How to rollover a former employer's 401(k) plan

When you leave your job you have the option to roll your 401(k) balance over to an IRA. Moving your money to an IRA often gives you a better selection of investment options and more control over your money. But a rollover needs to be done carefully to avoid taxes, and there are a few instances when it's better to leave your money in the 401(k). Here's how to make a graceful exit from your 401(k) plan.

Why rollover? When you rollover your retirement account when you leave your job you gain better control over your circumstances. If you leave the account with the former employer, you are effectively handing over a portion of the control of your money to the plan administrator. The plan administrator's primary job is to ensure that the plan remains as effective and efficient as possible for your former employer, not for you. Your interests are not taken into account at all as a non-employee. In fact, many activities that the plan administrator undertakes (and passes along the costs to the plan accounts) are of no benefit to you whatsoever. By rolling your funds over to an IRA, you can make sure that the costs associated with your account's maintenance are directly benefiting your own account.

In addition, by rolling over your retirement funds into an IRA, you can exercise more flexibility in your investment choices. Employer plans only have a limited list of mutual funds to choose from. In an IRA, you can invest in just about any fund, stock, bond or ETF you would like to.

When to stick with the 401(k). For some folks, there may be good reasons not to rollover your 401(k) to an IRA. Perhaps the plan at your former employer has some very good investment options. There are certain investments that may not be available to individual investors that are available in your former employer's plan. By staying with the plan you would still have access to these investments.

In addition, if you leave employment at age 55 or later, you have easier access to the funds when they are in the former employer's plan than you would if the funds are rolled over into an IRA. With an IRA, if you access the funds before you reach age 59½ you will be assessed a penalty of 10 percent (unless you meet one of the exceptions). When the money is in a 401(k) plan and you've left employment at age 55 or later, you can access the funds at any time without penalty. Of course, income tax is always due on these withdrawals from either type of account.

If you have significant amounts of company stock in your former employer's 401(k) plan, you'll want to be careful with your rollover. You may still rollover these funds, but you'll want to do some homework on the net unrealized appreciation treatment of the stock holdings. There may be significant tax savings if you distribute the money from the 401(k) account, but if you roll it over to the IRA it will be subject to ordinary income tax rates.

How to rollover. When rolling over your 401(k) balance, it's important to maintain the tax-deferred nature of your investment. You should always have an IRA set up to receive the money before requesting the withdrawal from your current plan. If you don't have a place to put the money, the plan administrator will assume that you're taking a "cash out" distribution, and they are required to withhold 20 percent of the withdrawal for income tax.

The way to resolve this is to ensure that your withdrawal paperwork from your old account indicates a "direct rollover" is occurring. The old plan administrator may still send a check to your home address, but it will be made out to the new account custodian. You can just forward this to the new account.

If you don't do a direct rollover, you must complete the deposit of the funds in a new retirement account within 60 days, or you will be taxed on the withdrawal and a rollover will be disallowed. The 401(k) plan administrator may send you a check for your rollover that is made out to the new custodian, but it's up to you to make sure that you get the check sent to the new plan custodian as soon as possible, so that there's no danger of taking more than 60 days to complete the rollover.

Here's how to rollover your 401(k) to an IRA:

1. Establish your new account.

2. Request a "direct rollover" withdrawal from your old plan.

3. Receive the rollover check. (This may not occur. They may send the funds directly to your new account.)

4. Submit the check with the appropriate "direct rollover" deposit slip to your new account.

The process is straightforward. But if you don't pay close attention to what's going on and meet the deadlines, you could trigger income tax and the early withdrawal penalty.

Jim Blankenship is a certified financial planner who blogs at Getting Your Financial Ducks in a Row.

Copyright 2015 U.S. News & World Report

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