Before I answer this question, I think it is important to explain the difference between a 401k and an IRA. The taxation is similar but the way each can be used is different.
What is a 401k?
A 401k is part of an employer’s retirement benefit plan offered to employees. The employer controls the plan. Employees can participate in the 401k plan and decide how much they will contribute up the max allowed by IRS funding rules. The main area of concern with a 401k plan is that the employer—not the employee—chooses the custodian (financial institution) for the 401k . The employer also decides which investment options will be offered and negotiates plan fees. The employee has limited options with a 401k plan.
What is an IRA?
An IRA (individual retirement arrangement) is owned and operated by an individual. With an IRA, the individual chooses the custodian (financial institution). The individual can choose from all available investment options as to how the funds will be invested. The IRA owner negotiates fees and retains all control of the account.
Given the high level of individual control, it is obvious that the IRA, in most cases, is the better option. So why doesn’t everyone rollover their 401k to an IRA? The rules don’t allow for that. In most cases, a person can rollover their 401k to an IRA if they are no longer employed by the employer that controls the 401k plan. If a person retires, leaves employment for any reason, or is laid off, they can move their 401k plan to an IRA. In most cases, a person also can rollover their 401k if they are over 59 1/2 years old even if they still work for the employer where the 401k resides.
Are there any taxes owed when you rollover your 401k to an IRA?
No! The IRS allows a person to rollover their 401k to an IRA without any tax implications as long as they move the funds directly to the IRA.
How do you rollover a 401k to an IRA?
In most cases the process is easy. You simply call the institution where the 401k is held and tell them you would like to rollover your 401k to an IRA. In some cases, you will be able to complete the transaction over the phone. Some plans require a form to be signed. The institution will send you the forms needed. You will sign them, send them back, and that’s it. In most cases, the institution will send to your home a check (for the amount in the fund) made out to the institution where you have set up your IRA for benefit of (FBO) (for example: Scottrade FBO John Doe). Before you start this process, you need to know where the IRA is going and have an idea of how you want to invest the IRA.
If this process seems a little overwhelming you can always seek the assistance of a financial professional. It would be a good idea to work with a CERTIFIED FINANCIAL PLANNER™ professional who specializes in IRAs and 401k rollovers.