Eventually we all get to the point where we are no longer going to continue working for our employer. This may mean that you are going to switch jobs. Or it may mean that you are going to retire.
When either of these happen you must look at your 401(k) rollover options and decide which is best for you.
Think of your 401(k) as a delicate egg. When you move this “delicate egg” to a new place, you don’t want to break it.
And it’s easy to break it. If you choose the wrong 401(k) rollover options, you could inadvertently lose the tax deferral on your 401(k) funds. This could leave you with a big tax bill, and a reduced retirement fund.
Let’s be careful with that egg.
The 4 Main 401(k) Rollover Options
You are going to have just a couple of options of what you can do with your 401(k). Be sure to check out all of the options below so you will know which one works best for you.
And it’s not a one size fits all decision. Some people will benefit more from different options.
But I do know that there are some options that generally will not make sense for most people. I will tell you about some of those options below as well.
So let’s get started!
Option 1 – Take a lump sum distribution of your 401(k)
This is probably the worst of all the options. You simply cash out your 401(k) and pay the income taxes on it.
The reason this is so bad (if it’s not obvious enough already) is that the 401(k) proceeds will count as income for the year you cash it out.
This could put you in a higher marginal tax bracket. You could be paying a higher percentage in taxes to the IRS if you do this.
Secondly, you lose the power of tax deferral. The longer you can tax defer your investments, the larger they can grow. Even when you consider the fact that you will pay taxes on the larger balance, you still come out with more money for yourself.
Thirdly, if you take a lump sum distribution before you are age 59 ½, you will pay a 10% penalty to the IRS (in addition to the income taxes you’ll pay on the funds).
You may be able to avoid the 10% penalty to the IRS if you qualify under the age 55 scenario that I will describe in Option 3 below.
Option 2 – Roll your 401(k) account to your new employer
This option is for people that are changing employers. If your new employer will allow it, you may want to roll your 401(k) from your old employer into the 401(k) plan at your new employer.
This is not going to be the best option for everyone, but for some people this will make a lot of sense. Here’s why:
If you plan on working beyond age 70 ½, you can delay your required minimum distributions from your 401(k) account at your current employer.
As you probably know, the IRS requires you to begin taking required minimum distributions from your qualified accounts once you reach the age of 70 ½.
But if you are still working beyond age 70 ½, you don’t have to pull the required minimum distributions from your 401(k) at your current employer.
With an IRA you are required to make the distributions at age 70 ½. Not so with a 401(k) at your current employer if you are still working.
So if you plan on continuing to work past age 70 ½, it may make sense for you to roll your old 401(k) funds into your new employers funds and keep delaying the required minimum distributions.
Option 3 – Leave your 401(k) with your old employer
When you leave your old employer you may have the option to leave your 401(k) funds in the plan. Why would you do this instead of rolling the funds into an IRA that gives you much more investment options?
One reason would be to get access to the funds without having to wait until you are 59 ½. If you withdraw funds from an IRA before 59 ½, under most circumstances you will have to pay a 10% penalty to the IRS (you’ll also pay taxes on the funds as well).
But if you retire from your employer in the calendar year that you will turn 55 (or older) you can withdraw funds from that employer’s 401(k) plan without paying the 10% penalty to the IRS.
So if you needs some funds to hold you over from age 55 to 59 ½, you may want to choose this option.
And note, this only applies to 401(k) funds in an employer’s plan if you quit working with that employer in the year you turn 55 or older.
So if you have 401(k) funds still sitting at former employers, and you quit working for those former employers before the calendar year that you turned 55, you would still pay the 10% IRS penalty for withdrawing before age 59 ½.
So if you need access to all of your former employer 401(k) accounts, be sure to roll them into your current employer’s 401(k) account before you quit work. Then when you quit work in the calendar year you turn 55, you’ll have penalty free access to these funds before age 59 ½.
You’ll still have to pay the income taxes on withdrawals. That never changes.
Option 4 – Roll your 401(k) to an IRA
One of the best 401(k) rollover options is to roll it into an IRA. This gives you full control over where to invest the funds.
If the rollover is done properly, you can continue tax deferral on the funds.
This is a common option for retirees because of the flexibility it gives them. After your funds have been rolled into an IRA you can allocate them into investments that will make sense for you.
This may include:
- Putting a portion into an IRA fixed annuity that has no market risk and conservative growth potential
- Putting another portion into an IRA managed fund in the market that has greater growth potential
- Using smart allocation strategies to plan for income needs in retirement
- Holding a portion in cash inside an IRA CD at the bank
You can do all these options and more, and they could all be done using IRA accounts that allow you to continue tax deferral on your 401(k).
There is a lot of flexibility with this option as it lets you plan for your retirement needs.
If you know anyone that needs help with their 401(k) rollover options, be sure to forward this article to them. We can reach more people spreading the word together than I ever could on my own.
And if you need help with your 401(k) rollover, then CLICK HERE to download the free “401(k) Rollover 10-Point Checklist For Baby Boomers.”
It will take you through the process in 10 easy steps.