Radio host and bestselling author Dave Ramsey shared a blunt warning for Americans changing jobs about cashing out 401(k)s rather than rolling them over to IRAs.
“Let’s get this out of the way — cashing out 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,” he continued. “And if you’re under 59 1/2 years old, you’ll also get hit with a 10% early withdrawal penalty.”
“Plus, cashing out early robs you of the chance to continue earning tax-free or tax-deferred growth on your investments for years, maybe decades. It’s almost always just a bad idea all around.”
For most investors, rolling funds over from a previous 401(k) into an IRA is the most advantageous strategy. This approach grants individuals maximum authority over their investment choices.
“You see, an IRA gives you potentially thousands of mutual funds to choose from,” Ramsey wrote. “You can pick from the best of the best instead of just a few so-so options. You can work with an investment professional who can walk you through the rollover and help you manage your investments for the long haul — no matter where your career takes you.”
IRS explains tax implications of 401(k) rollovers to IRAs
A retirement plan rollover requires an account holder to move distributed cash or assets from one eligible plan to another within 60 days of the withdrawal.
“This rollover transaction isn’t taxable (unless the rollover is to a Roth IRA or a designated Roth account from another type of plan or account), but it is reportable on your federal tax return,” wrote the Internal Revenue Service (IRS). “You must include the taxable amount of a distribution that you don’t roll over in income in the year of the distribution.”
Upon receiving an eligible rollover distribution from a retirement plan, an account holder must complete the transfer to another qualifying plan within 60 days.
“If you have a qualified plan loan offset amount, you have until the due date (including extensions) for the tax year in which the offset occurs to complete an eligible rollover,” wrote the IRS. “Refer to Publication 575, Pension and Annuity Income for more information.”
“If you’re under age 59½ at the time of the distribution, any taxable portion not rolled over may be subject to a 10% additional tax on early distributions unless an exception applies.”
Vanguard clarifies 401(k) to IRA rollover benefits
Rolling over a 401(k) into an IRA maintains the tax-advantaged status of the money, avoiding upfront taxation and allowing the retirement balance to grow uninterrupted over time.
“Rolling over your 401(k) to an IRA often opens access to a broader range of investment options, including stocks, bonds, mutual funds, and exchange-traded funds (ETFs), supporting better diversification and growth potential,” Vanguard explained.
“If you have several 401(k) accounts or IRAs, consolidating your retirement savings into one account makes it easier to monitor and manage your long-term goals,” Vanguard added.
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There are several things to consider before rolling over a 401(k) to an IRA.
“While IRAs can have low fees, your employer plan fees may be even lower,” Vanguard wrote. “You should review your plan’s fee structure and the IRA fee structure to determine which might be the most cost-effective.”
“If you leave your employer between ages 55 and 59 1/2, you may take penalty-free withdrawals from your 401(k). IRAs require that you wait until age 59 1/2.”
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Dave Ramsey describes direct, indirect 401(k) rollovers
Account holders choosing to move funds from one retirement plan to another can execute the transfer using either a direct rollover or an indirect rollover.
“A direct rollover is always the safest way to avoid taxes and penalties,” Ramsey wrote. “With a direct rollover, the money in one retirement account — an old 401(k) you had at your last job, for example — is transferred directly to another retirement account, like an IRA.”
“That way, you never touch the money, and you won’t have to pay any taxes or penalties on the cash being transferred,” he added. “Once it’s done, it’s done!”
Indirect rollovers, on the other hand, involve additional complexity and carry significantly higher risk for account holders.
“When you do an indirect rollover, the cash goes to you first instead of going straight into your new account,” Ramsey wrote.
“Here’s the problem with that: You only have 60 days to deposit the funds into a new retirement plan. If you don’t, you’ll get hit with taxes. If you’re under 59 1/2, you’ll also rack up 10% early withdrawal penalties.”
Related: Dave Ramsey warns Americans on 401(k)s, Roth 401(k)s
