Top 7 Reasons to Roll Over Your 401(k) to an IRA

Rolling over your 401(k) into an IRA account comes with many benefits

When you change jobs, you generally have four options for your 401(k) plan. One of the best options is doing a 401(k) rollover to an individual retirement account (IRA). The other options include cashing it out—and pay taxes and a withdrawal penalty, leave it where it is—if your ex-employer allows this, or transfer it into your new employer's 401(k) plan—if one exists. For most people, rolling over a 401(k) (or its 403(b) for those in the public or nonprofit sector) is the best choice. This article explains why and how to go about it.

Key Takeaways

  • When you change jobs, you have several options for what to do with the 401(k) plan at your old employer.
  • For many people, rolling their 401(k) account balance over into an IRA is the best choice.
  • By rolling your 401(k) money into an IRA, you'll avoid immediate taxes and your retirement savings will continue to grow tax-deferred.
  • An IRA may also offer you more investment choices and greater control than your old 401(k) plan did.
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1. More Investment Choices

Your 401(k) has limited investment choices. In all likelihood, you have a choice of mutual funds from one particular provider. However, with an IRA, you can invest just about anywhere. In addition, you're likely to have more types of investments to choose from—not just mutual funds but also individual stocks, bonds, and exchange traded funds (ETFs), to name a few.

You can also buy and sell holdings any time you want. Most 401(k) plans limit the number of times per year that you can rebalance your portfolio, as the pros put it, or restrict you to certain times of the year.

2. Better Communication

If you leave your account with your old employer, you might be treated as a second-class citizen, though not deliberately. It just could be harder to get communications regarding the plan (often news is distributed through company email) or to get in touch with an advisor or administrator. Having ready access to information is extra important in the unlikely event something goes south at your old workplace.

Most 401(k) plan rules state that if you have less than $1,000 in your account, your employer is allowed to simply cash it out and give it to you (minus 20% tax withholding). If you have between $1,000 and $5,000, your employer is allowed to move it into an IRA for you.

3. Lower Fees and Costs

Rolling your money over into an IRA will often reduce the management and administrative fees you've been paying, which can eat into your investment returns over time. The funds offered by the 401(k) plan may be more expensive than the norm for their asset class. And on top of that, there is the overall annual fee that the financial institution managing the plan charges.

The bigger 401(k) plans with millions to invest have access to institutional-class funds that charge lower fees than their retail counterparts. Of course, your IRA won't be free of fees either. But again, you'll have more choices and more control over how you'll invest, where you'll invest, and what you'll pay.

4. The Option to Convert to a Roth

An IRA rollover opens up the possibility of switching to a Roth account. (In fact, if yours is one of the increasingly common Roth 401(k)s, a Roth IRA is the preferred rollover option.) With Roth IRAs, you pay taxes on the money you contribute when you contribute it, but there is no tax due when you withdraw money, which is the opposite of a traditional IRA. Nor do you have to take required minimum distributions (RMDs) at age 72 or ever from a Roth IRA.

If you believe that you will be in a higher tax bracket or that tax rates will be generally higher when you start needing your IRA money, switching to a Roth—and taking the tax hit now—might be in your best interest.

The Build Back Better infrastructure bill—passed by the House of Representatives and currently under consideration by the Senate—includes provisions that would eliminate or reduce the use of Roth conversions for wealthy taxpayers in two ways, starting January 2022:

  1. Employees with 401(k) plans that allow after-tax contributions of up to $58,000 would no longer be able to convert those to tax-free Roth accounts.
  2. Backdoor Roth contributions from traditional IRAs, as described below, would also be banned.

Further limitations would go into effect in 2029 and 2032, including preventing contributions to IRAs for high-income taxpayers with aggregate retirement account balances over $10 million and banning Roth conversions for high-income taxpayers.

If you're under the age of 59½, it's also a lot easier to withdraw funds from a Roth IRA than from a traditional one. In most cases, there are no early withdrawal penalties for your contributions, but there are penalties if you take out any investment earnings.

Your 401(k) plan rules may only permit rollovers to a traditional IRA. If so, you'll have to do that first and then convert the traditional IRA into a Roth. There are a number of strategies for when and how to convert your traditional IRA to a Roth that can minimize your tax burden. Should the market experience a significant downturn, converting a traditional IRA that is down, say 20% or more, to a Roth will result in less tax due at the time of the conversion. If you plan to hold the investments until they recover, that could be an attractive strategy.

But this can be tricky, so if a serious amount of money is involved, it's probably best to consult with a financial advisor to weigh your options.

5. Cash or Other Incentives

Financial institutions are eager for your business. To entice you to bring them your retirement money, they may throw some cash your way. In late 2021, for example, TD Ameritrade was offering bonuses of up to $2,500 when you rolled over your 401(k) into one of its IRAs. If it's not cash, free stock trades can be part of the package at some companies.

6. Fewer (and Clearer) Rules

Understanding your 401(k)'s rules can be no easy task because employers have a lot of leeway in how they set up their plans. In contrast, IRA regulations are standardized by the Internal Revenue Service (IRS). An IRA at one financial institution follows substantially the same rules as one at any other.

An often-overlooked difference between a 401(k) and an IRA has to do with IRS rules regarding taxes on distributions. The IRS requires that 20% of distributions from a 401(k) be withheld for federal taxes. When you take a distribution from an IRA, you can elect to have no tax withheld.

It's probably wise to have some tax withheld rather than winding up with a big tax bill at the end of the year and possibly owing interest and penalties for underpayment. However, you can choose how much to have withheld to more accurately reflect the actual amount you'll owe, rather than an automatic 20%. The benefit is that you're not depleting your retirement account faster than you need to, and you're allowing that money to continue compounding on a tax-deferred basis.

7. Estate Planning Advantages

Upon your death, there's a good chance that your 401(k) will be paid in one lump sum to your beneficiary, which could cause income and inheritance tax headaches. Rules vary depending on the particular plan, but most companies prefer to distribute the cash quickly so they don't have to maintain the account of an employee who is no longer there. Inheriting an IRA has tax implications too, but IRAs offer more payout options.

How to Roll Over Your 401(k) to an IRA

The easiest and safest way to roll over your 401(k) into an IRA is with a direct rollover from the financial institution that manages your 401(k) plan to the one that will be holding your IRA. Note there are three key types of rollovers from a 401(k) to an IRA:

  1. Rolling over a traditional 401(k) to a traditional IRA. Here the taxes are deferred and you won't owe anything.
  2. A rollover from a Roth 401(k) to a Roth IRA. Here you also won't pay taxes.
  3. Rolling over from a traditional 401(k) to a Roth IRA. Here you'll pay taxes the rolled-over amount.

Your plan administrator can guide you through the process, and the financial institution where your money is going will usually be more than happy to assist. In many cases, your plan administrator will give you a check made out to your new IRA custodian for you to deposit there. Thus, open your new IRA first, then contract the plan administrator for of your former employer.

Indirect Rollover

Another option—but a far riskier one—is to have the check made out to you and take possession of the money yourself. If you do that, you typically have just 60 days from the date you received it to roll it over into an IRA. If you fail to meet that deadline, the distribution will be treated as a withdrawal, and you'll be subject to income taxes and possibly penalties on the full amount.

A further complication of receiving the distribution yourself is that your ex-employer will be required to withhold 20% of it for taxes. If you then want to deposit your full balance into an IRA, you'll have to come up with other money to make up for the 20% that's been withheld.

Can You Roll Over an IRA Into a 401(k)?

Yes, if your 401(k) plan permits it, you can roll over a traditional IRA (but not a Roth IRA) into it. This is sometimes referred to as a reverse rollover.

What Happens If I Cash Out My 401(k)?

If you simply cash out your 401(k) account, you'll owe income tax on the money. In addition, you'll generally owe a 10% early withdrawal penalty if you're under the age of 59½. It is possible to avoid the penalty, however, if you qualify for one of the exceptions that the IRS lists on its website. Those include using the money for qualified education expenses or up to $10,000 to buy a first home.

Why Would You Roll a 401(k) Into an IRA?

Rolling over your 401(k) into an IRA gives you the added benefit of a greater number of investment options. You also cannot make contributions to a 401(k) after you leave the company, but you can if you roll it over into an IRA.

The Bottom Line

For most people switching jobs, there are many advantages to rolling over their 401(k) into an IRA. But shop around for an IRA provider with low expenses. That can make a big difference in how much money you'll have at your disposal when you retire.

Article Sources

Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
  1. Internal Revenue Service. "Rollovers of Retirement Plan and IRA Distributions."

  2. Internal Revenue Service. "Roth Comparison Chart."

  3. National Law Review. "Tax Reform: What's In and What's Out (For Now)."

  4. U.S. Congress. "H.R. 5376 - Build Back Better Act."

  5. Internal Revenue Service. "Publication 590-B: Distributions from Individual Retirement Arrangements (IRAs)," Page 30.

  6. TD Ameritrade. "Open an Account Today and Get up to $2,500 Cash."

  7. Internal Revenue Service. "401(k) Resource Guide - Plan Participants - General Distribution Rules."

  8. Internal Revenue Service. "Retirement Plans FAQs Relating to Waivers of the 60-Day Rollover Requirement."

  9. Internal Revenue Service. "Rollover Chart."

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