So you’ve just changed jobs and you want to rollover your 401(k) into an IRA. What should you do?
Well there are 4 key decisions you need to make before you can roll-over.
Broker Or Robo advisor
Whether you are a do-it-yourself (DIY) investor or you want a complete hands-off approach to managing money, you have to select a broker.
If you are a DIY investor and prefer to remain in control of your assets and make your own investing decisions, you can choose a broker like Fidelity, Schwab or TD Ameritrade to open a retirement account.
On the other hand, if you prefer a complete hands-off approach to investing, you can decide between robo advisors like Betterment or Wealthfront that will manage and rebalance your retirement money for an annual fee, usually between 0.25% to 1% of your account size.
Roth vs Traditional IRA
When you open a retirement account with a broker, you have to decide whether to open a Roth or a Traditional IRA.
So what’s the difference?
The amount you contribute is tax deductible and grows tax deferred…meaning the amount you set aside in a traditional IRA is deducted from your income before you pay income tax.
You assets continue to grow tax deferred in a traditional IRA and you only pay taxes once you withdraw your money. The minimum age to withdraw without paying the 10% penalty is 59.5 years.
If you decide to dip into your retirement before reaching the eligible age of 59.5 years, you will have to not only pay taxes on the amount you withdraw but also pay a 10% penalty.
In a Roth IRA, you contribute your after-tax income. Your money grows tax free and when you are eligible to withdraw (at 59.5 years of age, same as traditional IRA), you don’t pay any taxes.
But there is a catch: you need to see if you qualify for a Roth IRA.
That depends on how much you earn and whether you are filing taxes as a single individual or filing jointly with your spouse.
Income Criterion For Roth IRA Qualification
2017 Single Filers
|Income up to $118,000||Eligible for max contribution of $5,500 or $6,500 if you are 50 or older|
|$118,000 - $133,000||Eligible for partial contribution|
|Income over $133,000||Ineligible for Roth IRA|
2017 Joint Filers
|Income up to $186,000||Eligible for max contribution of $5,500 or $6,500 if you are 50 or older|
|$186,000 - $196,000||Eligible for partial contribution|
|Income over $196,000||Ineligible for Roth IRA|
Say you qualify for both and you want to transfer your money from pre-tax 401(K) or a traditional IRA to an after-tax Roth IRA this calendar year.
Well, then, you will have to pay income tax on the transfer amount when you file your taxes next year.
If you decide to transfer, please ensure that the transfer amount + your annual salary combined doesn’t bump you up into a higher tax bracket that results in you paying more taxes now.
On the other hand, if you expect your taxes to be higher in the future and you qualify for Roth IRA, you might find it beneficial to pay taxes now and let your money grow tax free in a Roth IRA.
You can consult a tax advisor who can calculate the taxes you would pay as a result of converting to a Roth IRA.
Here are the key differences between a Traditional and a Roth IRA at a glance.
|Roth IRA||Traditional IRA|
|Tax Benefits||Tax free growth & after-tax contributions||Tax deferred growth & tax deductible contributions|
|Age requirements||Contribute at any age||Up to age 70.5 years|
|Income Requirements||Yes (see tables above)||No|
|Withdrawal Tax||No tax on contributions or earnings||Contributions & earnings are taxed|
|Minimum Required Distribution||No||Start minimum required distribution when you turn 70.5|
Direct vs Indirect Rollover
Here you can make your life a lot easier by directly rolling over your 401(k) into a IRA account.
A direct rollover means you never receive the cheque for the money in your employer 401(K). The money transfers directly from your 401(k) to your retirement account with the broker where either you invest or a robo advisors invests on your behalf.
Indirect rollover is where your employer sends you a cheque for the assets in your 401(k) but withholds 20% of it.
You have 60 days to deposit the cheque with the new broker along with the 20% that the employer withheld.
When you file your taxes, the amount your employer withheld will be returned to you.
But what if you don’t have cash handy to cover the 20% your employer withheld?
In that case, if you can’t deposit the 20% withheld, it is treated as early withdrawal…and that means you have to pay taxes on that 20% + a 10% penalty (remember you need to be 59.5 years to be eligible to withdraw.)
We would recommend that you save yourself all this hassle and directly transfer your assets from your employer 401(k) to your retirement account at the broker.
How To Invest Your Funds
Now if you are a hands-off investor, then you can handover the management and investing of your retirement assets to a robo advisor like Wealthfront or Betterment for a small fee.
But if you are a DIY investor, you have to decide how to invest your assets by choosing from the thousands of mutual funds, index funds, ETFs, stocks, bonds that are available on your broker platform.
You can spread your wealth among ETFs or index funds. Both are low fee investment securities and you can create a well diversified portfolio for yourself.
If you are interested, you can try our retirement analysis service where we show a customized and well diversified portfolio for your specific situation.
You can choose from a portfolio of ETFs or index funds, depending on your familiarity with the investment products.
Your Capital is an SEC registered investment advisor, not a broker, so you can’t invest through us. If you want to invest, you will have to select a broker.
Let us know your experience rolling over your 401(k).