If you have an old 401(k) because you changed jobs or you’re now fully self-employed, you might have to decide what to do with that 401(k) account you contributed to every payday. Before you move it to a rollover IRA, which most people will tell you what you should do, you may want to hit the pause button. A rollover IRA may not necessarily be the best option. In this article, we will share three options you may want to consider when deciding on what to do with your old 401(k).
What is a rollover IRA?
A rollover IRA allows you to consolidate old employer-sponsored retirement plans such as a 401(k) into an IRA. In a rollover IRA, your savings will grow tax-deferred until you withdraw your savings during retirement. The act of rolling over an old 401(k) into a Rollover IRA is often considered non-taxable.
What is the purpose of a rollover IRA?
The purpose of a rollover IRA is to allow you to move funds from your old 401(k) into an IRA, where you may have more investment options. You can keep the tax-deferred status of your retirement assets and there won’t be taxes or early withdrawal penalties at the time of transfer.
What’s the difference between an IRA and a rollover IRA?
The only difference between an IRA and a rollover IRA is that the money in a rollover IRA has been rolled over from an employer-sponsored retirement plan. The accounts share the same withdrawal rules and required minimum distributions.
When might you use a rollover IRA?
You can consider a rollover IRA if you are not happy with the investment options in your old 401(k). If you move your old 401(k) into a rollover IRA in the right brokerage platform, you will have more options to invest in.
Three options that may be better than a rollover IRA:
1) Move your old 401(k) to your new 401(k)
This option may make sense if your new 401(k) fund lineup is solid. How will you know if it’s solid? There are two considerations to help you decide.
One, if you see the words “institutional index” in a couple of the fund options, then you know that’s a good, solid fund lineup. Institutional class index funds essentially are really low-cost funds that are typically only made available to large institutions like pension funds or foundations, but your employer is making those institutional index funds available for you.
The second thing that I look for is the words “brokerage link.” Typically, this would be found at the end of the 401(k) fund lineup. Not a lot of companies have this, but this brokerage link option, if it’s available in your new 401(k), will give you the option to buy almost any mutual fund or ETF that’s available on the platform. For example, if your 401(k) is housed in Fidelity and it has this brokerage link option, once you enroll in the 401(k), then you can buy any mutual fund or ETF that’s available in the Fidelity platform. That’s a really great option.
2) Keep your old 401(k) where it is rather than do a rollover IRA.
I know that might seem odd, but sometimes the best action is to take no action. It may make sense to keep your old 401(k) if you already have those institutional class index funds that I mentioned earlier available in your old 401(k). Also, if you already have that brokerage link in your old 401(k), then you really want to keep that account because you’ll have access to all of those mutual funds or ETFs in that platform.
Now, you don’t really want to overdo this because according to the Bureau of Labor Statistics, on average, each of us will hold around 12 jobs in our lifetime, and you don’t really want to have twelve 401(k)s floating around by the time you retire.
You may be wondering why you wouldn’t just choose to do a rollover IRA for all of your old 401(k)s and keep it simple. In short, this could cause negative tax implications if you ever choose to do a Backdoor Roth IRA, which you may want to do if you earn too much to contribute directly to a Roth IRA. We explain this in more detail in our Backdoor Roth IRA blog.
3) Roll your 401(k) over to a Roth IRA.
You have to read carefully because this is not for everyone. This move could trigger both state and federal income taxes if your 401(k) is pre-tax and you are moving it to a Roth account. This may make sense, rolling it over to a Roth IRA, if you expect to be in the low tax bracket this year (22% tax bracket or lower). Now, this might happen if you expect to be in-between jobs for most or part of the year, or if you’re planning to take a sabbatical and won’t have much-earned income for the tax year.
If you are going to be in one of the lower tax brackets and you move your pre-tax 401(k) to a Roth IRA, you are taking advantage of paying lower taxes on that transfer this year compared to when you retire and may be in a higher tax bracket when you withdraw your pre-tax funds.
Pros and Cons for the 3 alternatives to a rollover IRA
| Pros | Cons | |
| Move your old 401(k) to your new 401(k). | There may be new investment choices Avoid immediate taxes and a potential 10% early-withdrawal penalty Protection from creditor claims under federal law Preserve tax-deferred growth | Some plans don't allow rollovers There may be waiting periods or other restrictions Investment choices may be limited |
| Keep your old 401(k) where it is rather than do a rollover IRA | Access to familiar investment choices No additional costs Protection from creditor claims under federal law Preserve tax-deferred growth You will retain the right to roll over or withdraw the funds any time in the future | Investment choices may be limited You won’t be able to make new contributions or take loans |
| Roll your 401(k) over to a Roth IRA | Withdrawals of contributions are federal income tax-free Qualified withdrawals of any earnings No required minimum disributions (RMDs) for original account owner | Income taxes are paid when you do the conversion You cannot take any loans There may be additional fees You must have a Roth IRA for 5 years before you can withdraw earnings tax-free No protection from creditor claims under federal law |
Do you pay taxes on a rollover IRA?
A rollover IRA is generally not taxable if you do a direct rollover and the assets go directly from your employer-sponsored retirement plan into a Rollover or Traditional IRA via a trustee-to-trustee transfer. However, you must report it on your federal tax return. If the rollover transaction is into a Roth IRA or a designated Roth account then you may be liable for taxes.
Can you contribute to a rollover IRA?
Yes, you can contribute to a rollover IRA. The contribution limit for 2024 is $7,000 ($8,000 if you’re aged 50 or older). However, this contribution may or may not be tax-deductible. Generally, you do not want to mix tax-deductible and non-deductible accounts.
Is there a limit on how much money you can rollover?
No, there is no limit on how much money you can rollover to an IRA.
Can you take money out of a rollover IRA?
A rollover IRA is subject to the same withdrawal rules as other IRAs. This means that if you withdraw from your IRA before you reach age 59 ½, then you will likely need to pay income taxes and a 10% withdrawal penalty.
Can you have more than one rollover IRA?
You can have more than one rollover IRA, but it is important to keep track of each one because you need to report it on your federal tax return.
Does my rollover count as a contribution for the year?
No, your rollover doesn’t count as a contribution for the year. You can contribute additional money to your rollover IRA in the year that you open it. This means that if you open a rollover IRA in 2024, then you can contribute an additional $7,000 (or $8,000 if you’re aged 50 and older). However, this contribution may or may not be tax-deductible. Generally, you do not want to mix tax-deductible and non-deductible accounts.
How long can I keep money in a rollover IRA?
You have 60 days from the day you receive the distribution to put it into an IRA. If you don’t complete the transaction within those 60 days, then the IRS may deem it as an early withdrawal which means a 10% early withdrawal penalty. The IRS may waive this 60 day requirement in certain situations but it’s easiest to just complete the transaction in 60 days.
Is a rollover IRA a good idea?
It depends on your situation. If the investment options in your old 401(k) are not that good, then moving it to a rollover IRA can potentially give you access to better investment options. The flexibility in a rollover IRA can backfire if you invest the money unwisely,
Rollover rules for various retirement plans
| Rollover To | |||||
| Roth IRA | Traditional IRA | SIMPLE IRA | SEP-IRA | ||
| Rollover From | SIMPLE IRA | Yes, after 2 years | Yes, after 2 years | Yes | Yes, after 2 years |
| SEP-IRA | Yes | Yes | Yes, after 2 years | Yes | |
| Roth 401(k) | Yes | No | No | No | |
| Roth 403(b) | Yes | No | No | No | |
| 457(b) | Yes | Yes | Yes, after 2 years | Yes |
You may want to consider other options before doing a rollover IRA
To recap, if you have an old 401(k), before you do any rollover IRAs, make sure you consider your other three equally great alternatives. Deciding what to do with your old 401(k) is really a crucial financial decision and I strongly recommend you to seek out an expert, credentialed financial planner to make sure that you’re doing what is really the best for you. If you have questions and would like to speak with one of our financial planners about how we can help you elevate your finances, you can schedule a complimentary discovery call.
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.
