60% of workers in their 20’s fail to convert their 401(k) to an IRA when leaving or changing jobs. Thus, creating an unnecessary taxable event.
Besides Packers+win, I can’t think of a combination of words I least like hearing in the same sentence than unnecessary+taxable.
The purpose of this post is to explain your options with your 401(k) when leaving or changing jobs. More specifically, to look at the steps to convert your 401K(k) to an IRA, since this is most likely the optimal choice.
401(k) Rollover Options
Upon leaving or changing jobs you need to decide what to do with your 401(k). You have 5 options.
- Cash Out - By cashing out of a Traditional 401(k), you pay income taxes AND a 10% penalty on the entire amount. If you cash out of a Roth 401(k), you pay a 10% penalty on only your earnings. The only situation where cashing out could make sense is if you have high-interest debt.
- Rollover to Traditional IRA - You can convert your Traditional 401(k) to a Traditional IRA. There are no penalties and no taxes for this type of conversion.
- Rollover to Roth IRA - Converting a Traditional 401(k) to a Roth IRA is a taxable event. Although, depending on your future income, this could be a good thing (More on taxes below). If you convert a Roth 401(k) to Roth IRA, there are no taxes.
- Rollover to New Employer Sponsored Plan -This option is available to those moving from one job, immediately to a new job. The problem with converting an old 401(k) to your future employer’s 401(k) is generally 401(k)s have higher expenses than IRAs.
- Keep 401(k) Balance in Existing Plan - As mentioned above, since IRA expenses are typically lower than 401(k) expenses, this option isn’t optimal.
Which Type of IRA?
Out of the 5 options for converting a 401(k) to IRA, the two optimal choices are to convert your 401(K) to a Traditional IRA or to convert your 401(k) to a Roth IRA.
Your next decision, therefore, is choosing what type of IRA (Traditional or Roth) you want to rollover your 401(k) too (That is assuming you contributed to a Traditional 401(k) and not a Roth 401(k). If you did contribute to a Roth 401(k), your optimal choice is to convert to a Roth IRA).
Choosing between a Traditional or Roth IRA to convert your Traditional 401(k) isn’t easy. There are a many variables, which make it impossible to just enter information into a calculator. I’ve covered the Roth vs. Traditional before, if you’re unsure these two posts will help:
- Regular IRA vs. Roth IRA
- Roth 401(k) or Traditional 401(k)
Steps to Convert 401(k) to IRA
The inspiration from this post came while I was helping my wife rollover her Traditional and Roth 401(k) (She had two was because her employer matched contributions with before-tax money).
Our goal was to convert her Traditional 401(k) to a Traditional IRA and convert her Roth 401(k) to a Roth IRA.
Here are the steps we took:
- Called our mutual fund company where we have our IRAs, which is Vanguard, and asked what was needed to do to complete both a Traditional and Roth 401(k) rollover. The representative gave gave us forms to complete after we received the funds.
- Called the 401(k) provider, which was ING, and told them we needed to perform a direct rollover to Vanguard. Meaning, the funds would go directly into my wife’s IRA. This is very important because if you don’t ask for a direct rollover, some providers will withhold 20% for tax purposes.
- A week later, two checks arrived. One check for the after-tax (Roth) contributions that were to be deposited in a Roth IRA. The other check for the before-tax contributions, meant for the Traditional IRA.
- Sent the checks to Vanguard, with the paperwork the representative gave us in Step # 1. And that was it!
Convert 401(k) to IRA
The biggest recommendation I have is to maintain communication between both your previous 401(k) provider and where you plan on depositing the money (mutual fund, brokerage account). Even if you can do everything online, it’s still beneficial to get a human involved.
Photo by: Michael Jacksonfan