How Can You Roll Over Your 401(k) or 403(b) Without Penalty?

Changing jobs can be stressful. Not knowing what to do with your 401(k) or 403(b) account when leaving an employer can increase your stress level.

You have four options for your 401(k) or 403(b) account when leaving a job or retiring. Two of these options include penalty-free rollovers. Understanding each choice helps determine which is right for you.

The following four options include two penalty-free methods to roll over your 401(k) or 403(b) account when leaving your job.

1. Roll Over Your 401(k) or 403(b) Account into Your New Employer's Plan

Check whether your new employer’s 401(k) or 403(b) plan accepts rollovers from previous employers. The benefits of these rollovers include:

• Consolidating your 401(k) or 403(b) accounts makes it easier to manage your retirement savings.

• Many plans offer low-cost investment options.

• Your money can continue to grow tax-advantaged.

• If you leave your job with your new employer at age 55 or older, you can take penalty-free withdrawals.

• You might be able to defer required minimum distributions (RMDs) starting at age 73.

• Federal law protects 401(k) and 403(b) accounts from creditors.

Focus on these factors before rolling over your 401(k) or 403(b) account into your new employer’s plan:

• Ensure you understand the new plan’s rules, which might differ from the old plan’s.

• Consider whether the investments in the new plan fit your goals, objectives, and risk tolerance.

• If you hold appreciated company stock in your 401(k) account, consider the impact of net unrealized appreciation (NUA) when deciding whether to stay in the previous plan, take the stock in kind, or roll over the stock into an Individual Retirement Account (IRA) or your new employer’s plan. Rolling over the stock into another tax-advantaged plan eliminates any NUA.

2. Roll Over Your 401(k) or 403(b) Account into an IRA

A rollover IRA lets you roll your funds from your former employer’s 401(k) or 403(b) plan into an IRA. The benefits include:

• You might have a wider range of investment options.

• Your pre-tax money can continue to grow tax-deferred.

• If you are under age 59 ½ and meet one of the IRS’s exceptions, such as a qualifying first-time home purchase, you can withdraw money penalty-free.

The drawbacks of rolling over your 401(k) or 403(b) account into an IRA include:

• IRA investment fees might be higher than those in a 401(k) or 403(b) plan.

• Unless you were born in or after 1960, once you reach age 73, you must take RMDs from a traditional IRA annually.

• Federal law offers more protection for money in a 401(k) or 403(b) plan than an IRA.

• If you hold appreciated company stock in your 401(k) account, the net unrealized appreciation (NUA) can impact your taxable income, potentially pushing you to a higher tax bracket and increasing the amount owed in taxes.

3. Keep Your 401(k) or 403(b) Account in Your Former Employer's Plan

Most companies allow you to keep your 401(k) or 403(b) account in their plan after you leave. The benefits include:

• You might have unique and lower-cost investment options.

• Your money can continue to grow tax-deferred.

• If you leave your job at age 55 or older, you can take penalty-free withdrawals.

• Federal law protects your 401(k) or 403(b) account from creditors.

The drawbacks of keeping your 401(k) or 403(b) account in your former employer’s plan include:

• Depending on the plan rules, if your balance is under $7,000, it might be sent to you as a taxable distribution or rolled over into an IRA.

• You cannot add money to your account or take out a loan.

• You might be required to withdraw the entire balance rather than take partial withdrawals.

• If you were born before 1960, you must take RMDs beginning at age 73. If you were born in 1960 or later, your RMDs start at age 75.

4. Cash Out Your 401(k) or 403(b) Account

Avoid withdrawing money from your 401(k) or 403(b) account before retirement, unless you have a critical need for immediate cash and no other options. The consequences depend on your age and tax situation:

• Withdrawals from your 401(k) or 403(b) account before age 59 ½ typically are subject to ordinary income taxes and a potential 10% early withdrawal penalty.

• If you stopped working for your former employer in or after the year you reached age 55 but are not yet age 59 ½, an early withdrawal penalty does not apply.

• This exception does not apply to assets rolled over to an IRA or a 401(k) plan.

Direct and Indirect Rollovers

If you decide to roll over your 401(k) or 403(b) account, a direct rollover is better than an indirect rollover. A direct rollover involves one financial institution sending a check endorsed to another financial institution with instructions to roll the money into your new employer’s 401(k) or 403(b) plan or your IRA. 

In contrast, an indirect rollover involves a financial institution sending you a check for the amount in your 401(k) or 403(b) account:

• The plan administrator is required to withhold 20% for taxes.

• If you want the full value of your former account to stay in a tax-advantaged retirement account, you have 60 days to gather the 20% that was withheld and put it and the rest of your withdrawal into your new employer’s plan or an IRA.

• Failure to complete the transfer within 60 days of withdrawal subjects the distribution to taxes and a potential penalty.

• If you cannot make up the 20%, you lose the potential tax-advantaged growth on that money, as well as potential taxes and a 10% penalty if you’re under age 59 ½, or under age 55 if separating from service in that year or later.

Consider talking with a licensed financial professional to help make the best rollover decision based on your goals, time horizon, risk tolerance, and financial position.  

*This information is for educational purposes only.

Are you considering rolling over your 401(k) or 403(b) account, or have you done so in the past? Let me know in the comments!