Have you recently decided to resign from your job for various reasons, like getting a new job or just to take a break from employment? Then you are probably thinking of what to do with your 401(k) plan.
When you quit a job, you can cash out your 401(k), keep it in your previous employer, consolidate it with your new employer, or rollover your assets into an IRA.
If you consider rolling over your 401(k), here are some things to know.
What is a 401(k) rollover?
A 401(k) rollover is putting your retirement plans from your previous employers into an individual retirement account or IRA. Some people like to track their money from a single retirement account than different smaller ones. If you do, this might be the right option for you.
How is it done?
Rolling over your 401(k) plan is not that complicated. Find a bank, a brokerage, or other financial institution, and open an IRA. Then, tell the plan administrator of your 401(k) after doing so.
Your pre-retirement payments can be rolled over within 60 days from the date that you receive an IRA, according to the Internal Revenue Service (IRS).
Rollovers have two types. These are direct and indirect.
Direct rollovers are transferring your money from one account to another account. Your plan administrator can also issue and deposit a check made to your account.
Indirect rollovers are usually done if you want to take a 60-day loan from your retirement account. But, you have to re-deposit your funds within 60 days into a new plan. Don’t miss this deadline if you don’t want to pay penalties.
What happens when you roll over your 401(k) into an IRA?
Generally, you do not pay taxes on your retirement plan distribution until you withdraw it from your new plan. The money you save from this keeps on growing, tax-deferred.
Owning an IRA also gives you more control than the typical 401(k)s when it comes to investment options. Some of the 401(k) available plans only have a couple of investment funds from which you can choose from. Fees for these can be high, too.
On the other hand, you can invest in almost all types of assets, whether it’s annuities, bonds, mutual funds, stocks, and many more. Also, fees on IRAs can be lower, depending on what kind of investments and custodian.
Traditional and Roth IRA
Once you’ve decided that you want to rollover your 401(k), the next thing to ask yourself is you either open a traditional IRA or a ROTH IRA.
When you roll over to a traditional IRA, your funds now will be tax-deductible. Once you deposit your contributions to this type of IRA, the amount will be deducted from your taxable income. While contributions are tax-deferred, you need to pay taxes when it’s time to start withdrawing, called required minimum distributions (RMDs) at 72, which is the RMD age. The RMD age was younger before (70 ½), but according to IRS, your RMDs will be based on 70 ½ if you turned this age before January 1, 2020.
Roth IRA rollover distributions, on the other hand, are tax-free because you have to pay taxes now on your contributions. This is a better option if you want to shield yourself from a possible increase in the rates of taxes when it’s time for you to retire. However, you will be getting a lesser amount on your paycheck more than the traditional 401(k) contribution. If you managed to maintain your Roth IRA for at least five years and also met some of its requirements, then your funds can be tax-free.
For Roth IRAs, you can continue to grow your funds as there are no lifetime distribution requirements.
The main difference between these two is how your contributions will be taxed. Take note, though, that President Donald Trump signed a $2 trillion coronavirus stimulus bill on March 27, 2020, that waived RMDs in 2020.
Other factors to consider
Rolling over accounts that are taxed similarly is the best way to do it. For example, you should roll over a traditional 401(k) to a traditional IRA and a Roth 401(k) to a Roth IRA.
In case you have a traditional 401(k) and want to roll over to a Roth IRA, you have to roll over your money first to an IRA. After that, you have to convert this to a Roth IRA.
By now, you must be asking which IRA you should choose. The answer depends on your current income and your long-term income goal. Ask yourself some questions before making a decision.
Are you currently in the high tax bracket? Do you think you won’t require to withdraw the funds for a couple of years? Are you going to need the money even before retiring? Do you have other options?
Before leaving your job, check your 401(k) balance and decide on your next steps to avoid tax penalties and different retirement accounts on your previous employers.