The Safe Way for Employees to Roll Over a 401(k) to an IRA
To avoid pitfalls employees should talk to a financial advisor before making changes to retirement accounts.
Employees who plan to roll their employer-sponsored retirement accounts into individual retirement accounts (IRA) should seriously consider talking to a financial advisor first. They could lose a lot of money in taxes and penalties by improperly moving money out of a 401(k) when they leave their jobs.
While 401(k) plans and IRAs both let investors put away tax-advantaged savings for retirement, 401(k)s differ from IRAs in three major ways:
- 401(k)s have higher contribution limits — usually three times higher than an IRA.
- 401(k)s typically provide limited investment options while invested in stock exchange-traded funds (ETF) or mutual funds.
- Many employers match employee 401(k) contributions up to a certain salary percentage.
Many employees prefer 401(k)s because of the much higher employer contributions (as much as $19,500 for 2021), compared to IRAs where contributions are limited to up to 3 percent of the employee's salary. However, if an employee has quit or been terminated for any reason, an IRA might be their best option.
Here are a few issues employees should know about before rolling over to an IRA.
Staying Put
Employees can leave their money in a 401(k), even if they leave the company. They will no longer be able to contribute, but the money will continue to grow in the "orphan" account.
"Staying put" can be a great option for someone who likes the current investment and won't withdraw funds. Or, if an employee doesn't have a new job yet, the money can be left in the account until moving to the new company's plan.
Transferring to an IRA
When employees move money from a 401(k) to an IRA rather than taking cash, they avoid the 10 percent penalty applied to early withdrawals if they are younger than 59½.
Employees should choose a good brokerage. Financial experts recommend that investors seek a brokerage offering zero trading commissions and few or no other fees, a variety of investment options, good customer service, usability, and research tools.
After an account is created employees can have the 401(k) funds transferred to the IRA or get a check, which must be deposited to the new IRA within 60 days to avoid tax penalties.
This way there should be little or no cost associated with rolling over a 401(k) to an IRA.
The rule of 55
An employee who leaves a job when or after they turn 55 (but before 59½) can take penalty-free distributions from their 401(k) (although the distribution will be taxable).
However, if an employee moves money to an IRA, the ability to take early distribution without paying the 10 percent penalty will be lost — unless they qualify for another reason.
Tread Carefully with Company Stock
Employees should be aware that if their 401(k) has company stock in addition to their other investments, when they roll over all of their 401(k) assets to an IRA, they will lose the potential to get more favorable tax treatment on any growth from those shares while in their 401(k).
If the company stock is publicly traded, and has unrealized gains, the employee can transfer it to a brokerage account instead of rolling it over to the IRA. Then it will be taxed on its cost basis (the value of the stock) when acquired in their 401(k). However, when they sell their shares from their brokerage account — either immediately or later — any growth the stock experienced inside the 401(k) would be taxed at long-term capital gains rates (0 percent, 15 percent or 20 percent, depending the person's tax bracket). This could be less than the ordinary-income tax treatment they'd get if the stock went into a rollover IRA and was then withdrawn.
Financial Advisors
Obviously, things can get complicated so finding a good financial advisor who will talk to your employee about their situation and goals is a good idea. Your 401(k) managers also may have recommendations. The employee can review their profiles before using them.
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