By in Advanced Investing, Asset Allocation, Investing, Reader Question, Retirement, Saving

How and When to Rollover Your 401K into an IRA

I just switched jobs and have over $100,000 saved in my workplace retirement account. I would like to take the money out and use it for my bills, home repairs, and holiday shopping, what do you think? My new job pays well and so I’m not too worried.” Isabela, age 40

What is a 401K? 

During Isabela’s years of employment, she contributed part of her earnings into a 401K. Employers offer  a program which allows employees to transfer part of their salary into a retirement plan where the funds grow tax deferred. Employers frequently add matching funds into these plans as well.

401k information

Do Not Cash Out Your 401K

The funds are deposited pre-tax and grow tax free. It’s a great way to build a nest egg for retirement.

Isabela contributed $377 per month for 10 years and her employer added $200 per month. The money grew at an annual rate of 7%. Isabela only contributed $45,000 and ended up with $100,000 after 10 years.

Cash Out the 401(K)?

Since Isabela is not yet 59 1/2, if she cashes out her 401K she will owe taxes on the entire amount plus a 10 percent penalty. The penalty alone is $10,000. Additionally, she forfeits the opportunity for the funds to continue growing tax deferred. If she leaves the funds in the existing 401K or rolls it directly into a self directed IRA, the $100,000 could grow to $386,000 by age 60 assuming a 7 percent return. That’s without adding another dime!

Isabela, do not cash out your 401K, it is a losing proposition.

Since your new job pays well, use the income from the new job to pay down debt and shop. Do not cash out the 401K. You cannot get back those 10 years of compound returns. Even if you start a new 401K now, it will take another 10 years to get back to $100,000 (given the same scenario), and at that time you’ll be 10 years closer to retirement.

Your best alternative is to either leave the funds in your previous employers plan or roll it into a self-directed IRA where you can invest the funds as you wish.

How to Rollover your 401K  into an IRA

If you rollover your 401K directly into an IRA, you avoid paying a penalty or taxes. You allow your funds to continue to grow tax deferred. And you may be able to add to the funds (if you are eligible). My husband I have rolled over several 401K’s into IRA’s and the process is quite straight forward.

Choose a discount broker and open an IRA account. The instructions are online or you can call the company as well. We have IRA accounts at Charles Schwab, Fidelity, and TD Ameritrade.

Call the 401K contact and ask how to complete a trustee to trustee transfer. At my spouse’s last job, he filled out some paperwork and faxed it back to the company. That paperwork will ask where you want the funds sent so you’ll need the account information for the IRA account.

The entire transfer was completed within less than one week.

What Happens to the Investments in the 401K?

You must ask the 401K representative about the process. In our recent case, all investments were sold before transfer and the cash was deposited into the new IRA. That creates the opportunity for you to reinvest the funds in the new IRA. In general, I recommend a diversified distribution of index funds, in line with your asset allocation. Learn about how to invest in the free ebook, 20 Minute Guide to Investing.

Why to Rollover into an IRA?

There are many reasons to roll over your funds. Frequently the individual IRA at a discount broker has low or no fees, unlike a 401K. You control how your assets are invested in the IRA. Your money continues to grow tax free until withdrawal. An IRA is one of the greatest wealth building tools.

Isabela, if you’re still unsure, seek the advice of a financial professional for help with this decision.

 What have been your experiences rolling over a 401K into an IRA? Have you ever withdrawn the funds from a 401K only to regret the decision later?

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