Back in the old days, it was pretty common for someone to work for the same company for 40 years before retiring with a nice pension and a gold watch. Well, those days are long gone.
A recent study found that the youngest baby boomers worked 12 different jobs over the course of their careers.1 Did you hear that? Twelve! And younger generations are even more likely to look for greener employment pastures. In fact, almost a third (31%) of millennials say they would quit their jobs as soon as possible if they could.2
But in the process, many American workers are leaving behind a trail of forgotten 401(k)s, sometimes with thousands of dollars in retirement savings left behind!
There’s even a name for those retirement accounts that are left behind: orphan 401(k)s. Even the name is sad! It’s time to stop for a minute and think about giving the money in those long-forgotten accounts a new home.
That’s where rollovers come in.
What Is a 401(k) Rollover?
A rollover simply allows you to transfer your retirement savings from one retirement account to another without having to pay any taxes on the money you’re rolling over.
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The most common type of rollover is the 401(k) rollover, which lets you transfer money from a 401(k) you had at a previous job into an IRA or the 401(k) at a new job. This is the type of rollover we’re going to focus on.
You could also transfer money from an IRA into a 401(k)—sometimes called a reverse rollover—but in most cases, it’s not a good idea. That’s because you usually have fewer investing options in a workplace retirement plan than with an IRA.
Direct Rollover vs. Indirect Rollover: What’s the Difference?
Okay, once you decide to roll money from one account to another, you have two options on how to do the transfer: a direct rollover or an indirect rollover. Spoiler alert: You always want to do the direct transfer. Here’s why.
With a direct rollover, the money in one retirement account—an old 401(k) you had in a previous job, for example—is transferred directly to another retirement account, like an IRA. That way, the owner of the account (that’s you) never touches it, and you won’t have to pay any taxes or penalties on the money being transferred. Once it’s done, it’s done!
Indirect rollovers, on the other hand, are a bit more complicated—and needlessly risky. In an indirect rollover, instead of the money going straight into your new account, the cash goes to you first. Here’s the problem with that: You have only 60 days to deposit the funds into a new retirement plan. If not, then you’re going to get hit with withholding taxes and early withdrawal penalties.
Now you should see why the direct rollover is the only way to go. There’s just no reason to take a chance on an indirect rollover that leaves you open to heavy taxes and penalties. That’s just dumb with a capital D!
Rolling Over a 401(k): What Are Your Options?
Let’s say you’re starting a new job and you’re wondering what to do with the money in a 401(k) you had at an old job. You have three options, and we’ll walk you through each one:
Option 1: Do nothing and leave the money in your old 401(k).
Now, you could just leave the money in your old 401(k) if you’re happy with the investments there and the fees are low. But that’s rarely the case. Most of the time, we recommend folks do a direct transfer rollover to an IRA.
Option 2: Roll the money into your new employer’s plan.
Rolling your money over to your new 401(k) plan has some benefits. It simplifies your life because your investments will be in one place and you’ll also have higher contribution limits with a 401(k) than you would with an IRA. But there are lots of rules and restrictions with rolling money over into your new employer’s plan, so it’s usually not your best option. Which brings us to . . .
Option 3: Roll over the funds into an IRA.
Transferring the money into an IRA is probably your best option. That’s because an IRA gives you the most control over your investments. You see, your new 401(k) plan probably only has a handful of investing options to choose from, and if you’re feeling iffy about those options, you might not want to put your money in there. An IRA, on the other hand, gives you potentially thousands of mutual funds to choose from!
Traditional vs. Roth: Which Type of IRA Should I Roll My 401(k) Into?
Now, the type of rollover IRA you transfer your money into depends on what type of 401(k) you’re rolling over.
If you had a traditional 401(k), you can transfer the money into a traditional IRA without having to pay any taxes on it (you’ll pay taxes later when you take the money out in retirement, though). Likewise, if you had a Roth 401(k), you could roll the money into a Roth IRA completely tax-free. Easy, right? Traditional to traditional, tax-free. Roth to Roth, also tax-free.
When Does a Roth Conversion Make Sense?
Now, there is one other type of rollover we need to talk about: a Roth conversion. That happens when you roll over money from a traditional 401(k) into a Roth IRA.
Here’s how it works: When you put money into your traditional 401(k), you used pretax dollars—that means it hasn’t been taxed yet. So, when you transfer that pretax money into a Roth IRA, which is funded with after-tax dollars, you’ll have to pay taxes on that money now. That’s the bad news.
But the good news is that from now on, that money will grow inside your Roth IRA tax-free and you won’t pay any taxes on that money when you’re ready to withdraw from the account in retirement. A Roth conversion might feel like ripping off a Band-Aid now, but it’ll feel great once you retire.
You might want to seriously consider doing a Roth conversion only if you can afford to pay the tax bill with cash you have saved up. But be careful, because a conversion could add thousands of dollars to your tax bill. If that’s just too much for you to stomach, then stick with a traditional IRA rollover.
This is a big decision, and you don’t have to make it alone! Get in touch with a tax advisor who can help you understand the tax implications of a Roth conversion and help you decide which option might work best for you.
How to Roll Over a 401(k) Into an IRA
Okay, now it’s time to get the ball rolling! Once you’re ready to do a 401(k) rollover, you can get the money transferred to your new retirement account in just four easy steps:
1. Decide between a traditional or Roth IRA.
Like we just talked about, the type of account you roll your old 401(k) money into will depend on what kind of 401(k) you’re transferring the money from. In most cases, if you have a traditional 401(k), you’ll probably want to roll the money into a traditional IRA.
2. Open the IRA account.
Opening a rollover IRA can be as simple as visiting a bank or brokerage firm’s website and filling out an application online. But the best way to start an IRA is to talk with your investment professional. If you don’t have one, our SmartVestor program can help you find a pro in your area who can help you open up a rollover IRA .
3. Request a direct transfer rollover from your old 401(k).
Remember, you need to ask for a direct transfer rollover from the plan administrator of your old 401(k)—this could be your old employer or a third party. They’ll give you a form to fill out that will usually ask you to provide your information and account information for the plan you’re transferring money from and the account your transferring the money to.
4. Choose your investments.
When it comes to investing, your IRA or 401(k) is like a grocery bag—and your investments are the groceries that go inside it. Now that you’ve got the ball rolling on your rollover, it’s time to pick and choose what goes inside your bag!
We recommend investing 15% of your gross income for retirement into good growth stock mutual funds with a good track record of success. You’ll also want to evenly spread out your investments between four different types of mutual funds: growth, growth and income, aggressive growth, and international.
There are thousands of mutual funds out there to choose from, so how do you know which funds to invest in? That’s where it helps to work with an investment professional who can help you find the right mutual funds to add to your portfolio and walk you through the 401(k) rollover process. Our SmartVestor program can get you in touch with someone in your area to help you get started.