The idea of rolling over your 401(k) might seem like a simple task until a small mistake costs you thousands in penalties and unexpected taxes. It happens time and time again, when Americans unknowingly trigger tax consequences or even lose out on investment growth simply because the rollover was not handled properly.
The good news? A few tips can save you a lot of money. If you’re changing jobs, consolidating accounts, seeking better investment options, or looking for lower advisory and investment fees, understanding your 401(k) rollover options is crucial to protecting your retirement goals.
At DHJJ, we’ve helped hundreds of individuals successfully transition their retirement funds without unnecessary costs. With years of expertise in 401(k) management and retirement planning, we’ve seen several mistakes and know exactly how to avoid them.
In this guide, you’ll learn the smartest ways to roll over your 401(k), including how to protect your investments, avoid IRS penalties, and make a seamless, tax-efficient transition.
The Costly Mistakes That Could Ruin Your Rollover
Not all 401(k)’s are alike. A single oversight can mean losing part of your savings.
Key Considerations Before Rolling Over:
Does your new employer’s plan accept rollovers? If you are transitioning from one employer to another, you may want to check with your HR department or plan administrator to verify whether your new plan accepts rollovers.
What are the investment options, fees, and waiting periods? Be sure to ask about the types of investments available, any associated fees, and whether there’s a waiting period before you can start contributing.
Are you fully vested in your employer’s contributions? When you are rolling your 401(k) over to a new employer, you may not be taking as much with you as you thought. If you had employer contributions and you were not fully vested, that portion of your account doesn’t get to come with you.
401(k) vs IRA: Which One Is Right for You?
What if I’m retiring? If you decide you’re ready to leave the workforce, you may want to flirt with the idea of rolling over your traditional 401(k) into a traditional IRA, or your Roth 401(k) into a Roth IRA.
Let’s face it, 401(k)’s tend to have fewer funds to choose from and sometimes you’re just not happy with the fund lineup. This would be a great opportunity for you to roll your funds into an IRA where you can either manage it yourself or work with an expert.
401(k) vs. IRA: What’s the Difference?
Investment Options in a 401(k)
In 401(k) plans, you’ll find a predetermined list of funds curated by the financial services group your employer is working with. Most of the options are mutual funds that range in categories and risk levels.
When you are analyzing funds for yourself you should make two basic assessments:
- How much will I be paying in fees?
- What is the risk level compared to the value it could bring to my portfolio?
You will surely see actively managed funds, which tend to be more expensive. These fund companies implement deeper analysis and employ unique strategies in an effort to beat the indices. Then, you’ll also observe passively managed funds, which are most index funds and will be less costly.
Investment Options in an IRA
If you decide to roll over your 401(k) into a traditional or Roth IRA, you’ll have the freedom to choose from several investment options in the open market.
This allows you to:
- Diversify your portfolio as you see fit
- Decide how much you’d like to spend on investment fees or advisory services.
Any fee taken will affect your overall return, so you should be comfortable with the amount of risk you are taking at the price you are paying. Financial Advisors take the stress out of fund searching and assist in implementing a plan that best suits your retirement goals. It could be more costly to make a mistake with investment selection than it would be to work with a pro.
The Benefits of Consolidating Your Accounts
Maybe you have several accounts, and you just want to consolidate. No one likes being bothered by having to check in on multiple sources.
Why Consolidate?
Having all your money in the same place can:
- simplify your account management
- lower administrative costs
- Help you better allocate your investments with a comprehensive view
- Make estate planning and beneficiary designation easier
Having multiple accounts increases the chance of accidental early withdrawals, tax miscalculations, or excess contributions.
How to Start the Rollover Process
Direct Rollover vs. Indirect Rollover
When getting ready to start the actual transfer, you may have a choice between a Direct Rollover or an Indirect Rollover.
Direct Rollover: Your old plan administrator would transfer your funds directly to your new 401(k) provider, or your new IRA. No taxes or penalties would apply, and your money remains in a tax-advantaged account.
Indirect Rollover: Your old plan sends you a check and you must deposit it into either your new 401(k) or an IRA within 60 days.
The Risk of an Indirect Rollover
Here’s the catch, an Indirect Rollover will have a mandatory 20% federal income tax withholding, and you’ll have to replace that amount with personal funds to avoid taxes. The 20% federal income tax withholding would be recovered in the form of a tax credit when you file your income tax return.
The Final Step: Investing Your Rollover Funds
Once you’ve completed the transfer, your work isn’t over.
Don’t Leave Your Funds in Cash
It’s advised that you should follow up with your new 401(k) provider to make sure the transfer was successful. If you are rolling into an IRA, verify that all your funds are deposited into the account.
Now that the rollover is confirmed, you must take the next step of reinvesting if your funds were liquidated and came over as cash.
Vanguard analyzed that 28% of rollovers stayed in cash for at least 12 months, with minimal changes after the first three months following the rollover. They further analyzed that 55% of those funds left in cash were from Direct Rollovers (i).
The Risk of Not Investing
The common error of investors that take on managing their account post rollover is forgetting to invest the cash, subsequently missing out on potential returns. Sitting in cash could mean:
- Losing out on market returns
- Earning lower yields than a standard savings account
This is another reason you may find value in working with a Financial Advisor.
The Costly Mistakes You Must Avoid
Ultimately, rolling over your 401(k) the right way can mean the difference between a seamless, carefree transition and an expensive mistake.
By avoiding common pitfalls and taking advantage of more tax-efficient methods, you can better control your financial future.
The biggest mistake you can make is allowing your hard-earned savings to be penalized by accidental early withdrawals, sitting in cash, or creating an unwanted taxable event.
A Real-Life Example: Carol’s Costly Mistake
Carol is 48 years old and is ready for early retirement. She’s saved up a handsome amount of money in her traditional 401(k) in the amount of $1,000,000. She wants to rollover her 401(k) into a traditional IRA.
However, her employer only allows for Indirect Rollovers. Her employer sends her a check for $800,000 and withholds the mandatory $200,000. She has 60 days to put $1,000,000 into her traditional IRA.
The Consequences of Missing the Deadline
- If she misses the 60-day deadline, the entire amount could be considered a taxable distribution
- She would be taxed on $1,000,000 as ordinary income and hit with a $100,000 early distribution penalty because she is under the age of 59-1/2
- A $1,000,000 distribution will put her into the highest current tax bracket (37%) where she could owe as much as $370,000 in taxes
Carol would have effectively turned $1,000,000 into $530,000 with taxes and penalties.
Review the graph below to see how this could significantly impact Carol’s savings with the assumption of a conservative 5% average return.
Final Thoughts: Making the Right Move
No one wants to make Carol’s mistake. If you feel empowered and up to the task to complete the rollover yourself, heed the prior tips and pay close attention to the movement of your hard-earned nest egg.
On the other hand, a Financial Advisor can:
- Evaluate your rollover options based on your financial goals
- Minimize taxes and penalties
- Select the right investment strategy
- Ensure the entire process is handled with the utmost care
Whichever direction you choose, ensure that you are optimizing your savings and returns. It could mean the difference in your livelihood in retirement. Now, let’s get rolling.
Adams, N.E.(2024, August 5). Talking points: The biggest 401(k) rollover mistake. NAPA. https://www.napa-net.org/news/2024/8/talking-points-biggest-401k-rollover-mistake/
This article does not serve as a substitute for a rollover recommendation. Speak to an investment adviser for a formal rollover recommendation. Please remember that past performance is no guarantee of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by DHJJ Financial Advisors [“DHJJ”]), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, no portion of this discussion or information serves as the receipt of, or a substitute for, personalized investment advice from DHJJ. contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from DHJJ. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Neither DHJJ’s investment adviser registration status, nor any amount of prior experience or success, should be construed that a certain level of results or satisfaction will be achieved if DHJJ is engaged, or continues to be engaged, to provide investment advisory services. DHJJ is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the DHJJ’s current written disclosure Brochure and Form CRS discussing our advisory services and fees is available for review upon request or at www.dhjjfinancial.com. Please Note: DHJJ does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to DHJJ’s web site or blog or incorporated herein, and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please Remember: If you are a DHJJ client, please contact DHJJ, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. Unless, and until, you notify us, in writing, to the contrary, we shall continue to provide services as we do currently. Please Also Remember to advise us if you have not been receiving account statements (at least quarterly) from the account custodian.
