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How to Rollover Your 401(k) When You Retire

Retiring soon? Congratulations! Reaching retirement is a big and exciting accomplishment. But it’s also a time of transition, and there are a lot of changes and decisions to make.

One of the biggest choices is how to handle your 401(k). You have a few options, but you'll want to weigh them carefully to make the most of your money and avoid paying any extra taxes. Rolling over your 401(k) into an IRA is often the best choice, but there are a few things to consider before you do it.

What Are Your Options?

When you retire and leave your job, you’ll need to decide what to do with your 401(k). In most cases, you’ll have a few choices for how to handle the money:

  • Leave It Alone - Closing your 401(k) when you retire is an option but usually not a requirement. If your balance is less than $5,000, you’ll automatically receive a lump-sum distribution. Otherwise, the plan administrator must maintain the account. Aside from required minimum distributions, you can leave the money alone.
  • Take Qualified Distributions - If you’re 55 or older when you retire, you’re free to take withdrawals from your 401(k). The rules vary by plan, but you can usually opt for fixed periodic distributions or lump-sum withdrawals. Just remember that all withdrawals are subject to your current tax rate.
  • Rollover to an IRA - Instead of leaving the money in your 401(k), you can move it into an IRA. You’ll need to coordinate with your 401(k) plan administrator, but rolling over to an IRA provides more flexibility and control over your savings.

Why Rolling Over to an IRA Makes Sense

Contributing to a 401(k) during your working years is an important part of using the tax triangle to boost your retirement. But once you’re retired, rolling your 401(k) into an IRA has a lot of advantages:

  • Fewer Accounts to Manage - Consolidating into an IRA reduces the chance of forgetting about an account or ending up with an orphan 401(k)
  • More Investment Options - Employer-sponsored plans usually have a small pool of investment options, while IRAs allow you to invest in almost any stock, fund, or bond you choose
  • Lower Fees - 401(k)s often carry administrative and management fees, while fees on most types of IRAs tend to be much lower
  • Continued Contributions - You can’t contribute to 401(k)s once you’ve left a job, but you can add funds to your IRA for as long as you’d like
  • Flexibility for Withdrawals - 401(k) plans usually have rigid rules for periodic distributions, while IRAs give you flexibility for withdrawals to minimize your tax burden
  • Estate Planning Advantages - Many 401(k) plans require beneficiaries to take a lump-sum payment, but IRAs have more inheritance options

How to Do a Rollover The Right Way and Avoid Extra Taxes

401(k) rollovers might sound like a daunting process, but they’re usually quite easy. There are four key steps to protect yourself from extra taxes or fees.

1) Set Up an IRA

If you don’t already have an IRA, you’ll need to set one up to roll your 401(k) into. Most financial firms offer competitive options, but you’ll want to select a plan with as few fees as possible and no trading commissions.  

2) Consult Your 401(k) Administrator 

There’s no standard process for closing a 401(k), so it’s important to consult the plan administrator about what to expect. In some cases, you’ll need to provide your IRA information so they can roll the funds directly into your account. However, the 401(k) administrator will often send a check that you’ll be responsible for transferring into your IRA. Getting the details on both sides of the rollover will help avoid any hiccups that could have tax consequences.

3) Deposit Funds into Your IRA ASAP

If your 401(k) administrator sends you a check, it’s critical to deposit it into your IRA quickly. Any funds that you hold for more than 60 days become taxable income. And if you’re 59 or younger, there are early withdrawal penalties on top of that.

4) Invest Your Newly Deposited Funds

Once you roll your 401(k) funds over to your IRA, don’t leave them sitting as cash or in a money-market account. Allocate them to stocks, mutual funds, bonds, or other investments based on your overall portfolio and financial planning strategy. If you're not already working with a financial advisor, this might be a good time to engage one, as they can help you evaluate your options.

Other Considerations to Keep in Mind

Rolling your 401(k) into an IRA when you retire is generally advantageous, but there are a few situations to think about before you go through with it:

  • Traditional IRA vs. Roth IRA - Depending on your financial situation, you may be able to reduce your tax burden with a Roth conversion. This option can be beneficial for people nearing retirement age or who have just retired.
  • Risk of Litigation or Bankruptcy - The federal Employment Retirement Income Security Act (ERISA) protects 401(k)s and other employer-sponsored retirement plans from creditors, but does not protect IRAs. If your line of work is prone to civil lawsuits - such as doctors - or you’re at risk of filing for bankruptcy, leaving funds in a 401(k) might be a safer bet.
  • You’re Retiring Early - The IRS allows early retirees to make penalty-free withdrawals from their 401(k) plans beginning at age 55. However, there’s another way to pull funds penalty-free from your retirement accounts (including IRAs) if you retire before age 59½. A 72(t) distribution, also known as Substantially Equal Periodic Payment (SEPP) exemption, allows for penalty-free distributions from a retirement account over a 5-year period. Payments are calculated based on your life expectancy and must be similar in size. A 72(t) distribution is not constrained by the age 55 rule so you can start distributions at any time.  

If you’re unsure whether any of these situations apply to you, a trusted financial advisor can help you understand the details and select the option that’s best for your retirement plan.

Want to make sure you're prepared to maximize your nest egg? Download a copy of our 2021 Essential Retirement Guide to perfect your personal retirement plan.

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