If you have a 401(k) plan and you leave your job, you normally can roll the account over to a traditional individual retirement account. You can open the account at a bank or brokerage of your choice and it will then operate like a normal IRA. You can usually add additional money to a rollover IRA. Depending on the rules of 401(k) plans at your future employers, you may or may not be able to then roll the IRA back into a 401(k) if you wish to do so.
How a 401(k) Works
A 401(k) is a retirement plan that's set up for you by an employer. You can contribute up to $18,500 per year to the plan as of 2018, and the money is generally regularly taken out of your paycheck for investment in the 401(k). Some employers will also make some matching contributions to your 401(k) plan.
You don't pay federal income tax on the money you put into your 401(k) at the time you deposit the money. Instead, when you retire, you pay tax on the money you withdraw from the plan, which can often save you money if you're in the same or a lower tax bracket after retirement compared to when you are working.
If you take money out of 401(k) plan before you reach age 59 1/2, you generally must pay this so-called deferred income tax plus a 10 percent penalty unless certain hardship exemptions apply.
How an IRA Works
Like a 401(k), a traditional IRA is a retirement account that you can contribute to while you are working, paying taxes on the funds only when you withdraw them later in life for your retirement.
You can set up an IRA at many banks, brokerages and other financial institutions and you can contribute up to $5,500 per year to your IRAs in 2018. If you're 50 or older, you can contribute up to $6,500 per year to your IRAs. You can add money to an IRA only from earned income, so your contributions must be no more than what you and your spouse earned that year.
When you reach 59 1/2, you can withdraw from your IRA and pay taxes on the funds you withdraw, but if you withdraw money before that age, you normally must also pay an additional 10 percent penalty to the Internal Revenue Service. Certain hardship exemptions and other special situations, such as buying a first home, can let you make early IRA withdrawals without paying the 10 percent penalty.
Rolling Over a 401(k)
When you leave a job that offers a 401(k), you're usually able to roll the funds over to a new employer's 401(k) or to what's called a rollover IRA.
Rolling over to an IRA can be advantageous since you can choose your own provider, rather than using one assigned by an employer, and since IRAs often allow a wider range of investment choices than a 401(k).
You generally want to have the funds transferred directly from one financial institution to another without going directly into your hands. If you do take possession of the funds, you must deposit them within 60 days or be considered to have taken a withdrawal, which will trigger taxes as well as penalties if you are under 59 1/2.
You may also face a withholding tax that you must pay out of your own funds until your tax return is processed or you will be considered to have taken a withdrawal.
You can also roll over money from one IRA to another, but you're only allowed to do so in a way where you take possession of the funds once in a one-year period. This limit on the IRA rollover rules is in place to prevent people from taking repeated rollovers as a way to take a permanent, no-interest loan from their retirement accounts.
Contribute to Rollover IRA
Once you open a rollover IRA, you can contribute additional funds to it if your plan allows for it. You can also roll your IRA back into an employer 401(k) at a later date if you so choose.
Some 401(k)s will only allow you to roll over funds from other employer plans, so if you begin commingling IRA assets, you may not be able to move the rollover IRA money back into a 401(k) or similar plan later on.
If this is a concern for you, one solution may be to simply open a second IRA, either with the same provider or a different financial institution, to which you will contribute your own funds. You can have as many IRAs as you wish, although the contribution limits apply across all of your traditional and Roth IRAs.
How Roth IRAs Work
Roth IRAs work slightly differently from traditional IRAs. Rather than deferring taxes until you retire, you pay tax as normal on the amount that you contribute to a Roth IRA.
When you do retire, you don't pay any additional tax on what you withdraw from the Roth IRA, including any investment earnings. This effectively enables your retirement savings to grow tax-free, which is especially valuable if you anticipate high earnings or being in a high tax bracket when you retire.
Some employers do offer Roth 401(k) plans, and you can roll these over into Roth IRAs. If you want to convert a traditional 401(k) or IRA into a Roth IRA, you must work with the financial institution that manages the plan to pay the deferred tax.
You can withdraw the money you put into a Roth IRA early without a penalty or a tax bill, since you've already paid federal income tax on it, but if you withdraw investment earnings before age 59 1/2, you must pay tax and the 10 percent penalty unless one of the exemptions applies.
Early Withdrawal Penalty Exceptions
If you have an IRA, you can withdraw money before 59 1/2 without paying a penalty under certain circumstances, though you will still owe the tax due on the money you withdraw at your ordinary income tax rate.
You can withdraw up to $10,000 as a first-time homebuyer in order to pay for expenses relating to acquiring that home. You can also often withdraw money without a tax penalty if you are in the military reserves or the National Guard and you are called up for active duty or if you become permanently disabled.
If you are unemployed and need to pay for health insurance for yourself and your family, you can do so with IRA funds without paying a tax penalty. You can also use IRA money without a penalty to pay for certain higher educational expenses for yourself or your family.
Only a portion of these exceptions applies to 401(k)s, which generally have stricter rules on hardship exceptions from the tax penalty. That greater flexibility can be another reason to roll a 401(k) over to an IRA.
Taking a 401(k) Loan
One option available with a 401(k) that's not available with an IRA is taking a loan against your 401(k), provided your plan allows it.
You generally can only do so for up to five years and only while working for the company that sponsored the plan. Sometimes you can take longer loans for the purchase of a house. If you leave your job while your loan is outstanding, you may need to pay it back faster.
You pay interest on a 401(k) loan, although the interest accumulates in your account. Your repayments, including interest, are not tax deductible.
- IRS: 401(k) Plans
- IRS: Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits
- IRS: Rollovers of Retirement Plan and IRA Distributions
- IRS: Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs)
- IRS: Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs)
Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.