Bestselling personal finance author and radio host Dave Ramsey has a warning for Americans saving for retirement about a common 401(k) pitfall.
“Let’s get this out of the way — this is the worst thing you can do with your old 401(k),” Ramsey wrote. “If you withdraw the money from your 401(k) plan and take a direct cash distribution, you’ll have to pay any state and federal income taxes you owe on every last penny. And if you’re under 59 1/2 years old, you can go ahead and add another 10% early withdrawal penalty to your tab.”
“But the worst part is, you’re robbing yourself of the chance to continue earning tax-free or tax-deferred growth on your investments for years, maybe decades,” he added.
“It’s just a bad idea all around, folks.”
Dave Ramsey explains a 401(k) to IRA rollover
The better alternative is rolling over a 401(k) to an Individual Retirement Account (IRA).
“A 401(k) rollover simply allows you to transfer your retirement savings from a 401(k) you had at a previous job into an IRA or another 401(k) with your new employer,” Ramsey wrote. “And you won’t have to pay any taxes on the money you transfer (in most cases).”
Ramsey explains four 401(k) choices one faces when moving between jobs.
“Let’s say you’re starting a new job and you’re wondering what to do with the money in a 401(k) you had at an old job,” Ramsey wrote.
When departing from a job, you have four main avenues for handling your retirement savings.
You can choose to cash out your 401(k) balance entirely, though this usually comes with tax hits and early withdrawal penalties.
Alternatively, you can simply leave the funds in your previous employer’s plan to let them continue growing as they are.
Another seamless path is transferring the balance directly into your new company’s 401(k) plan, keeping your retirement nest egg consolidated under your current workplace.
But, as Ramsey explains, you can execute a rollover into an Individual Retirement Account (IRA), which gives you access to a broader range of investment choices while preserving the tax-deferred status of your money.
IRS clarifies 401(k) to IRA rollover rules
Transferring tax-advantaged retirement funds from a plan or IRA into a new retirement account is a straightforward process.
You can complete an indirect rollover by personally receiving the payout and depositing the full amount into your designated account within 60 days to avoid penalties.
Alternatively, you can opt for a direct rollover, authorizing your custodian to transfer the money straight to your new retirement plan or IRA without you ever handling the funds.
“When you roll over a retirement plan distribution, you generally don’t pay tax on it until you withdraw it from the new plan,” the Internal Revenue Service (IRS) explains. “By rolling over, you’re saving for your future and your money continues to grow tax-deferred.”
“If you don’t roll over your payment, it will be taxable (other than qualified Roth distributions and any amounts already taxed) and you may also be subject to additional tax unless you’re eligible for one of the exceptions to the 10% additional tax on early distribution,” the IRS emphasized.
Fidelity emphasizes steps to open a rollover IRA
Before setting up your transfer, you must first open an IRA to serve as the destination for your old workplace account funds if you do not already have one.
If your employer plan contains a mix of both pre-tax and post-tax contributions, you may need to open a Roth IRA alongside a traditional IRA to ensure each portion is transferred into the correct tax-advantaged status.
There are key differences to consider regarding traditional IRAs and Roth IRAs.
“Traditional IRAs’ and Roth IRAs’ primary difference is the type of tax advantage you can receive for contributing to and investing in the account,” Fidelity wrote.
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- Charles Schwab, Fidelity alert workers to forced 401(k) rule
- Dave Ramsey warns Americans on 401(k)s, IRAs (he’s not wrong)
- Congress research arm warns Americans on 401(k), IRA penalty
A Roth IRA is an individual retirement savings account that operates independently from employer-sponsored plans and offers key tax advantages.
Because you fund the account with after-tax dollars, your contributions can be invested to potentially grow federally tax-free.
You are free to withdraw your original contributions at any time without penalty, and you can withdraw your investment earnings federally tax-free once you meet specified eligibility requirements.
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Dave Ramsey advises on 401(k)s when starting new job
Beginning a new job frequently involves a high volume of information, including team introductions, orientation sessions, and procedural training.
Navigating these initial weeks requires adapting to unfamiliar workflows and memorizing new workplace contacts. While entering a new role brings opportunity, the onboarding period also presents a steep learning curve and significant administrative demands.
“While you’re settling into your new gig, don’t forget about the 401(k) retirement funds you worked so hard to build at your old job,” Ramsey wrote.
“If you’re stressed about what to do with that money, don’t worry — you have options. One of the smartest things you can do with your old 401(k) is roll it over to an Individual Retirement Account (IRA).”
Related: Dave Ramsey has blunt warning on Social Security, 401(k)s
