Everything You Need to Know About a 401(k) Rollover

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You may have just landed a new job — congratulations! Switching jobs can be a great personal finance decision that leads to more money, better benefits, and new opportunities.

There’s just one thing you have to do before you settle into your new position: Figure out what to do with your old employer’s 401(k) plan.

Oftentimes, workers choose to take advantage of a 401(k) rollover when switching jobs. This post explores what a 401(k) rollover is and how to complete one.

What is a 401(k) Rollover?

A 401(k) rollover involves taking money out of an existing retirement account and transferring it into a new individual retirement account (IRA) or 401(k) offering.

After you switch jobs and cash out on your 401(k), the IRS gives you 60 days from the date that you receive an IRA or retirement plan distribution to transfer it into another retirement account.

If you don’t move the money to another retirement plan within the 60-day time frame, the IRS will make you pay federal taxes on the funds. You’ll also have to pay early withdrawal penalties on the money, too.

This means you can’t freely take money that was previously tied up in individual stocks, exchange-traded funds (ETFs), and mutual funds and use it to start buying things. If you do so, you’ll face tax consequences and other penalties from the IRS.

As such, protecting your 401(k) is one of the most important tasks to consider when switching jobs, especially if you’ve built up a significant nest egg. A job transfer can be chaotic and stressful. But it’s very important to get the details straight regarding your 401(k) to avoid any potential issues. Before making any decisions, make sure to talk to your plan administrator to see what options are available to you.

How To Do a 401(k) Rollover

1. Figure out if you can keep your former employer’s 401(k)

You may not have to do a 401(k) rollover. Some companies let employees keep their retirement savings plans after they leave the company — meaning you could potentially switch jobs and keep your former employer’s plan in place.

It may sound strange to avoid severing ties with your previous employer. But this is actually a fairly common approach. You’ll be dealing with your brokerage account — not the company — so there’s no need to worry about any potential conflict.

Keeping your existing 401(k) plan comes with several benefits, too.

Continued tax-deferred growth

Keeping your money in your old 401(k) plan allows for continued tax-deferred growth. This enables you to maximize your retirement savings for decades after working for the company.

Penalty-free withdrawals at retirement age

You’ll still be able to make penalty-free withdrawals from your 401(k) after you reach age 55 (but you’ll have to pay income tax on these funds). Leaving your job won’t impact your 401(k) tax benefits.

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Lower cost investment options

Since you signed up for the 401(k) through an employer, you may be able to continue leveraging lower-cost investment services, saving you money. But be sure to ask your former employer whether the plan charges an annual fee. If it does, you may want to consider a rollover to avoid those expenses.

Restrictions to be aware of when keeping a 401(k)

Keep in mind that if you decide to keep your former employer’s 401(k) plan, you can’t make any further contributions to the account. Of course, your employer is going to stop contributing to the account as well.

You may also face limited withdrawal options from your account. Check with your bank about the rules so that you’re aware of your options and rights.

2. Ask if your new employer has a 401(k) plan

The next step is to approach your new employer and see if the company offers a 401(k) plan. Chances are you’ll already know the answer to this question. You also need to make sure that the new company accepts rollovers from previous employers. It’s not always possible to make a transfer.

If the new employer offers a 401(k) plan and allows for transfers, it could lead to continued tax-deferred savings. You can continue making contributions and benefit from potential employer contributions.

Plus, it’ll all be in one place. Having a single 401(k) plan is easier to manage. You are legally allowed to have more than one 401(k) plan, but it’s just one more account to keep track of and monitor. If possible, and if it makes financial sense, you should consider consolidating your accounts.

3. Look into a rollover IRA

In addition to having a 401(k) plan, many investors also choose to open IRAs for further long-term tax benefits.

An IRA is a retirement account set up through a broker that allows you to save for retirement on a tax-free or tax-deferred basis. You can open an IRA from an IRA provider like Schwab, Fidelity, or Vanguard.

Many leading banks also offer IRAs in addition to a range of investment options for short-term or long-term planning. Shop around and find an IRA that offers a combination of low fees, a robust online platform, and strong customer service ratings.

There are a few types of IRAs to choose from.

Traditional IRA

A traditional IRA allows you to add pre-tax income for growth on a tax-deferred basis. In other words, you’ll pay taxes when you go to touch the money at the retirement age of 59 ½. If you withdraw money before then, you’ll incur tax penalties.

Select this option if you think you’ll be in a lower tax bracket at retirement age.

Roth IRA

A Roth IRA enables you to pay taxes upfront, for tax-free growth until retirement. If you select a Roth IRA, you’ll avoid paying taxes when you reach retirement age.

Select a Roth IRA if you anticipate being in a higher tax bracket at retirement age.

Traditional and Roth IRAs have a combined contribution limit of $6,000 for the 2021 tax year.

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A simplified employee pension (SEP) IRA is an IRA that a self-employed individual can use to fund their retirement.

Contribution limits are much higher for SEP IRAs. For the 2021 tax year, an employer cannot exceed the lesser of 25% of the employee’s compensation or $58,000.

Why open an IRA?

An IRA can be useful for a rollover if there is no 401(k) offering in your new employer’s plan of benefits. You can seamlessly transfer the money into an IRA, avoiding having to pay penalties from the IRS as long as you complete the process within the 60-day grace period after leaving your job.

Rolling over a 401(k) into an IRA can provide continued tax-deferred growth. You can also use IRAs and 401(k)s at the same time for additional retirement savings. Everyone’s financial circumstances are different. Talk to a financial advisor today to determine which retirement accounts make the most sense for you.

4. Wait until retirement to cash out

Once your rollover is complete, you’ll face the hardest part of the process: not touching your money until you reach retirement age.

IRAs do allow some exceptions, allowing you to make early withdrawals without paying a 10% penalty. For example, the CARES Act temporarily eliminated minimum distribution requirements for the 2020 calendar year, providing easier access to retirement income.

Further exceptions to the IRA early withdrawal penalty include:

  • Qualified medical expenses
  • Disability
  • Health insurance
  • Inheriting an IRA
  • 72(t) payments
  • Purchasing a home for the first time
  • Qualified reservist distributions
  • Qualified higher-education costs

Just because you can touch your IRA money for these types of transactions doesn’t mean you should. First and foremost, it sets a bad precedent for yourself. Once you tap into your retirement savings to fund one initiative, you’ll be more apt to look at that account as a source of revenue again at a later date. If you keep doing this, there won’t be much — or any — leftover at retirement age.

Saving money for retirement is difficult and it takes years to accumulate enough money to retire. Share what you have now with your future self and you’ll be very grateful down the line.

Indirect vs. Direct Rollovers

As you can see, a 401(k) rollover is a pretty seamless transaction. There aren’t too many ways of messing it up.

There is one important decision to make, however: Will you move forward with a direct or indirect rollover?

Direct rollover

In a direct rollover, the financial institution either funds a new account for you or sends a check to the other financial institution, meaning your new IRA brokerage firm or 401(k) provider. The check goes directly to that institution and you don’t have to get involved at all.

Indirect rollover

In an indirect rollover, the check goes to you — and this is where it can get a bit messy. You’ll have a 60-day grace period from the time of the withdrawal to put the money back into a tax-advantaged account.

Keep in mind that your employer will withhold 20% of your funds for tax purposes. As a result, you’ll be on the hook for the 20% that was withheld and put into the new account.

Failure to make the 20% payment could result in a 10% penalty. Plus, you’ll lose out on tax-free or tax-deferred growth advantages.

Frequently Asked Questions

Can you complete a 401(k) rollover without leaving work?

The majority of employer plans do not allow workers to take money out of their 401(k) plans while they are still with the company — a move that’s referred to as an in-service rollover. As a result, you most likely can’t take money out of a 401(k) and roll it over into an IRA while you are still with your company.

If you are considering this strategy, check with your employer first.

Is a 401(k) better than an IRA?

It’s not a matter of saying that one plan is better than the other.

A 401(k) and IRA have some major differences regarding eligibility, contribution limits, fees, and withdrawal criteria.

Spend some time researching the key differences between the two types of plans, and consider talking with a financial advisor to see what you are eligible for and which plan is best for your needs. You may be in a position to open an IRA and a 401(k). And some investors go as far as opening a Roth IRA, a traditional IRA, and a 401(k). It all depends on your specific needs and your situation.

Do I need a retirement plan?

The short answer is yes — you absolutely need a retirement account, assuming you hope to achieve financial independence.

Many young people today have a pessimistic view about retirement because it tends to be a far-off and rather nebulous idea. But it doesn’t have to be. In fact, you can retire much sooner than the traditional age of 66 if you put your mind to it.

Remember that it’s not about when you retire. It’s about how much money you retire with. Retirement is just a mindset.

Spend some time visualizing what retirement means to you and then build a retirement plan that matches your vision. Why not plan for very early retirement and spend your best years hiking through remote jungles, lounging on boats, and funding nonprofits?

Or, consider a mini-retirement, where you leave the rat race behind but transition into your golden years by working (probably for less money and fewer hours) at a job you love. All of this is possible. You just need the right approach.

I’m having trouble meeting my retirement savings goals. What can I do?

If you’re having trouble meeting your savings goals for retirement due to your current cash flow, here’s some tough but necessary advice.

First, take a hard look at your budget and consider adjusting your spending so that you can put more money into retirement. Chances are likely there is something that you can cut — even if it’s just Netflix for now. You need to know what money is coming in and where it’s going.

Next, you need to make more money. Figure out your current value to your company and try and get a sense if you’re getting paid fairly for the amount that you contribute. If not, consider asking your employer for a raise and don’t feel bad about doing it.

Chances are that’s only going to bring in a fixed amount. Your next step should be to look into starting a side hustle for extra income on the side. Assess your skillset, and look for a way to bring in more money walking dogs, writing blogs, filling out online surveys, or managing social media.

If that’s still not enough, consider switching jobs altogether and asking for a large bump in salary when you find your next gig. If you can’t swing this due to your lack of experience or education, do what you have to do to elevate yourself.

Any way you slice it, planning for retirement is a critical need. There’s no excuse to neglect it.

The Bottom Line

At the end of the day, you don’t have to panic about your 401(k) when switching jobs, but you need to make sure you figure out your options and take steps that work for you. There are different investment choices to consider. Whether you keep your existing account, roll it into a new one, or open an IRA, you’ll be in an ideal position to put money aside so that it can grow.

Just make sure to check the details on your account so that you know the rules that are available to you. You should also strongly consider doing a direct rollover to avoid getting hit with tax withholdings or running into additional complications.

Retirement planning is an essential part of your journey toward financial independence. If you have further questions, work with a tax advisor who can help guide you through the process. It’s a decision you won’t regret.

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