How to Establish a Rollover 401k IRA

If you have a 401k, you probably started participating in the plan when you started a new job.  The 401k is an employer sponsored plan and, therefore, has a special place in your overall retirement plans, as many employers offer matching funds and other perks to encourage employee participation. However, a 401k isn’t always the best long-term home for your money.  Knowing how to begin 401k rollovers to and from this kind of plan will save you money and help keep your investments in that all important tax deferred status.

If you’re thinking of a rollover, it’s likely that you’ve recently changed jobs or had some other major change in your life.  One of your first questions should be, “Do I even need to establish a rollover 401k, either to or from an existing 401k?”  For example, you may believe your old 401k account isn’t performing up to its full potential, or you might have multiple 401ks or retirement investment accounts and think it would be a good idea to consolidate those accounts to simplify, or even optimize, their management.

What you have to know is that moving your money from one 401k to another qualified retirement investment plan is the basis for all 401k rollovers.  In general, there are two different types of 401k rollovers – direct and indirect.  You’ll have to choose the right one in order to avoid the taxes and penalties that you may otherwise incur.

Consider direct 401k rollovers first.  With a direct rollover, your money goes from your 401k account directly into another qualified 401k or IRA account.  Most 401k accounts can be rolled over into a new rollover 401k or IRA, with the exception of Roth IRAs and Simple IRAs.  This transaction may also be referred to as a plan to plan transfer or a trustee to trustee transfer.  There are usually no 401k rollover taxes involved in this kind of transaction.

However, if you move your money to a Roth IRA, things are a bit different.  Roth IRAs grow with after-tax dollars, meaning that no taxes have yet been paid on your contributions.  This means that you will pay taxes on any money moved into a Roth IRA, unless you are moving it from a Roth IRA or Roth 401k in the first place.

Be warned – the most common mistake made in all 401k to IRA rollovers is not having the receiving IRA ready and able to accept your funds.  You can avoid this mistake by calling the trustee of the receiving fund and asking about the status of the new account.

An indirect rollover is another 401k rollover option, but it’s not the one you want to establish your new account with if you have another alternative.  This transaction is sometimes called payment then transfer, which should tell you something about how the transaction goes – you receive the funds from your 401k, typically in the form of a check, which you then deposit into a new IRA.

The drawbacks to this particular type of transaction are many.  First, you’ll have a limited amount of time to accomplish the second transaction.  If you hold on to the money too long, for example, not only do you lose potential interest, but the IRS will classify the transaction as a disbursement or payment and you may find yourself owing 401k rollover taxes and penalties.  Fortunately, it’s easy to avoid this risk by simply choosing a direct rollover or trustee to trustee transfer in the first place.

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