How to Roll Over Your 401(k)

When leaving a job, you must decide what to do with your 401(k). You have the choice of leaving it where it is (this makes sense if you like the investment options offered by the plan), rolling it over into a qualified retirement plan with your new employer (if your new employer accepts rollovers and you like the investment options in the new plan), or rolling it into your IRA (if you want maximum control over your investment options).

If you want to transfer funds from your 401(k) to a qualified plan of a new employer or your IRA, you have two options and some wrinkles to consider.

Direct Rollover

To process a direct rollover, ask the plan’s trustee to make the payment to another qualified retirement plan or IRA. Usually, you will complete paperwork verifying that you want the plan administrator or trustee (the person in charge of the plan) to make this transfer. You can roll over some or all of the funds.

• Pros: Usually, distributions from a qualified retirement plan are subject to a mandatory 20% tax withholding, but a direct rollover avoids withholding. Even if the plan sends you a check, as long as it is payable to the new plan or IRA, it is treated as a direct rollover and there is no withholding.
• Cons: It may take time for the trustee to process your paperwork and send the funds to the new plan.

Special Considerations

Rolling over a 401(k) that includes stock in your employer's company may not be a good move; a partial rollover may be better. Here’s why: employer securities have a net unrealized appreciation (NUA), which is the difference between the original cost and their current fair market value. If you roll over the stock, you forfeit the potential tax benefit of converting ordinary income into preferentially taxed capital gains. With a rollover, the eventual distribution stemming from the employer securities will be taxed as ordinary income.

In contrast, if you take a current distribution of the stock (called an in-kind distribution), you’ll pay ordinary income taxes and possibly an IRS premature withdrawal penalty (10% if under 59 1/2) on the original cost of the distributed stock; however, you will position yourself for favorable tax treatment later on. The NUA and all future appreciation will be taxed as capital gains when you sell the stock.

60-Day Rollover

You can make a rollover by depositing distributed 401(k) funds into another qualified retirement plan or IRA. The rollover can be completed by endorsing the issued check over to the new plan or IRA, or by depositing the funds in your (non-IRA) account and then writing a check on that account payable to the new plan or IRA. You have 60 days from the date you receive the distribution to complete the rollover.

Advantages and Disadvantages of a 401(k) Rollover

One primary advantage of a 401(k) rollover is that you have control over the funds for the short term and can use them before completing your rollover. For example, if you need funds for a specific purpose (e.g., paying your tax bill for the year), you can use the distribution and not incur any income tax as long as you come up with other funds to complete the rollover within 60 days.

A primary disadvantage is that the distribution is typically subject to the automatic 20% withholding tax (although you can request the plan administrator to withhold more or less taxes from the rollover amount). If you take a distribution and then decide to make a full rollover, you’ll have to come up with the 20% amount from your own pocket to complete the rollover; you’ll recoup this amount when you file your tax return.

For example, say you have $50,000 in your 401(k) and want to take a complete distribution with a 20% withholding. The plan will send you $40,000 ($50,000 - (20% x $50,000)). To make a full rollover so that you won’t owe any current tax on the distribution, you’ll have to use the $40,000 you received plus $10,000 of your own money to complete the rollover. When you file your return, the $10,000 withheld is a tax credit that you can receive as a refund. Another drawback is that it’s all too easy to miss the 60-day rollover deadline, despite good intentions.

If you do this and can’t get an extension from the IRS, you’ll owe income tax on the distribution. What’s more, if you’re under the age of 59½, you’ll owe a 10% early distribution penalty unless you can show that you used the funds for a purpose that’s exempt from the penalty (e.g., you’re disabled).

Transfer to a Roth IRA

Roth IRAs enable you to build up funds that will be tax-free to you in the future. You can transfer some or all your 401(k) to a Roth IRA. However, this rollover won’t avoid the current tax. You’ll be taxed on the portion going into a Roth IRA. It’s considered a Roth IRA conversion (in the same manner as if you’d converted a traditional IRA to a Roth IRA).

The Bottom Line

If the value of your 401(k) account is under $1,000, the trustee may decide to disburse the funds to you, regardless of your preferences; the funds will be subject to the 20% withholding tax. If the value is between $1,000 and $5,000, the trustee may deposit the money in an IRA in your name unless you opt for a distribution.

For larger accounts, it’s up to you to make a decision. When in doubt, consult with a financial advisor. For related insight, read about using age-based funds in Your 401(k) and what to do if you max out your 401(k).