401k Rollover: How It Works, Rules, and Tax Implications

If you have assets in a 401k plan and are approaching retirement or considering leaving your employer, there are several options you can take. You can take a withdrawal, keep the old 401k (if your former employer allows it), or do a 401k rollover into an IRA or another 401k plan.

What is a 401k rollover?

A rollover is the transfer of your 401k plan assets into another retirement plan. Most people rollover their 401ks into an IRA, solo 401k, or a new 401k with their next employer.

Reasons to rollover a 401k

You cannot cash out your 401k without penalties if you’re under the age of 59½. Therefore, if you decide to leave your employer that sponsors your 401k, a penalty-free and tax-free rollover would make more sense for most people.

The most common reason for doing a 401k rollover is if you’re leaving your employer. Whether it’s due to retirement, termination, or a career change, funds sitting in an old 401k plan can usually be put to better use by rolling them over to another retirement plan.

While it varies by provider, most 401k plans cannot be rolled over into another plan without penalties if you’re still employed at the company. However, some employers do allow you to rollover your assets while you’re still working there. In such cases, it may make sense to transfer your money to another retirement account that offers more investment options (like an IRA or solo 401k).

Are there any penalties or taxes with 401k rollovers?

There are typically no taxes or penalties associated with rollovers. However, you may trigger a taxable event if you move pre-tax funds into a Roth retirement account.

For example, if you move funds from your pre-tax 401k into a Roth IRA, you would have to pay income taxes on the amount you rollover because a Roth retirement account is funded with post-tax dollars.

However, if you move a pre-tax 401k into a pre-tax traditional IRA, there would be no taxes or penalties applied. If you have a Roth 401k, funds can be transferred to another Roth retirement account (like the Roth IRA) without any penalties or taxes.

Penalties are only applied if you take a distribution before the age of 59½. An early withdrawal penalty for 401k plans is 10% plus income taxes.

401k rollover options

You have several options when considering a 401k rollover.

Rollover your 401k into a new 401k

There are a lot of variables in play here since every 401k plan has different offerings. First, if your old employer allows ex-employees to keep their 401k plans at their company, you can choose to leave the money in there if the old plan has better investment options and lower costs.

If your new 401k plan offers rollovers, then you may opt to transfer the funds to your new account. 

Rollover your 401k into an IRA

Instead of rolling it over to a new 401k, you could instead choose to rollover the funds to an IRA. An IRA has much more investment options than a 401k. A typical 401k plan only lets you invest in a handful of mutual funds selected by your employer when they set up the plan. An IRA lets you invest in a wider selection of traditional assets like individual stocks, ETFs, bonds, and mutual funds.

You could also choose to open a self-directed IRA and invest in alternative assets like crypto, real estate, or even private equity.

If you have a pre-tax 401k plan, the funds should be rolled over into a traditional IRA if you want to avoid a taxable event. Roth 401k funds can be rolled over into a Roth IRA without triggering a taxable event.

What if my income is too high for a Roth IRA?

A Roth IRA has income limits that prevents high income earners from making contributions. The Roth IRA income limits are $144,000 for 2022 and $153,000 for 2023. However, the income limits only apply to contributions and do not apply to rollovers. Even if your income is too high for Roth IRA contributions, you could still rollover your assets into your account; you just can’t make any contributions.

Rollover your 401k into a solo 401k

A solo 401k is an individual 401k plan and offers the most tax advantages for self-employed individuals. If you have a day job with a 401k plan, but also run a side business, you could make contributions to a solo 401k. A solo 401k has higher contribution limits ($66,000 vs $22,500 in 2023) and the ability to invest in any asset class, including alternative assets like crypto and real estate.

If you become eligible for a solo 401k, it usually makes the most sense to move your assets from retirement accounts with more restrictions into the more flexible, versatile solo 401k with higher limits.

How to rollover your 401k

The process of initiating a rollover is quite simple. Here are the steps to performing a 401k rollover:

Do 401k rollovers need to be reported to the IRS?

Yes, all 401k rollovers need to be reported to the IRA using Form 1099-R, even if the rollover does not trigger a taxable event. If you failed to report the rollover in your tax return, you can report the rollover on Form 1040X: Amended Return.

Direct vs indirect rollover

There are two types of 401k rollovers that you could choose from: direct and indirect.

Unless you need access to your money as a short-term loan, the best option is a direct rollover.

In a direct rollover, you never touch the money and are not at risk of triggering any penalties or taxes. The money is sent directly from your old plan provider to your new plan provider.

In an indirect rollover, your old plan provider will send you the money rather than sending it to the new provider. You’ll then have 60 days to deposit the money in full to your new account. Also known as a 60-day rollover, many people choose indirect rollovers as a form of short-term loan. You’re allowed to use the money however you wish as long as you make the full deposit within 60 days.

The downside of an indirect rollover is that your old plan provider is required to withhold 20% of your rollover amount. You then have to come up with the 20% on your own from other sources in order to make the deposit in full. The withheld amount will get returned to you as a tax credit.

Can a 401k be transferred to another 401k or solo 401k?

Transfers are different from rollovers in that all rollovers need to be reported to the IRS, while transfers do not need to be reported.

When moving from a 401k to another 401k plan or to a solo 401k, you should complete a direct or indirect rollover. Transfers are generally between IRA and IRA or for inter-plan transfers.

Other options to consider

If you do not want to rollover your 401k into another retirement plan, you could also choose to withdraw the money or leave the funds in your old 401k plan, if your previous employer allows it.

Withdraw your 401k funds

If you’re under the age of the 59½, any withdrawals made from your 401k plan are hit with a 10% early distribution penalty plus income taxes. For example, if you withdraw $100,000 from your 401k, you’ll have to pay $10,000 in penalties plus income taxes on the $100,000 that you’re taking out.

If you’re over the age of 59½, you could withdraw money from your 401k without the 10% early distribution penalty. If you’re withdrawing from a pre-tax 401k account, you’ll have to pay regular income taxes based on your tax bracket and tax rates at the time of withdrawal. If you’re withdrawing from a Roth 401k, withdrawals are tax-free.

Leave the money in your old 401k

Some 401k plans allow you to keep your account even after you leave the company. If you like your old plan’s investment options and low rates, it may make more sense to keep the money in your old 401k. Another consideration is if your old 401k offers the option to take a 401k loan, but your new 401k plan does not. A 401k loan lets you borrow up to 50% of your account’s value, up to a maximum of $50,000.