The median number of years that U.S. workers stick with their current employer is 4.6 years, according to U.S. Department of Labor. This means that sooner or later you’re bound to quit, get fired, or get laid off from your current job. To avoid steep transaction fees, early distribution taxes, or losing retirement account contributions, you need to be ready to roll over your hard-earned nest egg when the time comes.
Establish How Much You Really Have
The first step is to determine the current balance of your 401K or IRA. While you’ll eventually receive a separation from employment notice from your previous employer stating your total vested account balance, you can save time by researching your vested balance, net of any 401K loan balances you may owe.
Take Care of Any Outstanding Loans From Your 401K
Unlike IRAs, many 401K plans offer the option to take loans from your retirement account. As long as you keep up with your payment schedule, you generally have up to five years to pay back your loan in full. However, when you change jobs, the unpaid loan balance becomes due within 60 days.
Any unpaid loan monies by the deadline or transaction date of your rollover are subject to federal income tax, a 10% early distribution penalty for those age 59 1/2 and under, and state income tax or penalty, if applicable. You can’t roll over unpaid 401K loans.
Know the Vesting Schedule
Your own contributions to your 401K or IRA are always fully vested. However, contributions from your employer to your retirement account may be subject to a vesting schedule. Trying to retain top talent as long as possible, employers may require a minimum period of employment before employees gain full control on part of their retirement accounts. The two most common vesting schedules are cliff vesting (100% vesting is only provided after a set number of years) and graded vesting (a vested percentage is provided every year).
When you separate from your employer, you forgo any non-vested contributions to your retirement account.
Once you know your outstanding loan balance and vesting schedule, you have a clear idea of how much you can rollover.
Choose Rollover Options
Under most scenarios, you have six options for your total vested account balance:
Keep your account;
Rollover account into a new or existing IRA;
Rollover account into a new or existing qualified plan;
Do an indirect rollover;
Request a full cash-out of your account; or
Do a mix of the above five options.
Let’s analyze each one of these scenarios, because some of them may trigger taxes.
1. Keep Your Account
All retirement accounts stipulate a minimum amount required to remain in your old employer’s plan, usually ranging from $1,000 to $5,000. If you’re happy with your current financial provider, you can choose to keep the account.
Make sure to read the fine print because some providers may strip away some services (such as certain investment options or coverage of fees) and gain the right to convert your 401K into an IRA without your input. According to a Plan Sponsor Council of America survey of 613 plans with eight million participants, 57% of 401K plans transfer balances between $1,000 and $5,000 to an IRA when the participant leaves the employer.
While such forced-transfer IRAs don’t trigger early withdrawal penalties or income taxes, they are often subject to high fees and low investment returns. A November 2014 report from the U.S. Government Accountability Office (GAO) found that forced-transfer IRAs have administrative fees, ranging from $0 to $100 or more to open the account, and $0 to $115 annually to retain the account.
2. Rollover Account Into a New or Existing IRA
Whether you have a 401K or IRA, your current provider will provide you the option to request a rollover to an existing IRA, or open a new one through any of their partner institutions. Either option triggers no income taxes or distribution penalties. Under this scenario, keep in mind that you’re not bound to the offerings from your old employer’s financial institution and have the option to shop around for a new IRA with other financial institutions, as well.
There are two types of IRAs: traditional IRA and Roth IRA. The main difference between them is that you pay taxes up front with the Roth IRA, and that you pay taxes at withdrawal with the traditional IRA. One of the advantages of owning an IRA is that there are many penalty-free ways to withdraw money from your retirement account before age 59 1/2. (See also: 7 Penalty-Free Ways to Withdraw Money From Your Retirement Account)
3. Rollover Account Into a New or Existing Qualified Plan
Besides an IRA, you can also rollover your retirement account into a 401K, 403(b), 457, Federal Thrift Savings Plan, or employer qualified plan, as long as the target plan allows those funds. Rollovers into new or existing qualified plans trigger no income taxes or early distribution fees.
The IRS provides a useful rollover chart to determine to which accounts you can rollover retirement contributions. However, the most surefire way to find out is by contacting your plan’s customer service center.
4. Do an Indirect Rollover
Direct rollovers are only possible if you already have a retirement account with a previous or new employer or are able to open a new plan on your own. In the event that you think that you can find a new job offering a retirement account within 60 days, then you could try to do an indirect rollover.
Your old employer would cut you a check, withholding the necessary 20% for income tax purposes. Once you have a qualified plan with your new employer, you would deposit the check in full and add the 20% withholding out of pocket. The IRS will return you the 20% withholding when you file your tax return. Make sure to deposit the full amount because any gap is subject to applicable income taxes and penalties for those age 59 1/2 and under.
5. Request a Full Cash-Out of Your Account
This is the least desirable of all options because not only do you pay incomes taxes and trigger early distribution fees, but also forgo investment returns. At age 20, a $600 balance on a 401K may not seem like much. However, assuming an investment return of 6% compounded annually and a target retirement age of 65, you would be saying goodbye to an extra $8,258.77 for your nest egg.
Every year you have a ceiling on how you much contribute to your 401K or IRA. By cashing out that past contribution, you’ll never be able to make it up.
6. Do a Mix of the Previous Options
Depending on your unique situation and set of rules from your old and new retirement accounts, you could use portions of your old account for different purposes. For example, you could cash out 10% of your vested account balance, subject to income taxes and early distribution penalties when age 59 1/2 and under, and rollover 90% of vested account balance to an IRA.
Doing a mix of rollover options requires careful planning and plenty of legwork, but it may provide the solution that is better suited to your financial goals.
The Bottom Line
Knowing how to rollover your 401K or IRA is a skill that you’ll use many times throughout your work years. The process is relatively simple but requires many steps. Before rolling over funds, make sure to plan ahead by minimizing loans from your 401K and maximizing total vested balance. Contact your old and new plan managers so that you are aware of all applicable rules and can make an informed decision. Keep an eye on the deadline for a rollover so that you’re not forced to take a cash-out or forced to transfer to a high-fee IRA.