401(K) Rollover – Tips for 401(K) Investing

Leaving an employer's retirement plan means taking care of both tax and investment requirements. Here's how to avoid tax consequences when investing your 401k rollover.
By Richard Barrington

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When you leave your employer, chances are you will have to take your money out of that employer’s 401(k) plan. Knowing what to do next can help you avoid an immediate tax hit and early withdrawal penalty – and keep your retirement investments on track.

Engineer a Tax-Free Rollover

Your first priority should be to avoid any adverse tax consequences as a result of pulling your money out of a 401(k) plan.

Tax-advantaged plans like 401(k) plans typically require you to leave your money in the plan until you reach age 59 1/2. If you don’t, under most circumstances you will owe any ordinary income tax on that money plus a 10% early withdrawal penalty.

One way to avoid these tax consequences when you leave an employer’s 401(k) plan is to roll your money over into another qualified retirement plan. The IRS requires that you do this within 60 days, or else it will be deemed a taxable distribution and subject to the tax consequences noted above.

When arranging to roll money over from a 401(k) plan to another qualified retirement plan, you should take the following steps:

  1. Give the administrator of your current plan written instructions of where your plan balance should be transferred, noting that this will be a transfer to another qualified plan.
  2. Let the administrator of your new plan know where the transfer will be coming from, how much to expect and when to expect it.
  3. As soon as the transfer was expected to happen, promptly check your new plan balance to make sure everything has gone according to plan.

While you can have the money from your current plan distributed to you directly and then deposit it in a new plan within the 60-day window, this is not advisable.

If the money goes to you rather than directly into a new qualified plan, the distribution would be subject to a 20% tax withholding. While this would ultimately be refundable if you met the 60-day deadline for depositing it in a new plan, in the meantime it would be out of your control and not invested on your behalf.

Plus, if any confusion or complications arise with respect to getting the money into a new qualified plan, it could subject you to further tax consequences.

Qualified Plan Rollovers

Since the idea is to preserve your retirement plan’s tax advantages, what are your options for rolling your 401(k) balance over into another qualified plan so you won’t be subjected to tax consequences?

You have a few different options:

  1. If you like your current plan, you may be able to keep your money in the plan even after you leave the sponsoring employer.
    However, if your balance is less than $5,000, the plan has the option of forcing you out of the plan. Plus, you may find leaving your retirement balance behind makes it harder to keep up with new information on investment options and to coordinate that balance with other investments.
  2. If your new employer’s plan permits it, you may be able to roll money directly over into that plan. This may force you to deal with a different set of investment options, but it should make things easier going forward.
  3. If your new employer doesn’t have a plan that permits money to be rolled into it, or if you just want to handle your retirement savings more independently, you can roll the money into an IRA.

Traditional and Roth IRAs and 401(k)’s

When making any kind of a rollover, it is important to match up the tax features of the old and new plans.

Traditional IRAs allow you to deduct your contributions up front. Those contributions are allowed to grow tax-free until you start taking money out of the plan in retirement, at which time you pay ordinary income taxes on those distributions.

Roth IRAs work the other way around. You don’t get a tax deduction on contributions; but once your money is in the plan, it is allowed to grow tax-free and you won’t have to pay taxes on money you take out in retirement.

Traditionally, 401(k) plans have been based on the model of tax-deductible contributions on the front end with taxable distributions on the back end. However, in recent years, some 401(k) plans have begun offering a Roth option, which allows you to pay taxes on the front end instead.

Whether you roll your existing 401(k) balance into a new employer’s 401(k) or an IRA rollover, to avoid adverse tax consequences, you should make sure you match the tax features of the existing plan with those of the rollover. In other words, you should make a like-to-like rollover with balances from a traditional-plan option going into a traditional rollover and balances from a Roth-plan option going into a Roth IRA or 401(k) rollover.

Coordinating Your Long-Term Asset Allocation

Once you have successfully rolled over your 401(k) balance, you need to choose the right mutual funds or other plan options to invest that balance in the new plan.

You won’t necessarily have the same investment options available in the new plan as in the old one, but you can at least shoot for a similar asset allocation as you had previously. First, though, you should check to see if that asset allocation still fits your situation.

Asset allocation is the mix of stocks, bonds and other investments in your plan balance. That mix goes a long way toward determining the risk and reward you will experience. Typically, people gradually shift their retirement savings to somewhat more conservative investments as they approach retirement.

If the plan you roll your 401(k) balance into becomes your main retirement-saving vehicle going forward, then you simply have to determine the right asset allocation for that vehicle. There are various planning tools that can help you do this yourself, and there are also “target-date” mutual funds that set your asset allocation based on when you plan to retire.

In cases where you end up with two separate retirement plans – say a 401(k) at your new employer and an IRA rollover from your previous retirement-plan balance – you will have to set up the asset allocation for each separately, but you should make sure the two are coordinated.

You can do this simply by matching the asset allocation of the two plans to each other so that each is appropriate to your situation, or you can use one plan for a more aggressive approach while the other holds more conservative investments. In the latter case, the important thing is to make sure that the overall asset allocation of the two plans in aggregate is where you want it.

Providing Liquidity for Distributions

If you have reached retirement age, part of investing your 401(k) rollover is to make sure you have liquidity ready when you need to take money out of the plan.

The IRS generally requires you to begin taking distributions from your retirement plan when you reach age 70 1/2 or when you retire. The amount you are required to take out of the plan is known as a required minimum distribution (RMD).

The timing of when you have to start taking RMDs depends on the type of plan you have and when you retire. Roth IRAs do not have an RMD requirement. When RMDs do apply, the amount of the RMD is determined by a formula based on your life expectancy.

Even if you have not yet reached age 70 1/2, you may choose to take money out of your retirement plan earlier to help meet retirement expenses. Whether you are taking money for an RMD or to meet expenses or both, you need to make sure there is going to be money available in your plan to be withdrawn, rather than having it all tied up in long-term investments.

To do this, you should plan to allow cash from interest, dividends and investment sales to build up and/or have securities mature in time to meet your withdrawal schedule. This will save you from having withdrawals force sales of securities at what might be a bad time from an investment standpoint.

Finally, remember that just because you have to take RMDs doesn’t mean you are obligated to spend all that money if it is more than enough to meet your expenses. If it is more than you need, you can reinvest some of it in a taxable investment portfolio so it can grow to help meet future needs.

In short, whether you are changing employers or retiring, rolling out of a 401(k) plan doesn’t mark the end of your retirement savings and investment program. It just marks the beginning of a new phase for that program.

About Author
Richard Barrington has been a Senior Financial Analyst for MoneyRates. He has appeared on Fox Business News and NPR, and has been quoted by the Wall Street Journal, the New York Times, USA Today, CNBC and many other publications. Richard has over 30 years of experience in financial services. He has earned the Chartered Financial Analyst (CFA) designation from the Association of Investment Management and Research (now the “CFA Institute”).