How to Do a 401(k) Rollover to an IRA

Do you have any orphaned 401(k) accounts from a former job? More than 25 million people who participated in a workplace retirement plan from 2004 to 2013 left at least one account behind when they split from their employer, according to the U.S. Government Accountability Office.

Transitioning from one job to another can be hectic, making it easy to overlook an old 401(k). The good news is that rolling these forgotten funds into a new investment account—and growing those dollars—is pretty simple. 

What are my options?

401(k) rollover into a new 401(k)

You have a few options here. You can do a 401(k) rollover from your old account to a new one at your current employer, effectively consolidating these funds and eliminating any fees you were paying on the old account.

401(k) cash out

Alternatively, and only as a last resort, you can cash out your old 401(k)—but think hard before you do so. Tapping this account prior to age 59 ½ will trigger a 10 percent penalty. That’s on top of the regular income tax you’ll pay on that money. Plus, pulling that money out of the market also means missing out on future returns that could otherwise be waiting for you in retirement.

401(k) rollover into an IRA

For many investors, a third option of an old 401(k) rollover into an Individual Retirement Account (IRA) makes the most sense. Your money is still working hard for you—without the administrative fees you might encounter with a 401(k). Here’s what you need to know.

What type of IRA should I choose?

The first thing to look at is the type of 401(k) you have. Traditional 401(k)s are funded with pre-tax dollars that are taken directly from your paycheck via payroll deductions. So when you begin drawing on this money in retirement, you’ll be taxed on it. Roth 401(k) plans, on the other hand, are funded with after-tax dollars, so retirement distributions won’t be taxed.

So a traditional IRA is generally the best home for a traditional 401(k), as their tax structures mirror one another. The same goes for Roth 401(k)s and Roth IRAs. Here’s a refresher on how these kinds of IRAs are alike and different.

Traditional IRAs are funded with money for which you’ve already been taxed. Contributions are tax-deductible if you meet certain income requirements and don’t have access to a workplace retirement plan. You will be taxed on any money you withdraw during retirement. For 2020, you can invest up to $6,000; $7,000 if you’re 50 or over. When you reach 72, contributions stop and you’ll have to begin making minimum withdrawals. And like 401(k)s, you’ll be penalized for dipping into this account prior to 59 ½. 

Roth IRA contributions are not tax-deductible, but the money you put in does grow tax-free, and you can tap this money in retirement without the tax hit. For 2020, you can kick in up to $6,000. Folks who are 50 or older can contribute an additional $1,000. (FYI, these contribution limits apply across all your traditional and Roth IRA accounts combined.)

Roth IRAs come with income caps, as well. For 2020, you can’t max out your account unless you earn less than $124,000, or $196,000 for married couples filing jointly. One notable benefit is that you can technically withdraw funds from a Roth IRA anytime you want, penalty-free—not just in retirement. It’s a different story, however, if you yank out your investment earnings before age 59 ½. 

SEP IRAs, also known as Simple Employee Pension IRAs, are another place to potentially roll over your 401(k). These accounts are designed to help self-employed folks and small business owners save for retirement. In 2020, you can contribute 25 percent of your compensation or $57,000 (whichever is less). Most or all of your contributions are tax-deductible, though you’ll pay taxes when you withdraw money in retirement. Like 401(k)s and traditional IRAs, withdrawing funds before 59 ½ will get you a 10 percent penalty, and you have to start taking minimum withdrawals at age 72. 

How to Do a 401(k) Rollover to an IRA

Remember: The goal of this type of retirement account is to grow your nest egg over the long haul. Having an IRA can be a bit more involved than managing your 401(k), which is generally monitored by the plan sponsor (aka your employer), but don’t let that deter you. Again, the tax benefits and opportunity for long-term growth make IRAs a powerful retirement savings tool. 

One way to build a diverse portfolio is by investing in a mix of exchange-traded funds (ETFs) and low-cost mutual funds. But if you’re looking for a more hands-off approach to managing your IRA, consider a trusted robo-advisor that can select investments on your behalf. Acorns offers a choice of three different types of IRAs, in addition to a regular brokerage account. You can do a 401(k) rollover into the appropriate IRA and your money will be invested automatically in a pre-selected portfolio that’s recommended for you, based on your time horizon and risk tolerance. 

Once you settle on the right account for you, contact your previous 401(k) plan sponsor to arrange the rollover. This will pan out in one of two ways: They’ll either deposit your funds directly into your IRA, or they’ll cut you a check for you to deposit yourself. If you choose the latter, you’ll have 60 days to do so—otherwise it’ll count as a 401(k) distribution, which means you’ll be responsible for paying income tax and a 10 percent penalty if you’re under 59 ½. 

What else should I consider when rolling over a 401(k) to an IRA?

As we hinted at earlier, one of the many perks of a 401(k) is its set-it-and-forget-it structure. After enrolling and checking a few boxes, the plan sponsor typically uses your age and other factors to handle investment decisions. This includes managing and monitoring things like asset allocation and rebalancing so you don’t have to. What’s more, 401(k) plans act as fiduciaries that operate in good faith to serve your best interests.

IRAs aren’t designed quite this way and generally require a little more attention and effort. So, unless you enlist the help of an advisor, be prepared to choose your own investments. 

In the end, a 401(k) rollover into an IRA isn’t all that difficult—and it’s a great way to stay invested and continue saving for retirement while enjoying some significant tax benefits. 

Learn more about Acorns Later accounts.