How to Roll over your 401k

Rolling over your 401(k) plan is simple – but don’t let the simplicity fool you. It is absolutely essential that you follow the simple rules, or you will be hit with an unexpected tax bill and will have probably wasted important investment opportunities.

To set the groundwork, let’s review what a 401(k) plan is. A 401(k) is set up by an employer for the benefit of employees. The employees can put money into a special account, managed on their behalf by their employer (and outside experts). The advantage of putting money into this account is that it is put in tax-free; that is, if you put in $3,000 per year, the government pretends that your income was $3,000 lower. In other words, the government is paying you to save money!

And it gets better. Most companies also encourage their employees to build long-term savings by matching a portion of what the employee chooses to save from each paycheck. This is usually 1% to 3% of a person’s gross salary. So that’s like a bonus that your company is giving you, just for doing a smart thing. Again, a great deal!

But the benefits noted above come with some restrictions. The primary one is that you can’t have the money until at least age 59 1/2 or until you retire. Also, it’s taxed when you take it out. If you need it before retirement, you basically have to pay taxes and a penalty for early withdrawal. So it’s a bad idea to put money into a 401(k) if you think you won’t be able to leave it there for a long time.

And that’s where the 401(k) rollover comes into play. When you leave a company, you are no longer allowed to put new money into that company’s 401(k). And you have three choices about what to do with the money that’s already in your account, and the first two are bad.

Choice No. 1 is to leave the money right where it is, and to let the former employer’s plan manage it for you. This is a bad idea because, almost in every case, a company’s 401(k) plan does not offer a great range of investments. For the sake of simplicity, the company probably offers you five or ten or fifteen different choices for investments. In the real world, there are tens of thousands of choices, so leaving the company plan is a good opportunity for you. Also, company 401(k) plans often cost more than if you have an independent manager; it’s the ugly secret of 401(k)’s, and one that the US Congress is trying to fix right now. So, while 401(k)’s are definitely worthwhile, you are in even better shape if you don’t leave your money in them.

Choice No. 2. Take out the money and spend it. Dumb, dumb, dumb idea. You get nailed with taxes and penalties, plus you have put a whole in your long-term savings. If you are laid off or fired by your employer, it’s possible that you really need the 401(k) cash to cover your expenses. That’s a legitimate need. But cashing-out your 401(k) in order to take a trip to the Caribbean is dumb.

Choice No. 3. A 401(k) rollover. In a rollover, you tell your company’s 401(k) that you want to transfer all of your money that they are holding to another investment company. You never see the money – you just roll it over from one place to another. And if you do this, the government does not hit you with any taxes or penalties.

The procedure for a rollover is totally simple. Decide where you want to put your money – like Schwab, TD AmeriTrade, AmeriPrise Financial, or whatever. Tell them that you want to open an account with a 401(k) rollover, and they will send you a form. It takes about 3 minutes to fill it out. Then contact your former employer’s human resources department, and tell them you are doing the rollover. They will give you another very simple form that basically asks you where your money should be sent. Fill it out in another three minutes. Wait two or three weeks for confirmation from both parties. Call them if you haven’t heard anything in a month. That’s all there is to it.

Two warnings. First, you usually have only a limited amount of time after you leave a company to tell the company what you want to do with the money. And if you don’t tell them, they get to decide whether they will keep you in the plan or write you a check (they have the choice most of the time).

Second, if the company sends you a check by mistake, do not cash it! The IRS will assume you wanted the dough. You have 60 days to correct the mistake and have a check or money transfer sent directly to the investment firm where you opened your IRA account. This mistake happens more often than you think, so watch out.

In conclusion, 401(k) rollovers are designed to enable you to retain the tax benefits of your long-term savings accounts. When handled well, you actually can gain a great deal of investment flexibility and pay less each year for having your investments managed by a third party. But you need to move promptly when you leave a job, and you need to make your intentions clear to all parties.