When Courtney McClasky left her former sales job to become a real estate broker, she rolled her employer-sponsored 401(k) into an individual retirement account (IRA). She simultaneously did the same thing with another retirement account from a previous teaching position.
Her financial advisor recommended the rollovers, which took place in 2018. As a broker, McClasky is an independent contractor, so joining another employer-sponsored 401(k) and moving the money into it was not an option. She was glad, in any event, that the IRA allowed her to invest in individual stocks, as opposed to the mutual funds the 401(k) offered.
“It has more investment options,” says McClasky.
As McClasky found, workers have some flexibility in deciding what to do with former 401(k) accounts. In her case, rolling over the money gave her additional investment choices, and offered the ease of monitoring consolidated accounts instead of keeping an eye on separate funds. But there are other options as well. Read on to learn more.
Four Main Choices
If you’re leaving a job where you contributed to a 401(k) plan, you have four options:
1. Keep your plan where it is if you have $5,000 or more in assets in it. If you have less, your employer might automatically send it to an IRA.
2. Roll over your account to a 401(k) at your next workplace if there is such a plan and the new employer allows this.
3. Roll the money over to an IRA.
4. Cash out and pay taxes on the money as income.
Benefits of a 401(k)
Keeping the money in your old employer’s plan or moving it to a new 401(k) gives you the advantage of continuing to grow the money tax-deferred—the money you put in is pre-tax. You only pay taxes upon withdrawal.
In addition, you get access to penalty-free withdrawals if you leave your job at age 55 or older. And 401(k) money is generally shielded from creditors by federal law.
Benefits of an IRA
If you opt for an IRA, you can open one at virtually any brokerage and some banks, and you—rather than your employer—will own the account.
While you can’t contribute to your old 401(k) after you leave the organization, you can add to an IRA until you hit the annual limit, which for 2021 is $6,000 or $7,000 if you’re age 50 or older.
If you are under 59 1/2, you can withdraw up to $10,000 from your IRA penalty-free if you qualify as a first-time home buyer. You are also exempt from the 10% early distribution penalty if you use the funds for qualified higher education costs. You can also take money from it penalty-free starting at age 59 1/2.
As McClasky found, IRAs also offer more investment options than are typically found in an employer’s plan. There are tax benefits as well, such as deducting contributions to a traditional IRA.
Downsides of IRAs
There are some drawbacks and restrictions to IRAs. Federal law offers more creditor protection for 401(k)s than IRAs, though states provide some protection, says Rita Assaf, vice president of retirement and college leadership at Fidelity Investments.
If you use a direct rollover from your 401(k), it will move from one account to the other. But if you receive a check made out to you, you only have 60 days to deposit it before taxes or penalties occur, says Assaf.
And like a 401(k), if you move the money into an IRA, you have to take required minimum distributions at a certain age.
Continue to Evaluate Your Options
Some people find that as their income increases, the tax benefits of a traditional IRA fade. To counteract those limitations as she earned more money, McClasky opened a simplified employee pension (SEP) plan. A SEP IRA is a retirement plan where employers in any size business can set aside money in retirement accounts for both themselves and employees. Contribution limits go up to $58,000 or 25% of compensation or 20% of net earnings from self-employment, whichever is less, for 2021.
She kept the earlier rollover money in her IRA, enjoying the control it still gives her over those investments. “I have the ability to make trades,” she says.
With tax law consistently changing and her financial profile evolving, McClasky relied on her financial planner to guide her through decisions like this.
“There are so many regulations, loopholes and things you don’t know that hiring someone good is worth it,” she says. “I appreciate working with someone who has a fiduciary duty to give me the best advice.”
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Elaine Pofeldt is an independent journalist who specializes in careers and entrepreneurship. She is the author of The Million-Dollar, One-Person Business, and her work has appeared in Fortune, Money, CNBC and more.