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Converting Your 401(k) to an IRA

September 20, 2021

So you’re leaving your job to pursue new opportunities — congratulations! If you’ve been contributing to a 401(k) in your previous job, you want to make sure you’re safeguarding and optimizing that investment. Generally speaking, when you leave a job, but you’re not retiring, you have four options to address your 401(k) plan:

1.   Consolidate your 401(k) into your new employer’s retirement plan.
2.   Leave your 401(k) with your former company.
3.   Roll funds from your 401(k) into an Individual Retirement Account (IRA), or convert the account to a Roth IRA.
4.   Cash out your 401(k).
 
First, if you’re below age 59½, you probably shouldn’t cash out your 401(k). You’ll have to pay taxes on that money as if it were ordinary income, and you’ll be missing out on potential tax-free growth of the funds you’ve invested in. If you’re below age 55, you’ll also pay a 10% penalty for withdrawing funds early from a retirement account. Employed people can’t access the money in their 401(k) without a penalty until age 59½.
 
You can contribute more to a 401(k) annually than you can to an IRA. If you’re not planning to enact a 401(k) to IRA rollover, your best option might be to leave your 401(k) with your previous employer. Your former company may offer better investment opportunities than your current company’s plan. Rolling your plan over to your new employer’s 401(k) may be the easiest option going forward. Automatic contributions pulled from your paycheck each pay period make saving easy. If your new employer offers a comprehensive plan, with employer matching and quality investment options, moving your account may be more convenient and potentially more rewarding.

 Why Would Someone Roll Over a 401(k) to an IRA?


An IRA provides you more control over your funds than a 401(k). With more investment options, your retirement funds may grow more in an IRA. And IRA management fees may be less than those you pay for 401(k) management. If you’ve decided on a 401(k) to IRA rollover, your next decision is what type of IRA you’ll choose: a traditional IRA or a Roth IRA.
young asian couple looking at 401k rollover on laptop











 

Traditional IRA

 
Many people choose a traditional IRA because contributions — up to a certain amount — are tax-deferred. You don’t have to pay any tax on these funds until you withdraw them in retirement, when your tax bracket is likely to be lower than it is during your working years. The transfer from a traditional 401(k) to a traditional IRA is simple because both accounts are tax-deferred. Similar tax plans simplify the 401(k) to IRA rollover rules.
 

Roth IRA

 
On the other hand, if you roll over your funds from a traditional 401(k) into a Roth IRA, you have to pay federal and state taxes on the funds at the time, as if it were income. However, after you’ve maintained a qualified account for at least five years, the after-tax funds and the accumulating interest are tax-exempt.
 
If your account was already a Roth 401(k), then it can only be rolled into a Roth IRA to ensure you don’t pay taxes twice on the same funds. You can convert a traditional 401(k) to a Roth IRA, but you’ll need to follow a two-step process to meet all the 401(k) to IRA rollover rules. First, you convert the traditional 401(k) to a traditional IRA, then you convert the traditional IRA to a Roth IRA.
 

How to Choose an IRA

Selecting a traditional IRA or a Roth IRA will depend on the size of your retirement account and your current holistic financial situation. If your 401(k) retirement account is sizable — and therefore would create a large tax liability — and you think you may need to access the funds before five years have passed, a traditional IRA is likely going to be your best choice. If you can afford to pay the taxes to convert a traditional 401(k) to a Roth IRA and you plan to continue contributing to the account in the future, you could enjoy significant tax benefits in the long run.
 
If you fall somewhere in the middle — and most people do — you can find a third path. If your 401(k) administrator allows it, you can convert a portion of your funds to a Roth IRA and a portion to a traditional IRA to split the tax liability between today and the future. If you’d like, you could also leave some of your funds in the 401(k). Essentially, opening a Roth IRA is very likely going to put you in a great position for retirement when the time comes, so converting what you can afford — even if it’s only 25% of your account — may help you create a more secure future.
 

How to Convert Your 401(k) to an IRA

 
A helpful professional at your local First National Bank and Trust can help you make your 401(k) to IRA rollover. Schedule a consultation, and they’ll offer advice about minimizing taxes and other aspects of retirement planning. If you’re ready to optimize your retirement plan, contact us. We’re happy to help.