers it an early distribution, and it becomes subject to income taxes and potentially the 10% early withdrawal penalty (depending on your age).
It’s also worth mentioning the Required Minimum Distributions (RMDs). Once you reach a certain age (73, as of May 2023), the IRS requires you to start taking minimum distributions from most types of retirement accounts. However, these rules do not apply to Roth IRAs while the owner is alive.
Both hardship withdrawals and rollovers have their place in retirement planning, but they serve very different purposes. It’s important to understand these differences and consult with a financial advisor before making any decisions.
The simplest and most secure method to transfer your 401(k) into an IRA is through a direct rollover from the financial institution handling your 401(k) plan to the one that will manage your IRA money.
It’s important to note that there are three primary types of rollovers from a 401(k) to an IRA:
Your plan administrator can provide guidance throughout the process, and the financial institution receiving your funds will also be eager to help.
Start by opening your new IRA, then reach out to your previous employer’s plan administrator to get the process started. Often, your plan administrator will issue a check payable to your new IRA custodian for you to deposit there. Alternatively, they may send your funds directly to the receiving institution via a direct rollover.
An alternative approach, albeit a substantially riskier one, is to receive the check personally with the money made out to you.
In this scenario, you generally have a strict 60-day window from the date of receipt to transfer it into an IRA. Should you miss this deadline, the distribution is deemed a withdrawal, making you liable for income taxes and potential penalties on the entire amount.
Any taxable eligible rollover distribution paid to you from an employer-sponsored retirement plan is subject to a mandatory income tax withholding of 20%, even if you intend to roll it over later.
Remember also that you’ll need to roll over your entire pre-tax retirement plan balance (before any tax withholding) to avoid costly taxes and penalties.
Yes, if your 401(k) plan permits it, you can roll over a traditional IRA (but not a Roth IRA) into it.
This is sometimes referred to as a reverse rollover.