When you leave a company
When you leave a company, your 401k stays with whichever investment firm your former employer used. That money is yours and you should receive from the investment firm a letter detailing what you can do with that money. Your options will include:
- leaving it there.
- transferring the money into a rollover IRA account.
- withdrawing the money.
We already know that option 3 is unacceptable since the costs of withdrawing retirement money before retirement is intentionally prohibitive, so your choice is between option 1 and 2. If you leave your money there, you might have some or all of the brokerage services you enjoyed before you left the company, but the real disadvantage is that your retirement money is not centralized. You can imagine that over the course of your career, you might leave your job every several years, each time adding to the trail of disjoint 401k accounts. That archipelago of retirement accounts would be a hassle to manage.
From 401k to Rollover IRA…
A convenient solution is to open a rollover IRA account with some brokerage (see this section on choosing a brokerage). Rollover IRAs are very similar to traditional IRAs except that they are explicitly for the purpose of “rolling over” old 401ks. Your old 401k company and rollover IRA company should have instructions on how exactly to do this. Your rollover IRA will function similarly to a 401k account except that you can invest in anything available to you through your brokerage (whereas 401k investment options are generally limited).
… and From Rollover IRA to Roth IRA
Here’s a neat trick. Once you have rolled your old 401k into a rollover IRA, you can then transfer the assets in your rollover IRA into a Roth IRA, and no contribution cap applies. The amount you transfer to the Roth IRA will unfortunately be taxed as income, so you will need to pony up a chunk of cash to pay the IRS, but it comes with the benefit that you will never have to pay tax on your Roth IRA withdrawals as a retiree. If you are in a position to take advantage of this, try to do this while you are still unmarried and childless and can afford to pay extra income tax.
This too works out to be particularly advantageous if your annual income is not particularly high because the tax rate you pay as a retiree may be higher than your current tax rate. Actually, the best time to transfer rollover IRA assets to a Roth IRA account is if you stop work to go back to school. In those calendar years, you will have no other income and hence your current tax rate will definitely be lower than your tax rate at retirement.
