When an employee quits one job and begins another, it’s common for the worker to roll over her profit-sharing plan assets or 401(k) or 403(b) retirement accounts to a traditional IRA, a Roth IRA or the retirement plan of a new employer. If the administrator of the new employer’s plan charges high management fees or has a relatively small offering of mutual funds, the employee may choose to roll over the 401(k) to a self-directed IRA.
All IRAs, including the self-directed ones, must be held by a bank, trust company or another authorized custodian. Self-directed IRA custodians specialize in managing self-directed assets, such as real estate or intellectual property. For the tax-deferred status of the account assets to be maintained, the transfer to the IRA custodian must take place without penalty. And, that requires the employee to roll over the 401(k) retirement account to an IRA promptly.
The following information will guide you through this process.
Traditional IRA vs. Roth IRA
The primary reason people set up an IRA is that the account is a tax-deferred and possibly a tax-free retirement account that allows individuals to save for retirement. The IRA comes in two flavors: the traditional IRA and the Roth IRA.
The Traditional IRA
The traditional IRA is a practical option for anyone who wants to save for retirement and defer taxes in the process. You can own multiple IRA accounts, but the sum of your contributions to all accounts must be less than or equal to the annual contribution limits for your age group.
What’s more, the traditional IRA can be opened despite your participation in an employer-sponsored retirement plan, such as a 401(k). Also, the traditional IRA places no income limits on the retirement account owners.
The Roth IRA
If your primary concern is your tax rate at retirement, you may not consider the deduction available from a traditional IRA to be of great consequence, particularly early in your career when your income is relatively low as is your tax burden. Instead, you might prefer the Roth IRA.
If you are single and your AGI is $125,000 or more in 2021, however, you’ll be unable to make the maximum Roth IRA contributions. Instead, if you earn more than $125,000 but less than $137,000, the IRS allows you to make partial contributions.
What’s more, the five-year rule applies to Roth accounts. Even at 59 ½, your first contribution or conversion to a Roth account must have occurred at least five years before a withdrawal, or you’ll be unable to take tax-free withdrawals of your investment's earnings.
401(k) Rollover Process
When you’re ready for the 401(k) rollover to an IRA, here’s how you can make it happen.
1. Select Your 401(k) Rollover Destination
Compare the benefits of a traditional IRA with those of a Roth IRA and make a preliminary choice for your 401(k) rollover.
401(k) Rollover to Traditional IRA. To maintain the same tax treatment as that of your 401(k), the traditional IRA may be a good choice. With this option, you experience minimal hassle and the required minimum distributions and tax treatment are the same as that of your current 401(k).
401(k) Rollover to Roth IRA. If your income is high, the 401(k) rollover to a Roth IRA can serve as a backdoor into a Roth tax treatment. You will need to pay the taxes on the amount in the 401(k) account.
2. Pick an IRA Provider for Your 401(k) Rollover
Before you transfer your cash, consider the services, investment offerings and fees of several investment companies who might serve as your IRA provider. For instance, to buy assets beyond stocks, bonds, mutual funds or ETFs, you’ll need a custodian that allows you to open a self-directed IRA – you can find a list of self-directed IRA custodians online to start your research.
Read More: Differences Between IRA and Non-IRA Accounts
3. Contact Your Current and Future Administrators
If you elect a direct rollover, your current 401(k) plan administrator may transfer your savings directly to your new IRA account. This is the most reliable way to avoid taxes or penalties.
The other alternative is for the plan administrator to issue a check that you personally deliver to your new IRA account administrator. You’ll speed things along if you open the IRA account and collect the information you’ll need for the rollover before you contact the 401(k) administrator.
Lastly, don’t be tempted to put the 401(k) money into your personal bank account. Also, take action early on during the IRS-limited 60-day conversion time period. Doing so will give you a good shot at avoiding the transaction becoming a taxable event.
- You can perform an indirect rollover, in which the funds from your 401k plan are given to you, and you are responsible for depositing those funds in the new IRA. However, this process requires more work on your part and could create a taxable event. If you choose an indirect rollover, your employer might be required to withhold 20 percent for taxes before giving you the proceeds of the 401k. You must deposit those funds in the self-directed IRA within the 60-day time frame required by law to avoid taxes and penalties.
Billie Nordmeyer is an IT consultant of 25 years standing. As a senior technical consultant for SAP America and Deloitte Touche DRT Systems, a business analyst, senior staff, and independent consultant, Billie has worked across the retail, oil and gas, pharmaceutical, aeronautics and banking industries. Billie holds a BSBA accounting, MBA finance, MA international management as well as the Business Analyst and Software Project Management certificates from the Cockrell School of Engineering at the University of Texas at Austin.