401k Rollovers: FAQs from Readers

I continually encourage interaction with readers. Among the most common sources of consternation expressed by retirement savers is the 401k “rollover.” Today, I want to step back from the daily hurly-burly of the markets to address this universal theme.

Below is a compendium of frequently asked questions regarding this important retirement investing topic, along with my answers.

What’s a 401k rollover?

This is the process of transferring your 401k savings into another plan, such as an Individual Retirement Account (IRA). Rolling over to an IRA is the most common choice for employees who leave a company and want to maintain their savings in a tax-deferred account, because it’s the most widely available option.

Do I have other rollover choices, besides an IRA?

You might be able to transfer your 401k money into your new employer’s 401k plan, where it can continue to enjoy tax-advantaged status and grow over the years. However, your employer’s 401k plan may not allow you to do so; check with your HR administrator to see how much leeway you have.

If I leave my job, should I simply cash out of my 401k?

No! Resist the temptation. According to a study by Hewitt Associates, roughly half of U.S. workers cash out their 401k when they leave one job for another. That’s almost never a good idea.

In addition to paying income tax on the money, you’ll get socked with a 10% early withdrawal penalty if you’re under age 59 ½. And then there’s the “opportunity cost” of not reinvesting the money.

Can I choose the same types of investments with an IRA that I once had in my 401k?

Typically, yes. In most cases, the investment choices available in IRAs mirror the stock mutual funds, bonds, etc. that are available in 401k plans.

What if I’m a non-spouse beneficiary and I inherit a 401k plan?

Non-spouse beneficiaries can roll over all or part of an inherited employer-sponsored retirement plan into an IRA.

Should I follow the same investment strategy in an IRA that I once did in my 401k?

Yes. Keep in mind, many investors who roll their 401k into an IRA short-change themselves by being more timid than they were in their 401k.

There’s no investment that beats the returns of stocks over the long term—and an IRA represents long-term money. So, why shoot yourself in the foot by playing it too safe?

According to IRS statistics, about three-fourths of self-directed IRA monies are in money-market funds, government bonds or other fixed-income securities. That defies common sense.

A common “risk-averse” mistake is to put rolled-over IRA money into tax-exempt investments, such as annuities, municipal bonds and tax-exempt money-market funds. These investments already are tax-exempt, so there’s no tax advantage to putting them in a tax-favored IRA.

And there’s a double whammy: The tax exempt income is bestowed in return for a lower yield, so you do yourself a disservice on the potential returns as well.

IRAs are still worth it for high-income savers. Deductible or not, any money you deposit accumulates free of taxes as long as it stays there. This means it can grow and compound without having a big chunk sliced off for current taxes, as would be the case with an ordinary investment. The result is that your pool of money grows faster. And tax-deferred compounding gets sweeter the longer it lasts.

But to make an IRA really worth it, you’ve got to stay with stocks. If you’re an older person nearing retirement and all you’re going to do is invest in cash or fixed-income investments, you’re far better off in an annuity. The bottom line: Money that doesn’t go into stocks shouldn’t go into your IRA.

What are the withdrawal rules for IRAs?

Of course, you’ll have to pay taxes on any IRA withdrawals if made before age 59 ½. The IRS imposes a 10% early withdrawal penalty on the taxable portion of your early IRA withdrawal. For tax-deferred IRAs, this is the entire amount. For Roth IRAs, the 10% penalty applies only to the early withdrawal of earnings. This is a one-time penalty paid in the year of the early distribution.

What happens if I have a 401k loan at work but then leave my job without paying back the loan?

First of all, I strongly advise against taking loans against your 401k plan. But if circumstances force you to do so and you leave with a balance remaining, check with your HR department as to whether you can continue making payments after you depart the company, or whether you must pay off the balance of your loan before you can roll over the remainder.

Can I first take the money out of my 401k plan and pick a course of action later?

Technically, yes. But that’s a bad idea. Weigh your options and reach a decision before you take out the money. If you take money out of your 401k plan in the form of a check payable directly to you, 20% of the original balance will be withheld for federal income taxes even before you receive the check.

You can still rollover the money into an IRA, or your new company 401k plan if allowed, but you must do so within 60 days.

If you don’t deposit the withheld amount to the new IRA or 401k plan, it will be tacked onto your ordinary, taxable income.

Will I incur taxes on my 401k rollover?

Typically you will not owe taxes on your rollover if you roll over your money directly from your company plan into an IRA or 401k.

Am I required to report a rollover on my tax return?

Yes. You must fill out IRS Form 1099R, reporting that you took a distribution from your former employer’s plan, and IRS Form 5498, reporting that you made a rollover contribution to your IRA.

Editor’s Note: I’ve just answered questions commonly asked by readers who are concerned about their financial future.

Worried that you won’t have enough money in retirement? Consider our premium trading service, Rapier’s Income Accelerator, helmed by our income expert Robert Rapier.

Up, down, sideways… even in the face of rising interest rates… tech selloffs…overseas war…and anything else Mr. Market throws at you, Robert’s trades are income-generating machines. Click here now for details.

John Persinos is the editorial director of Investing Daily. Send your questions or comments to mailbag@investingdaily.com.

Subscribe to John’s video channel: