Are Rollover IRAs a good option for you when changing jobs?

Retirement savings is probably the last thing on your mind when you change jobs. After all, you're just starting at a new company and there’s so much to learn as you ease into the transition—with retirement still perhaps years away.

In most cases, however, you’ll generally have about 30 days after leaving your previous job to decide what to do with that employer’s 401(k) plan. Once such option is a rollover IRA. Let’s explore this possibility in detail so you can make an informed decision.

What is a rollover IRA?

Simply put, a rollover IRA is an individual retirement account used to move funds from an employer-sponsored retirement account such as a 401(k), 403(b), or profit-sharing plan.

Your 401(k) options when changing jobs

If you’re happy your current 401(k), there’s really no reason to switch unless your employer requires that you do so (e.g., if your balance falls below the common $5,000 threshold). However, know that you can no longer contribute to this retirement plan and it will exist separately from any others offered by your new job as one more account to manage.

A second option is to roll over your savings into your new employer’s 401(k) or 403(b) plan, assuming they allow rollovers. If you're satisfied with the investment options, costs, and features offered by your new employer-sponsored plan, rolling over your savings into that plan sometimes makes the most sense. Another benefit of going this route is the ability to consolidate plans: meaning one less account to manage.

A third option—and one we don’t recommend—is to cash out your savings, an action referred to as a “lump-sum distribution.” This is almost always your worst option as you'll owe income tax on the amount withdrawn. Uncle Sam will also generally charge you a 10% “early withdrawal fee” if you’re under the age of 59½. What's more, you'll lose out on the time your savings could have grown.

A fourth and final option is to roll your funds over into an IRA, giving you complete control over the funds and an ability to take advantage of specific tax rules—putting you in the driver’s seat.

Rollover IRA benefits

Rolling over your old 401(k) or 403(b) into an IRA offers many advantages:

·       You enjoy much more control over your retirement savings. IRAs offer nearly unlimited investment choices compared to more restricted options associated with an employer-sponsored 401(k). Therefore, an IRA will allow you to invest your savings however you want: whether in real estate, stocks, bonds, mutual funds, and/or ETFs.

·       Rollover IRAs have tax advantages. Rollover IRAs offer numerous tax benefits that can save you a lot of money. As with your 401(k), a traditional IRA can score you an immediate tax break by funding the account with pre-tax dollars. If you go the Roth IRA route, however, you’ll pay taxes upfront but enjoy tax-free withdrawals in the future.

·       Rollover IRAs help simplify your finances. Some people like the idea of simply doing nothing as their previous employer manages their 401(k). If you land another new job in the future and must sign up for yet another 401(k), you’ll quickly realize how this can complicate your finances—meaning that if you plan on changing jobs at least a few times over the remainder of your career, you’ll appreciate how an IRA can serve as a single destination for the entire breadth of your older retirement savings plans.

It's easy to see how a rollover IRA can offer many advantages with respect to your financial life. They’re surprisingly versatile and are often extremely helpful for managing your future finances; but they do have some drawbacks, akin to any investment.

Rollover IRA disadvantages

Rollover IRA downsides include a lack of loan options, meaning you can’t borrow from your IRA as you often can from a 401(k) plan. While rolling over your 401(k) to an IRA typically doesn’t summon a fee, new IRA account fees are sometimes higher than those for a 401(k). Should you plan on retiring early, the Rule of 55 allows for penalty-free withdrawals (you’ll still pay taxes) from your 401(k) provided you’re at least 55 years old and retired; you’d need to wait until age 59½ with a rollover IRA. Finally, 401(k)s—relative to IRAs—tend to enjoy a bit more legal protection with respect to keeping your assets when filing for bankruptcy.

Choosing between a traditional and Roth IRA

A one-size-fits-all approach is simply not feasible as it relates to the type of IRA you should choose. A common reason why investors sometimes choose a traditional IRA over a Roth IRA, however, is that they assume they’ll fall into a lower income tax bracket after retiring—and thus enjoy associated benefits of these types of plans with withdrawals taxed at a lower rate. While it’s human nature to assume your gross income will decline in retirement, this doesn’t necessarily mean your taxable income will as well; this is particularly true when you factor in income from various sources including Social Security benefits, any freelance or part-time work, and/or other investments you may have. 

Because your future income is difficult to predict with any certainty, investing in both a traditional and Roth IRA is sometimes the most prudent approach: affording you some level of tax diversification (meaning some assets are fully taxed upon withdrawal while others remain tax-free). Therefore, if you already have one type of IRA, owning both a Roth and traditional IRA could make sense; just note that if you go with the former option, you’ll pay taxes on the rollover amount.

Choosing a rollover IRA provider

This step is easy if you're already working with a financial advisor, but you might not know that different types of financial advisors can help roll over your IRA—with each provider offering varying fee levels and perhaps diverse resources/services to help manage your savings. As an additional reference, click here to check out our article detailing how to choose a financial advisor.

Transferring money

Though we’ve used the umbrella term “rollover IRA” thus far, there are actually two different types of IRA rollovers.

With a direct rollover, your plan administrator transfers assets from your retirement plan directly into your new IRA. This is usually the ideal option as you never need to touch the money.

The second option, an indirect rollover, gives you direct custody of the funds via a check your plan administrator will provide for you to deposit. In this scenario, you can use the funds for any purpose for 60 days; but you’ll need to eventually redeposit this money into a new IRA by the end of the 60-day period to avoid paying income tax and a 10% early withdrawal penalty (assuming you’re under the age of 59½). This is precisely why indirect rollovers are usually only recommended if you need urgent access to the money and can execute this transaction within the 60-day window in the absence of risk.

Other IRA rollover considerations

Keep in mind you can contribute additional money to your rollover IRA in the year it’s established, as rollover funds are treated separately from your annual contributions. However, these contributions are limited to $6,500 per year ($7,500 if you’re age 50 or older). Furthermore, you may be restricted from contributing to a Roth IRA based on your income or if you (or your spouse) has access to a workplace retirement plan. Check out this article for more details on Roth IRAs, noting there is no limit regarding how much money you can roll over to an IRA.

In sum: rollover IRAs

While rolling over your 401(k) or 403(b) into an IRA is often the best choice due to the simplicity and flexibility of these accounts, they’re sometimes not suitable for all employees in the midst of a job change. That’s precisely why we recommend speaking with a CFP® professional to guide you through the process and help you make the best decision based on your own unique circumstances.

Still wondering if a rollover IRA is right for you? Schedule a FREE Discovery call with one of our financial advisors.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This material was created for educational and informational purposes only and is not intended to act as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, you must pursue the same independent of this educational material.