Leaving a job is stressful enough. Then comes the paperwork question nobody fully explains: what do you do with your old retirement account?
Most people assume rolling a 401k into an IRA is the obvious move. It often is. But the way you do it, and the choices you make along the way, can have real consequences for your tax bill and your long-term balance.
The CFP Board of Standards published a rollover guide on August 19 specifically to address two assumptions that advisors say cost investors money every year, according to CNBC.
Why a direct rollover is almost always the right first move
There are two ways to move money from a 401k to an IRA. The direct rollover and the indirect rollover.
In a direct rollover, your old plan sends the money straight to your new IRA custodian. You never touch it. No taxes are withheld. No deadline applies. The transaction shows up on your Form 1099-R with a code indicating it is nontaxable. This is the recommended method.
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In an indirect rollover, your old plan sends the money to you. Then you have 60 days to deposit it into an IRA. The plan is required by law to withhold 20% of the distribution for federal income taxes before cutting you the check.
The 20% withholding is where people get into trouble. More on that in a moment. Start with the direct rollover and you avoid the problem entirely.
The 20% withholding trap that catches people off guard
Say you have $100,000 in your old 401k and you choose the indirect route. You will receive a check for $80,000. The plan withheld the other $20,000 for taxes.
To complete a valid rollover and avoid paying taxes on the distribution, you need to deposit the full $100,000 into an IRA within 60 days. Not $80,000. The full $100,000.
That means you need to cover the missing $20,000 from your own savings. If you do, you get the withheld amount back when you file your tax return. If you cannot come up with it, the $20,000 counts as a taxable distribution. You pay income tax on it at your ordinary rate. If you are under 59½, you also pay a 10% early withdrawal penalty on top of that, according to the IRS.
There is one more rule worth knowing. The IRS limits you to one indirect rollover per 12-month period across all of your IRAs combined. Not per account. All of them. If you do a second one in the same year, it is treated as a fully taxable distribution. The rule does not apply to direct rollovers, which is another reason to use those instead.
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The fees that could be quietly eating your balance
Rolling from a 401k to an IRA does not eliminate fees. It can actually increase them depending on where you land.
Large 401k plans negotiate institutional rates on investments because they represent thousands of participants. Individual IRA accounts do not have that leverage. The expense ratios on funds available inside a 401k are often lower than what you find as an individual investor. Before you move your money, compare the investment options and costs available in both places.
The custodian you choose also matters. Fidelity, Vanguard and Charles Schwab charge nothing to open an IRA and carry no annual maintenance fees. Regional banks and specialty custodians may charge $50 to $300 per year, according to CNBC. That might not sound significant on a large balance, but it compounds over decades the same way your investment returns do.
The CFP Board also flagged advisor fees as a cost to watch. Rolling a 401k into an IRA managed by a financial advisor who charges a percentage of assets under management adds an ongoing cost that did not exist when your money was in the employer plan. Make sure you understand what you will pay and what you are getting in return.
What to check before you complete the rollover
Two things the CFP Board wants people to know before they move.
First: you do not have to roll over when you leave a job. Most 401k plans allow you to leave the money where it is after you separate from your employer. Few people do, but it is an option. If your old plan has strong investment options at low costs, staying put can make sense.
Second: this decision is not easily undone. Once the rollover is complete, reversing it is complicated and sometimes impossible. Do the comparison before you initiate the transfer, not after.
A few other things worth reviewing before you act. If you are between 55 and 59½ and you left your job this year or recently, check whether the Rule of 55 applies to you. It allows penalty-free withdrawals from a 401k in that window, according to the IRS. Roll the money into an IRA and you lose that access, because IRA early withdrawal rules use 59½ as the threshold, not 55.
If you are 73 or older, you must take your required minimum distribution for the year before you roll anything over. RMDs cannot be rolled over. Rolling the distribution along with the rest of your balance is a compliance error, according to CNBC.
And if your 401k holds highly appreciated company stock, look at the NUA rules before you move. In the right situation, those rules let you pay capital gains rates on the appreciation when you eventually sell, rather than ordinary income rates. Rolling the stock into an IRA before checking can eliminate that option permanently.
Related: Dave Ramsey says 3 things set 401(k), Roth 401(k), IRA apart