Tax Penalty for Moving a 401(k) to an IRA

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A 401k is an employer sponsored retirement plan. Employees contribute pre-tax money from their pay and employers match a portion. An individual retirement account, or IRA, is a retirement savings account you can open yourself. Individuals can contribute as much as $5,000 a year to IRAs, unless they’re 50 or older, in which case they can contribute an additional $1,000 per year. Money socked into an IRA reduces taxable income, so individuals contributing to IRAs pay less in taxes. Sometimes, moving your money from a 401k to an IRA is a wise financial choice, but beware of possible penalties.

Reason for Transferring Money from 401k

When you leave a job with an employer-sponsored 401k plan, you can either cash out the money in the account, let the money stay where it is or move it to another qualified retirement account -- either a new employer’s 401k plan or an IRA.

Reason Transfer to an IRA Makes Most Sense

Cashing out the money makes little sense because you’re then left with no nest egg. Leaving it put isn’t a much better solution, because since you can no longer add money to the account, it won’t grow into the cushion you need to retire on. You could always roll it into your new employer’s 401k plan, but financial experts don’t recommend doing this unless the new plan is stellar. Thus, rolling it over to an IRA is often the best choice. You can continue contributing to the IRA account so that your nest egg continues growing at a healthy pace.

Potential Tax Penalty

If you withdraw all your money from a 401k account after you leave your employer, you'll have to pay income taxes on the full amount. You also may be subject to a 10 percent early withdrawal penalty if you are under age 59 1/2. For this reason, it is not recommended that you cash out your 401k account when you leave your job.

Avoiding Tax Withholding

To avoid paying income taxes when closing your 401k account, you can roll it over into an IRA. If you’re rolling your 401k account directly into an IRA, you can ask the plan sponsor to make a check payable to the company where you’ve opened an IRA. This is a tax- and penalty-free transaction.