Employees who take advantage of employer-sponsored investment accounts can benefit from interest earnings on monies saved. When it comes time for an employee to leave a job or change employers, some decisions must be made as to where the money in a 401K investment account should go.
A 401K rollover allows employees to avoid withdrawal penalty fees and tax penalties while at the same time opening up other investment options for the future. Knowing your options for a 401k rollover may be one of the most important things to understand before deciding what to do with a 401K account.
Qualified Retirement Accounts
A 401K account is a type of qualified retirement account offered as an employer-sponsored benefit. In effect, a 401K provides a way for employees to save towards retirement while reducing the amount of taxes owed on monies earned. Qualified retirement accounts can also take the form of Traditional IRAs and Roth IRAs also known as Individual Retirement Accounts.
A 401K rollover involves transferring the money in a 401K account into another type of qualified retirement account, such as a Traditional or Roth IRA. A rollover to an IRA provides a way to preserve investment earnings in cases where an employee changes jobs or leaves the company.
Before You Decide to Cash Out Your 401(k)
Employees do have the option of cashing out a 401K account or even leaving it where it is in its current account. And while cashing out an account frees up existing cash earnings, the penalties involved with withdrawing tax-deferred earnings before retirement age far outweigh the benefits of freeing up cash reserves.
Early withdrawal taxes can run as high as 20 percent and apply whenever a 401K is cashed out before the age of 59-1/2. For some people, the extra cash on hand may actually bump their income earnings into a higher tax bracket, which can trigger a higher tax withholding rates. An additional 10 percent federal tax penalty will also be assessed at the employee’s tax time . Ultimately, a person will lose a lot more in earnings by cashing out a 401K than rolling it over into another account.
401k Rollover Process
So, what is a rollover? A rollover entails the specific steps required to move 401K monies from one account to another without triggering tax penalty fees. When rolling a 401K over to an IRA, the first step involves opening an IRA. This can be done at any financial company that offers IRAs, like Betterment.com. It’s important to research different companies in order to find the one that offers the types of investment products a person is looking for and charges reasonable fee rates.
The actual transfer of funds goes from trustee-to-trustee, where fund manager trustees transfer 401K funds from one account to another. Employees must notify their employers of the intended transfer and ensure the check payable is made out to the receiving investment company and not the employee. This trustee-to-trustee transfer is what prevents the 20 percent tax penalty from kicking in.
Taxable Versus Non-Taxable Accounts
The different types of qualified retirement accounts differ in terms of when account monies are taxed. 401Ks and Traditional IRAs are funded with pre-tax dollars. This means any monies withdrawn automatically become taxable. Roth IRAs are funded with after-tax dollars, so any monies withdrawn are done so tax-free.
These differences in tax treatment can directly affect a person’s taxable income within the year a withdrawal is made. Since Roth IRAs use after-tax dollars, rolling over a 401K into a Roth IRA can increase a person’s taxable income for the year. This is not the case with a Traditional IRA since 401Ks and Traditional IRAs are both funded with pre-tax dollars.
401k Account Transfers
Employees may opt to leave a 401K account intact if an employer plan offers exceptional investment options and earnings with low administrative fee charges. Otherwise, an account transfer makes for the most logical course of action when employees transfer to another company or wish to increase their investment options.
In general, insurance companies charge relatively high administrative fees to manage 401K accounts, so transferring from one 401K to another may be the least expensive way to go. In comparison, IRAs have lower administrative costs and also offer a larger range of investment option, which make a rollover to IRA the best option in terms of costs versus investment earnings potential.
Rather than transfer a 401K into another employer-sponsored plan, employees can transfer funds to a brokerage firm, many of which offer reduced fee rates. Brokerage firms specialize in working with a wide array of investment products, such as mutual funds, money market accounts and stocks and bonds. Many firms also offer banking services as well.
Make sure you research your options thoroughly and to act on the rollover while it’s fresh on your mind. The last thing you want is to leave an account in a previous employer’s plan and forget about it for years!