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Introduction

Employer-sponsored savings plans such as a 401(k) can be a great deal. The automatic paycheck deduction makes it easy to save. Many companies will also match your savings, giving you what is basically free money. But when you leave a job, these benefits go away. So you may want to consider a 401(k)-to-IRA rollover—that is, moving your plan’s assets into an IRA.

Moving your 401(k) to an IRA (or even a Roth IRA) isn’t too hard. Let’s walk through the steps.

1) Decide on a Rollover

One of the best ways to save for your future is by taking advantage of an employer-sponsored savings plan like a 401(k), which is entirely portable and transferable should you leave that employer. In a process known as a rollover, you can move your retirement savings from your old 401(k) into an Individual Retirement Account (IRA), where you’ll have a wider selection of investment choices and typically lower fees than in a 401(k). (Note that you can also move the money into your new employer’s 401(k), if that is permitted, though you won’t usually have the choices that you have with an IRA. Or you can even leave it in your current employer’s plan. Click here for more on all these choices.)

All the same, once you leave a job, doing an IRA rollover can make a lot of sense. There can be three main benefits:

  1. Simplified record-keeping. If you have multiple 401(k)s from different past employers, it can be a hassle to keep them organized. Combining them all into one IRA can make your life significantly easier.
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  3. Lower fees. Frequently, you can reduce your expenses (and therefore raise your return) by moving to an IRA.
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  5. Better investment choices. Plenty of 401(k)s have good investment options, but some are pretty limited in the offerings. IRAs have virtually unlimited investment choices, but also offer some one-stop options, such as like lifecycle funds that automatically balance your investments according to when you plan to retire.

2) Open an IRA Account

Obviously, an IRA has to be set up before you can roll your funds over into it.

If you already have an existing IRA account that you are happy about, it is easiest to move your 401(k) money there. Otherwise, you’ll need to open a new IRA somewhere. This can be done at most any brokerage and a number of banks. Some big-name brokerages like Fidelity, E*Trade or Merrill Lynch offer lots of choices combined with low costs.

Setting up an account online has never been easier. For example, Fidelity’s online process helps determine which IRA is right for you, prompts you for exactly what information is needed, and can even pull and register your information based on answers.

Note that to avoid tax complications, you need to move a regular 401(k) account to a Traditional IRA, and a Roth 401(k) account to a Roth IRA. Discuss this with the plan administrator and with the bank or brokerage with the IRA is located to be sure you are doing this correctly. If you want to switch into a Roth IRA from a regular 401(k), click here for detailed information.

3) Initiate the Rollover

To actually transfer the money from your 401(k) into your IRA, you will need to contact the plan administrator to start the rollover. Sometimes the bank or brokerage holding the IRA will contact the administrator for you and provide the information that’s needed. Either way, your brokerage company will provide you with the details of how the check should be made out and where it should be sent.

Your next decision involves how to execute the rollover. There are two choices. Read below for the details.

4) Choose: Direct Rollover or Indirect Rollover

Rollovers come in two types: direct and indirect.

  • In a direct rollover, the holdings are transferred straight from one account—in this case, your 401(k)—to another (your IRA in this case, though it can be any sort of retirement account).
  • In an indirect rollover, your account is liquidated. You get a check from your 401(k) plan administrator and have 60 days to deposit the money into the IRA (or whatever other retirement account you designate).

Direct Rollovers

Direct rollovers are simple. You ask your 401(k) plan administrator–usually someone who works in human resources at your old company—to move all your account’s assets  directly to another retirement plan or to an IRA. You never take physical possession of them. Alternatively, if assets are being liquidated, the administrator could give you a check made payable to your new account (never to you personally), which you then send to your new plan’s administrator or deposit in your IRA. You won’t owe taxes in either case.

Indirect Rollovers

An indirect rollover is much more complicated. Your 401(k) assets are liquidated by the plan administrator, and the money is paid directly to you—but minus 20 percent: That represents the mandatory withholding for income-tax purposes. (Remember, the money you contributed to your 401(k) was in pre-tax dollars, and grew tax-deferred; you didn’t have to pay taxes on it until you took it out. Well, now you’re taking it out.) You have control of the money for 60 days.

Before the 60 days are up, you have three choices:

  1. You can deposit the money from the check into an IRA (or some other type of retirement account), You will need to report the amount withheld twice on your income tax form, once as taxable income and once as taxes paid. In addition, you will pay a 10 percent penalty on the total withdrawal if you are under age 59½. So if a 50-year-old got $10,000 from his 401(k), had $2,000 of it (20 percent) withheld, and rolled over the remaining $8,000: he’d report $2,000 as taxable income, $2,000 as taxes paid and $8,000 as a nontaxable rollover. He’d also pay a $1,000 penalty.
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  3. You can deposit the money into a new IRA, making up the amount withheld with other funds. If, say, $2,000 is taken from your check for taxes, you can take $2,000 from elsewhere, add it to the total of your check and deposit $10,000. You’ll report the $2,000 as taxes paid, but incur no early-withdrawal penalty because you deposited the whole $10,000 within 60 days).  Using the same scenario as above, our 50-year-old would report $10,000 as a nontaxable rollover and $2,000 as taxes paid; in effect, his distribution is tax-free. And he doesn’t owe the $1,000 penalty.
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  5. You can just keep the money, all of it—but in that case, you’ve cashed out your 401(k). That is almost always a mistake. It’s important to keep it growing so that you have enough in retirement.
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Which is Better: Direct or Indirect Rollover?

In most cases, the direct rollover is better. A direct rollover triggers no taxes and is all-around simpler. An indirect rollover has tax consequences. And if you don’t follow the rollover rules, it becomes a partial or entire cash-out of your account, and you will owe taxes and a penalty on the money.

People usually do indirect rollovers if they need a fast, interest-free 60-day loan and figure their retirement account is the best source of it. If that’s you, make sure you meet the deadline to avoid unnecessary taxes and penalties.

What Happens Next?

That’s it. Your assets and funds will be transferred to your new account and, if liquidated, will be invested according to your choices. You’re all done.

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