By Bill Gallagher, CFP®, MPAS®
Q: What is a rollover?
A: A rollover is when you move funds from your 401(k) plan to a Traditional IRA, Roth IRA, or another employer-sponsored plan. There are two types of rollovers: a direct rollover and a 60-day rollover.
When you elect a direct rollover (or trustee-to-trustee transfer), the funds are transferred directly from your 401(k) to your IRA. As you never take possession of the funds, there are no tax consequences on the distribution. With a direct rollover, your 401(k) provider will either electronically transmit the balance directly to your new custodian or issue a check made payable to your IRA. For example, let’s say that Joe Smith would like to do a direct rollover from his 401(k) to his Charles Schwab IRA. In this situation, his 401(k) provider will send him a check that reads as follows: “Charles Schwab FBO Joseph Smith IRA”.
When you elect a 60-day rollover your 401(k) provider will send a check directly to you, made payable to you. Upon receipt, you can deposit the funds into your checking account and use them as you see fit. Providing that you re-deposit these funds into your IRA within 60 days of the distribution you will avoid the income tax consequences associated with the withdrawal. If the funds are not deposited into your IRA within 60-days, then the distribution will be taxed as ordinary income and the IRS will assess a 10% early withdrawal penalty if you are under 59 ½ at the time of the distribution.
Please note: if you elect a 60-day rollover, your 401(k) provider is required to withhold 20% of the taxable portion of the distribution. While you can still roll over the full amount of the distribution, you will need to make up the 20% that was withheld from your other assets.
Q: When can I roll over my 401(k) to an IRA?
A: Your ability to elect a rollover is mainly contingent upon your employment with the company. Most 401(k) plans, but not all, only allow you to initiate a rollover when you terminate your employment, either voluntarily or involuntarily. Therefore, it is not until you leave your employer when you are eligible to roll over your 401(k) to an IRA.
However, some 401(k) plans allow employees of a certain age (typically 59 1/2), to elect a rollover even when they are still employed with the company. This is referred to as an in-service rollover. Not all plans offer this feature, so it is important for you to check with your plan sponsor to determine if this option is available to you.
Q: How do I initiate a rollover?
A: Before you initiate the rollover, you will need to decide on where the funds will be deposited. If you would like to roll over the funds to an IRA, and you do not have an IRA, then this will be a good time to get one established at a bank or brokerage firm. Once your IRA is created, you will need to contact your 401(k) provider and inform them that you would like to roll over the funds from your 401(k) to your IRA. The 401(k) provider will provide you with the paperwork that you will need to complete in order for them to process the rollover.
Q: Can I roll over both pre-and post-tax money to my IRA?
A: You can roll over both your pre-tax and post-tax money from your 401(k) to a Traditional IRA or Roth IRA. In order to avoid taxation on the pre-tax portion, you would elect this portion to be rolled over to your Traditional IRA. However, if you happen to have funds in a Roth 401(k) or if you have made after-tax contributions to your 401(k), you would elect these funds to be rolled over in a Roth IRA. This way you can continue to take advantage of the tax-free distributions in retirement. It is important that this be handled correctly as it can be difficult to unravel. It is best to receive two separate checks (one for the pre-tax portion and one for the after-tax portion) from the 401(k) provider to keep the transactions orderly and clean.
Q: What are the benefits of rolling over my 401(k) to an IRA?
A: There are two main benefits associated with rolling over your 401(k) to an IRA. The first benefit is the ability to get access to a wider array of investment options. Typically, 401(k)s offer a limited selection of investment options and you may find it difficult to fully diversify your portfolio. While most of the major asset classes (stocks, bonds, cash) may be covered, you may find it difficult to diversify your portfolio further within those asset classes. If you establish your IRA with a brokerage firm, you will have the ability to fully diversify your portfolio as you will be able to invest in individual stocks, bonds, ETFs, and mutual funds. The second advantage of rolling over your 401(k) to an IRA is the potential to reduce your investment fees and expenses. Traditionally, 401(k)s have been associated with higher fees. Most companies, but not all, spread out the cost of maintaining the 401(k) plan across their employee base, leading to higher fees for the participants in the plan. In addition, most plans incorporate active mutual funds, as opposed to index funds which carry lower fees. Rolling the funds into an IRA will provide you with the ability to access low-cost index ETFs.
There are some disadvantages to rolling funds into an IRA, however. One of the main disadvantages of an IRA is the fact that you cannot take a tax-free loan from your IRA should you need to access the funds prior to retirement. Most plans allow employees to access the funds in their 401(k) through a loan feature. While there is a limit on how much an employee can borrow against their 401(k), it is an option should they find themselves in a financial pinch.