If you leave your job for reasons other than retirement, you have four options on what to do with your 401(k). You can:
- Leave it with your former employer
- Consolidate it into your new employer’s 401(k) plan
- Cash it out
- Roll it over into an IRA or Roth IRA.
Rolling Over a 401(k) to an IRA
IRAs offer more investment options than 401(k)s. IRA fees tend to be less costly than fees associated with a 401(k). If you decide to roll over your 401(k) into an IRA, your next decision is whether to opt for a traditional IRA or a Roth IRA.
When you deposit money into a traditional IRA, those contributions are tax-deductible. As 401(k) contributions are also pre-tax, rolling over into a traditional IRA is a simple process. This tax deferral is not permanent. You pay income tax on contributions and earnings when you start making withdrawals. You are required to start taking minimum distributions at the age of 72, whether or not you are still working.
Contributions to a Roth IRA are not tax-deferred. If you roll over your 401(k) into a Roth IRA, the entire account is immediately treated as taxable income. You are required to pay federal and state income tax right away. The funds in the account will likely be needed to pay the taxes. You may have to increase tax withholding or pay estimated taxes. On the plus side, if you maintain your Roth IRA for a minimum of five years and meet certain other requirements, then your contributions and earnings are tax-free. You will not have to worry about income tax shrinking your retirement savings.
There are no required minimum distributions from a Roth IRA. You can leave the funds in your account to grow tax-free as long as you like. It remains tax-free if you leave it to your children or heirs. However, they are required under the SECURE Act to draw down the account over the 10-year period after your death.
Which IRA to Choose
Factors to consider when choosing between a traditional IRA and a Roth IRA include:
- Your current financial status and expected financial status at retirement
- Your current tax bracket and expected future tax bracket
- How soon you will need to use the funds
You pay income tax on withdrawals from a traditional IRA. If you have not yet reached the age of 59 ½, you pay an additional early withdrawal penalty. Withdrawals of after-tax contributions from a Roth IRA are never taxed, and earnings are only taxed if you make a withdrawal within the first five years. If you are under the age of 59 ½, you may be subject to a 10% penalty for early withdrawal.
Splitting the Rollover
You are not required to choose one IRA or the other in which to rollover your 401(k). You can split the funds between a traditional IRA and a Roth IRA, if permitted by the plan administrator, in any ratio you like. If you need help deciding how to roll over your 401(k), speak with our experienced agent.