401k Rollover to an IRA – Why You Should Think Twice About It

When I was 26 I left my first job. It had a 401k that I had been contributing to since I started. Being the responsible investor I was at the time, I immediately decided to rollover that 401k into an IRA at my bank – Bank of America at the time. The total amount of […]
Adam

Written by Adam on October 29, 2018. Updated April 26, 2019.
16 min read. Investing. 6 comments.

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When I was 26 I left my first job. It had a 401k that I had been contributing to since I started. Being the responsible investor I was at the time, I immediately decided to rollover that 401k into an IRA at my bank – Bank of America at the time. The total amount of the account wasn’t anything huge – maybe $20,000 or so. This seemingly innocent action ended up costing me thousands of dollars in taxes over the next decade. Let me explain how.

Scooter with paths

What is a 401k Rollover?

Let’s say you have some money in a 401k today. To “rollover” the 401k means to move it from that 401k to a new (or existing) IRA somewhere – usually at a different financial institute.

An IRA, or individual retirement account, is very similar to a 401k in a lot of ways:

  • It can contain pre-tax money.
  • That money can continue to grow tax-free.
  • Can be accessed starting at age 59.5.
  • Have an early withdrawal penalty if you take money out before that.
  • Have a minimum distribution that must start by age 70.5.
  • Can be used to fund a SEP IRA using the 72(t) rule.
  • You can (usually) convert either into a 401k if you have a job that offers one.

For most people, these similarities are large enough that the way they’ll use these two accounts is roughly the same. 

How are a 401k and an IRA Different?

To be honest, I’d always considered them the same! There are some specifics for taxes and timing of events that could give you pause.

  • You can convert a 401k into an IRA at any time after leaving a job (and sometimes while at a job if your company allows it).
  • You can’t convert an IRA to a 401k until you have an active 401k and your plan allows it.
  • If you retire between age 55 and 59.5, you’ll be able to access the 401k from the company you retired at early without penalty. You won’t be able to access your IRA or other 401ks from past jobs without paying a penalty.
  • If you want to do a Backdoor Roth IRA conversion (which is a way of contributing to a Roth IRA when your income is above the limit) you incur taxes if you have pre-tax in an IRA (I’ll get more into this one later – it tripped me up and caused me to need to pay some taxes).

For these three reasons, having a 401k is more flexible than having an IRA. Having an IRA cuts off some options that are only available to 401k holders.

If you’re at a company with a 401k and you’re retiring at age 55, this also means it’s a great chance to move over all of your other IRAs and 401ks to the company you’re with now. That would give you the ability to start accessing right away (which is pretty awesome actually).

For early retirees (pre-55), the most important one on this list is the Backdoor Roth IRA constraint. Here’s a super-quick rundown on how that works with two situations – one where you pay taxes to get money into a Roth IRA and one where you don’t. Doing a 401k Rollover to Roth IRA is surprisingly simple.

Related:

Tax-Free Backdoor Roth IRA Contribution

Let’s say the total amount of money in all of your IRA accounts is $0 and you make more than $120,000 a year – the amount at which you will no longer be able to fully fund a Roth IRA. In that, your only option is to use a backdoor Roth IRA. The process is relatively simple:

  1. Contribute $5,500 in after-tax money to your IRA, bringing your IRA balance from $0 to $5,500.
  2. Perform an IRA Rollover of all $5,500 from your IRA to your Roth IRA.

That’s it. At that point, your Roth IRA will have an additional $5,500 in it and you will have contributed to it even though you were above the income limit. At the end of the year would pay $0 in taxes on this conversion since your IRA contained only after-tax money already.

Easy hunh?

Taxable Backdoor Roth IRA Contribution

This easy situation breaks down if you already have some money in an IRA somewhere. Let’s say you left your previous job and rolled over a 401k into an IRA at Vanguard. You have $11,000 in that IRA now. The process for rolling it over would take one more step (again assuming an income of $120k, single tax filing):

  1. Contribute $5,500 in after-tax money to your IRA, bringing your IRA balance from $11,000 to $16,500.
  2. Perform an IRA of $5,500 from your IRA to your Roth IRA. Bringing your IRA back down to $11,000 and your Roth IRA +$5,500.
  3. Pay taxes at the end of the year on this rollover.

Wait, taxes?! Yes, unfortunately. That IRA is now very messy. It has $11,000 in pre-tax money from your 401k and $5,500 in after-tax money from your contribution. Once these are mixed there is no good way to separate them again.

By rolling over this $5,500, you’re effectively rolling over part of your 401k into a Roth IRA through an IRA, which means paying taxes on it.

Since two-thirds of your IRA consists of pre-tax money, two-thirds of the money you take out will be taxable.

So 2/3 * $5,500 or $3,666. At the end of the year when you file taxes, you would include this $3,666 in income. If your tax rate is 24%, you’ll pay about $880 on this conversion. That’s no small sum!

What’s worse is that the taxes are due even if this IRA account had a balance of $0 and you had an IRA somewhere else with $11,000. For the IRS’s purposes, all of your IRA accounts are one IRA account.

My IRA Mistake

This is what ended up costing me money. I converted my 401k into an IRA then did a backdoor roth. At the end of that year, I realized I owed taxes on it! (OK, I knew I would, but did it anyway).

For me. it was a tradeoff of paying those taxes then, or not contributing to an IRA/Roth IRA or 401k at all, since my employer didn’t offer one at the time.

The tradeoff can be a tough one. Is it worth paying the taxes now if it allows you to contribute to a Backdoor Roth IRA for a year? 5 years? 10 years? It completely depends on two things:

  • How much you’ll pay in taxes to convert the entire IRA.
  • How many years you’ll be able to take advantage of the Backdoor Roth Conversion.

For me, I did this at age 27. That meant that I could potentially have another 32 years (or about $176,000) that I could put into a Roth over the decades. 

If I had known what I knew now, I would I have waited until I got another job that had a 401k. At that time I would’ve moved my IRA into my 401k then started performing a backdoor IRA conversion.

Best Of Both Worlds

In my case, I decided to convert my entire IRA to a Roth. One other strategy I didn’t consider was to perform a Roth Conversion each year (like the examples above), but with only moving the yearly limit over, keeping my IRA cost basis to be 100% pre-tax money.

This would allow you to make a Roth Contribution each year, but pay a little taxes each time. This has a few major benefits:

  • That money is now going to grow tax free and be able to be accessed tax-free.
  • If you retire early, you’ll now be able to take out the basis (the $5,500) tax-free at anytime.

If you’re planning on retiring early and using your Roth IRA, this can be a way to keep hydrating it with some cash in years you wouldn’t otherwise be able to.

Roth Conversion & Taxes

There may be situations where taking the tax-hit is the only option you have to make a Roth IRA contribution. If that’s the situation you’re in, I’d be cautious of what tax bracket you’re in. Will you be in a lower tax-bracket later when you’re withdrawing the money? If so it probably makes sense to skip the contribution and store that money in a brokerage account. For me in this situation that would have been marginally better. (I believe I was making around $65k at the time – similar to our goal yearly spending). 

So how do you get around this? The easy way is that you don’t convert a 401k to an IRA if you plan to do a backdoor Roth Contribution. The other way is to convert an IRA back to a 401k at your current employer; reseting your IRA balance back to $0.

Why Rollover a 401k to an IRA?

The biggest reason to rollover a 401k is because you have left the job that the 401k was for and now you want to consolidate accounts. As soon as you leave your job you won’t be able to contribute any more money to that 401k account. By rolling it over to an IRA, you’ll have more control over it and be able to contribute to it.

Another common reason is due to limited fund choice. Often, 401ks will have a limited selection of funds available often with high management fee and expense fees. If your 401k only offers actively managed funds with high fees, it’s likely you’ll be better off moving those away ASAP.

Not sure what fees your 401k charges? Or what to look for in a fund? Check out my free course on investing to learn everything you need to know!

How to Rollover A 401k to an IRA

Doing a 401k rollover to an IRA is one of the easiest financial transactions I’ve ever done. The process typically looks something like this:

  • Setup an account at the financial institution where you want your IRA (I recommend Vanguard).
  • Initiate a rollover from Vanguard, providing them with your current 401k’s information.

That’s actually it. For that rollover, you may be required to physically print something and mail it in to confirm that you’re you. The process is surprisingly easy.

Behind the scenes, Vanguard will work with your 401k company to liquidate your funds (convert your funds to cash). That cash will be transferred from bank to bank, then be available as cash in your Vanguard account for you to invest as you choose.

There is another way to rollover a 401k as well – they send you a check. This option freaks me out, as having a check for the full balance of my 401k in my possession sounds much more scary than a bank to bank transfer. If you do have them cut you a check, you can deposit it into your IRA.

401k Rollover Rules

There is an odd rule called the 401k 60-day rollover rule. This rule is all about how long you’re able to hold onto a physical check when rolling over an IRA.

If a distribution from an IRA or a retirement plan is paid directly to you, you can deposit all or a portion of it in an IRA or a retirement plan within 60 days. Taxes will be withheld from a distribution from a retirement plan (see below), so you’ll have to use other funds to roll over the full amount of the distribution.

The IRS, Rollovers of Retirement Plans and IRA Distributions

This is a bit difficult to understand, but the concept is straightforward. If you initiate a rollover from a 401k to an IRA and your 401k company issues you a check for the balance, you have 60 days to deposit that check into your IRA.

If you don’t deposit it by 60 days, you’re out of luck and might as well just deposit that money into your checking/savings account. You’ll need to pay taxes on it at the end of that year as if it were ordinary income. On the bright side you won’t pay an early withdraw penalty, so that’s not all bad, right?

One Rollover Rule

In addition to the 60-day rule there is a “one rollover per year” rule. 

Beginning after January 1, 2015, you can make only one rollover from an IRA to another (or the same) IRA in any 12-month period, regardless of the number of IRAs you own.

The IRS, IRA One-Rollover-Per-Year Rule

This sounds a little scary, but chances are this will never impact you. This only refers to transfers from an IRA to another IRA. You can transfer money all you want between a 401k and an IRA, or between an IRA an a Roth IRA. this is specifically for transferring money between multiple IRAs.

This rule only applies to the situation where your IRA issues you a check and you have 60-days to deposit it into a new IRA. You can only do that once a year. You can do a bank to bank transfer of an IRA to a new IRA as many times as you wish, but you can only have them cut you a check for an account once per year (but really, why would you want to?).

This rule may sound weird, but my guess is it’s setup to stop people from dipping into their IRAs by somehow accessing them during this time then repopulating them with money.

Luckily it’s not something you need to worry about unless you’re trying to consolidate a bunch of IRAs in a single year and more than one of them doesn’t allow bank to bank transfers.

401k Rollover Limit

If you no longer work at the company there is no time limit for when you would need to roll over your 401k to an IRA. As long as the 401k is actively maintained by the company you worked for it’s still there.

There is no limit on the amount you can rollover to an IRA either. Whether your account contains $500 or $500,000, you can roll it over.

If your 401k balance is below $5,000, the plan may require you to cash out the 401k to cash rather than roll it over to an IRA. This is their choice though. If you can roll it over, that would be the better option for tax-purposes.

Where Should You Rollover Your 401k To?

I prefer having all of my accounts in one place. There’s something to seeing a dashboard that has everything. I have a bunch of different accounts and prefer to use Personal Capital’s free investment dashboard to see everything in one place.

If you already have investments somewhere, you can always roll it over there. There are a few things you should check for beforehand though:

  • Is there a fee to open an IRA or a Roth IRA? (there shouldn’t be one)
  • Will they allow backdoor Roth Conversions? (good to plan ahead for this).
  • Is there a yearly fee to open this account? (there shouldn’t be one)

There are a number of great ones

Vanguard will allow you to rollover a 401k, as well a bunch of others including Fidelity, Merill Edge, Charles Schwab and T. Rowe Price. I know Vanguard allows for Backdoor Roth Contributions, because I’ve done it myself from there.

Another option is to open a robo-advisor account at somewhere like Betterment or Wealthfront. Betterment and Wealthfront both allow 401k rollovers to an IRA, which is handy.

Unfortunately, Wealthfront does NOT allow IRA to Roth IRA conversions, meaning you wouldn’t be able to do a backdoor Roth conversion down the line. If that’s part of your plan, I’d stick to Betterment or Vanguard.

When Should You Rollover a 401k?

If you’re thinking “how long do i have to rollover my 401k from a previous employer?” well, rest easy – there’s no time limit. As long as your 401k exists you’ll be able to leave your funds there.

As mentioned above, there may be reasons why it makes sense to move it over (reduce fees, lower management costs, more fund choices). If you’re leaving or have left your job you don’t need to worry about immediately moving it somewhere else.

You will need to make sure you can continue to access the account after leaving your job though. You should continue to have access to your funds, your dashboard and all the same tools you had previously. 

Takeaways

Whew, that was a lot! OK, let’s do a rundown of everything here.

  • 401ks and IRAs are VERY similar.
  • If you’ll be above the Roth IRA income limit ($120,000 filing single or $189,000 filing jointly), then strongly consider staying away from an IRA.
  • It’s more advantageous to have money in a 401k than an IRA due to flexibility, ability to access at 55 and fewer conflicts with other strategies.
  • If you leave a job with a 401k you don’t have to move it to an IRA (unless they tell you otherwise).
  • Open an account at somewhere like Vanguard or Betterment if you feel rolling over a 401k to an IRA is right for your situation.

What has your experience been with rolling a 401k over to an IRA? Did you do it? Have you run into any issues? 

Adam

About Adam

Hi, I'm Adam! I help millennials invest to reach financial independence sooner than they ever thought possible. Want to see what you could do to reach FI sooner? You're in the right place!

6 Comments

So one strategy to basically get the best of all worlds, I think, is to open up a Solo 401k. That way, you always have somewhere to put your old pre-tax accounts that’s still in the “401k bucket.”

I use Fidelity for my Solo 401k, and they accept rollovers from other pre-tax retirement accounts. Of course, to get a Solo 401k, you have to earn some self-employment income, but in today’s world, literally anyone can have self-employment income just by selling some trash or signing up for Uber or something and doing that a few times a year, so I don’t think that’s too much of a limiting factor.

If you find yourself wanting to do a backdoor Roth, but have IRA funds sitting, I’d definitely say get yourself a Solo 401k and roll those over there.

That makes sense! Having a solo 401k isn’t something I’ve ever looked into, but that would allow the flexibility to do a backdoor roth whenever it’s needed. I can’t say I’ve ever made enough side income to be able to justify it yet, but the tax savings would be a major motivation!

This is actually a great idea, and a timely one at that! I’ve had about $6k in self-employment income this year. I was on a break from full-time work so I didn’t contribute anything to a 401k. Sounds like I should open a Solo 401k and throw the $6k into there, so I can also avoid paying income tax on it. So far I just threw it all into a savings account.

Feel free to chime in if I’m missing something. I will be researching this.

This was very informative. I’ve always thought 401k and IRAs were the same too! This was a great read!

Hm. This opens up some more questions from me.
Are you assuming all of the 401(k)s are pre-tax? We have the ability to opt in to pre and post tax contributions for ours. What changes based on that information?
After going through your course and doing some research on pre and post tax contributions, I was convinced that pre-tax is best for my stage and FIRE goals. But I still have some Roth 401(k) funds in my current account and am wondering what the game plan should be if/when I leave this job. Does it still get so messy when you rollover those Roth accounts to a traditional IRA that already has funds?

Good catch! You’re right – this is assuming all of the 401ks are pre-tax.

The rules with Roth 401ks (from what I’ve just read now — https://www.rothira.com/401k-rollover-options ) seem even more simple. You could roll it directly from a Roth 401k to a Roth IRA, which seems like the best bet.

If you do decide to move it to an IRA, you could move it to a Roth later but you would have to pay taxes on the gains that it made while in the IRA. By moving straight from Roth 401k -> Roth IRA it’s tax-free on the conversion and going forward. Seems like a good choice if there are fees or lack of fund choice in your Roth 401k!

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