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What is a 401k Rollover, and How Does It Work?

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A 401k offers pretax retirement savings, high contributions limits, and potential matching bonuses. However, your 401k doesn’t follow you if you change jobs. As a result, you end up having to track several retirement accounts. Cashing out a 401k before retirement can also result in massive penalties and tax consequences.

A 401k rollover is the best potential solution when you switch employers. It helps you reduce the number of accounts to track and minimize potential taxes.

This article will explain how 401k rollovers work, their benefits, and the types available to help you make an informed decision as you make a shift in your career.

How Does a 401k Rollover Work?

A 401k rollover involves moving 401k retirement funds to another account. You must contact your former employer’s human resources department to start the process.

You can also visit the following sources to claim accounts you may have forgotten about:

  • U.S. Department of Labor’s Employee Benefits Security Administration
  • National Registry of Unclaimed Retirement Benefits
  • Pension Benefit Guaranty Corporation

In many cases, you can perform a direct or indirect rollover.

Direct Rollover

Here’s how to do a direct rollover:

  1. Tell your new plan provider you’d like to start a rollover.
  2. Tell your old 401k provider you’d like to roll over your funds to the new account.
  3. The old provider wires funds to the new account.

There are no tax consequences in most cases.

Indirect Rollover

Here’s how to do an indirect rollover:

  1. Tell your new plan provider you’d like to start a rollover.
  2. Tell your old 401k provider you’d like to get all your account funds.
  3. Your old provider mails you a check for 80% — the other 20% is withheld for potential taxes.
  4. Deposit the funds in your bank account.
  5. Write a check to the new provider.

You have 60 days to do this to get your 20% back at tax time and avoid penalties.

Types of 401k Rollovers

Here are the three main types of 401k rollovers you can perform:

Another 401k

If you’re changing jobs, rolling over your previous job’s 401k into your new job’s 401k can make managing your retirement asset easier.

Traditional IRA

If you want more investment choices or you’re retiring and won’t have access to a new 401k, rolling your existing 401k accounts into IRAs may be a good choice.

Traditional IRAs are pre-tax retirement accounts, just like 401ks. This makes the rollover more straightforward than a Roth IRA rollover discussed later.

You can perform a direct or indirect rollover to a traditional IRA. There are generally no consequences under the indirect method as long as the funds reach the new account within 60 days.

Roth IRA

Roth IRAs let you make qualifying withdrawals in retirement tax-free. Furthermore, they do not have RMDs(required minimum distributions). However, saving in a Roth IRA is not possible once you reach a certain income threshold.

Thus, rolling over your 401k to a Roth IRA can be a good potential option if you have a large income and a diverse set of retirement assets and you want to minimize your retirement tax burden.

However, since 401k contributions are pre-tax, the IRS will likely tax the funds you roll over to recoup the taxes you avoided.

Benefits of 401k Rollovers

Here are a few reasons to consider a 401k rollover:

  • Manage fewer accounts: If you have 401ks from several past jobs, rolling them all into an IRA can make it easier to track them.
  • More investment options: 401ks usually only offer a few funds. IRAs let you access a wider array of investments, like stocks, bonds, and ETFs.
  • Lower fees: Some brokers may charge lower account fees and no trading commissions. Plus, you can access investment funds with lower expense ratios.

The Bottom Line

A 401k rollover involves folding an existing 401k into a new account directly via wire transfer or indirectly via check. This helps you consolidate your assets into fewer accounts for easier management.

However, ensure your new accounts offer investment choices that fit your goals and charge lower fees. If your new 401k isn’t better than your old 401k, consider rolling over into a traditional or Roth IRA. Just be aware of the latter’s tax consequences.

Ultimately, you must make sure your rollover helps you make progress toward your retirement goals.

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