If You Recently Left Your Job, Here Are the Pros and Cons of Rolling Over Your 401K to an IRA

Unfortunately, many employees have lost their jobs over the past year as the Federal Reserve continuously raised interest rates. Whether you left voluntarily or were laid off, you must decide what to do with your former company's 401k. Most people roll over their 401k to an IRA because they have access to more investment options and more control over their accounts, but I will explain your options in detail.

When you leave your job, you generally have four options for your 401k plan. Generally, the best option is doing a 401k rollover to an individual retirement account (IRA). Other options include cashing it out and paying the taxes and a withdrawal penalty, leaving it with your former employer, but only if your former employer allows this, or transferring it into your new employer's 401k plan.

More Investment Choices

Most 401k plans have limited investment options depending on what plan administrator your company chooses to manage its 401k plans. Most 401k options consist of 20 various mutual funds, some index funds, and some money market options, which to most may seem very limited.

Most IRAs have almost unlimited investment options in the public investment marketplace, including individual stocks and ETFs. Another downside of 401k plans is that they limit the times you can rebalance your portfolio per year; most 401k plans only allow two rebalances or restrict you to specific times during the year, and IRAs don't limit the number of times you buy or sell investments.

Taxes and Distributions

An often-overlooked difference between a 401k and an IRA is the IRS rules concerning taxes on distributions. IRS rules require that 20% of distributions from a 401k be withheld for federal taxes. You can opt to have no tax withheld when you take a distribution from an IRA.

It is wise to have some tax withheld rather than ending with a large tax payment at the end of the year and conceivably owing penalties and interest for underpayment come tax season. It is better to be able to choose how much to have withheld to reflect the actual amount you will owe more accurately rather than an automatic 20%. You want your money to grow and continue to compound as long as possible on a tax-deferred basis, then have to wait for the IRS to send you a refund.

You must generally pay a 10% early withdrawal penalty if you withdraw from your IRA or 401k before you are 59½. There is, however, an important exception for 401k plans: Employees who leave their positions in the calendar year they turn 55 years old or later can receive penalty-free withdrawals from that employer's 401k plan.

However, if you roll that money into an IRA, you will have to wait until you are 59½ to avoid the 10% penalty unless you meet one of a handful of exceptions. Remember that you will still have to pay taxes on the withdrawals.

As of 2023, another thing to consider applies to people who plan to work past age 73, which is increasingly common. Ordinarily, you must take the required minimum distributions from your IRAs and 401k plans starting the year you turn 73. These required distributions are calculated by the value of your investment accounts at the previous year's end, and a life-expectancy factor found in IRS tables.

However, if you are still working at age 73, you do not have to take RMDs from your current employer's 401k plan. Furthermore, if your plan allows you to roll over money from an ex-employer plan into your 401k, you can also protect those assets from RMDs until you stop working.

401k Fees Are Higher Than IRAs

Underperforming funds and high costs hobble many 401ks. Even low-cost plans may charge ex-employees higher administrative fees if they decide to keep their 401k. Rolling your old 401k over into an IRA can reduce the management and administrative fees you have been paying, which limits your investment returns over time. Of course, your IRA will not be free of fees either. However, you will have more choices and control over how you will invest, where, and what you will pay.

The Option to Convert to a Roth

An IRA rollover gives you an excellent reason to consider converting to a Roth IRA account. For example, if you have a Roth 401k, a Roth IRA is your preferred 401k rollover option. With a Roth IRA, you make contributions with your after-tax earnings, and you can't deduct your contributions from your gross income come tax time, but there are no taxes owed when you withdraw cash. That is the opposite of a traditional IRA account.

Traditional IRAs deduct your contributions from your gross income, reducing your current taxes, but the downside is that your withdrawals are taxed in retirement. Traditional IRAs require minimum distributions to begin at the age of 73. With a Roth IRA, you are not required to take minimum distributions (RMDs) at age 73 because you have already paid income taxes on those funds.

One thing to consider is if you believe that you will be in a marginally higher tax bracket or that federal income tax rates will be generally higher when you start withdrawing your from your IRA, switching to a Roth from a traditional account, and taking the tax hit now might be in your best interest.

If you are under 59½, it is much easier to withdraw your funds from a Roth IRA than from a traditional IRA. Generally, there are no penalties for early withdrawals of your contributions, but there are penalties if you take out any investment earnings.

Income Limits for a Roth IRA

There are income limits to be able to make contributions to a Roth IRA, and single tax filers are required to have a modified adjusted gross income of less than $144,000 or less than $153,000 in 2023. If you are married and filing jointly, your joint modified adjusted gross income must be under $214,000 in 2022 or $228,000 in 2023.

Stay With a 401K if You Are Worried About Personal Lawsuits

The federal Employment Retirement Income Security Act (ERISA) shields 401k and other types of employer-sponsored retirement plans from creditors making claims on your assets. If you lose a judgment in a personal injury lawsuit, they cannot make a claim on your 401k plan. IRAs do not offer that same level of protection. They are generally protected if you file for bankruptcy, but state laws vary concerning other types of personal claims.

How to Roll Over Your 401k to an IRA

The easiest and safest way to roll your 401k into an IRA is with a direct rollover from your financial institution that manages your 401k plan to the one that will be holding your IRA. You must first set up the new account and then contact your plan administrator to have the funds transferred. There are three main types of rollovers from a 401k to an IRA:

1. Rolling over a traditional 401k to a traditional IRA. Here the taxes are deferred, and you will not owe anything.

2. A rollover from a Roth 401k to a Roth IRA. You will not owe taxes.

3. Rolling over from a traditional 401k to a Roth IRA. You will owe income taxes on the entire amount you roll over to the Roth.

Indirect Rollover

Another option, but a far riskier, is to have the check sent to you and take possession of the funds yourself. If you do that, you typically have 60 days from receiving the funds to roll it over into an IRA. However, if you fail to meet that 60-day deadline, the distribution amount will be treated as a withdrawal, and you will be subject to income taxes and possibly penalties on the total amount.

A further downside of receiving the distribution yourself is that your former employer will be required to withhold 20% of it for taxes. Mail issues or other complications can arise, and the IRS could claim that the funds were disbursed to you and not rolled over, and that is why we recommend doing a direct rollover to avoid any such issues.

Cashing out a 401k

If you cash out a traditional (but not Roth) 401k account, you will owe income tax on the money. In addition, you will generally owe a 10% penalty for early withdrawals if you are under 59½. However, it is possible to avoid the penalty if you qualify for one of the IRS-approved exceptions. Those include using the funds for qualified education expenses or up to $10,000 to buy your first home.

Summary

There are several advantages to rolling over a 401k into an IRA. First, if you roll your 401k money into an IRA, you will avoid immediate taxes, and your retirement savings will continue to grow tax-deferred. The most significant advantage is that an IRA can offer you substantially more investment choices than most company 401k plans while maintaining your tax-deferred status by staying in a qualified account.

You will have more options and control over how you will invest, where, and what you will pay, and most 401k plans only allow two rebalances or restrict you to specific times during the year, and IRAs don't limit the number of times you buy or sell investments. So if you have any questions, speak with an Infinitus Wealth advisor to see if rolling over your old 401k is right for you.

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