After leaving an employer, it’s a good idea to roll over your 401(k) into an IRA, but make sure that you pick the right IRA or there could be tax consequences.
What is a 401(k)?
Many employers offer 401(k) retirement plans for their employees. With the 401(k), funds are taken from your paycheck before taxes are calculated and put in a separate retirement fund. This reduces your taxable income, so you pay fewer taxes each paycheck than you would if the money was still there.
Some companies offer matching contributions to 401(k) retirement accounts. For example, if you contribute 3 percent of your paycheck to a 401(k), your company will throw in another 3 percent. Company matching funds usually aren't directly available to you until you are vested with the company. The amount of time required for an employee to become vested in a company retirement plan can differ from employer to employer.
For example, say you contribute $100 every paycheck to your 401(k) and your employer matches that contribution. Employees with the company are vested after five years. Three years into your job, you decide to leave. Over the years, your 401(k) has grown to $5,200 from your contribution and the company match. Since you are leaving before the five-year vesting period, you only get half, or $2,600, of that retirement account. To get the full amount, you would need to stay at least five years at that employer.
What can you do with your 401(k) retirement account when you leave?
Only employers can open 401(k) accounts on your behalf. You can’t go out and open one on your own. So what can you do with the money? There are a few options.
Cash out your 401(k)
This is the worst option and should only be done if you face financial hardship. Since the money was put into the 401(k) pre-tax, if you withdraw it, you will have to pay the taxes on it because the government considers that income. If you are under age 59.5, you might also be subject to a 10 percent early withdrawal fee.
Leave it where it is
There aren’t many 401(k) plans that allow you to leave your money in the accounts after you leave the employer that set it up. If they do, it's usually only for accounts with a considerable amount of money. You also won’t be able to continue to contribute to the account.
Roll it into a 401(k) at your new employer
If your new employer offers a 401(k) and that plan accepts rollovers, this is a good option. You won’t have to pay taxes on the rollover as long as your money is transferred to the new account within 60 days.
Rollover into an IRA
This is probably the best option for your 401(k) funds. You can open an IRA retirement account through any financial institution or brokerage firm.
Not all IRAs are created equal.
There are two types of IRA accounts—a traditional IRA and the Roth IRA. There aren't any tax consequences if you roll your 401(k) into a traditional IRA, which is funded with pre-tax money like a 401(k). There are tax consequences if you roll over into Roth IRA, which is funded with post-tax dollars.
Transferring funds from your 401(k) into a traditional IRA can be done directly by your retirement plan administrator. You can also choose to withdrawal your 401(k) funds and deposit them yourself in an IRA. In that case, you will have to do so within 60 days or else face tax consequences.
With a traditional IRA, you can contribute up to $6,000 per year or up to $7,000 if you are age 50 or older. Any amount you roll over into an IRA from your 401(k) or another IRA doesn’t count towards the contribution limits. You don’t have to pay taxes on the money in a traditional IRA until you decide to withdraw it.
There are tax consequences for 401(k) rollovers to a Roth IRA.
If you roll your 401(k) into a Roth IRA, you will have to pay taxes on that money. Unlike a pre-tax 401(k) and traditional IRA accounts, a Roth IRA is a post-tax account. This means that you pay taxes on the funds before you put them in the Roth IRA. A big advantage of the Roth IRA over the traditional IRA is that you can make withdrawals without paying additional taxes since the money has already been taxed.