- Consider all of the pros and cons of a rollover before making a move.
- Very high 401(k) fees may be a good reason to roll your account over to an IRA.
- Use “trustee to trustee” rollovers to avoid inadvertent tax traps.
Suppose you’re about to receive a distribution from your 401(k) plan, and you’re considering rolling it over to a traditional IRA. While these transactions are normally straightforward and trouble free, there are some very important factors to consider before pulling the trigger:
1. Weigh the pros and cons of a rollover carefully. You can leave your money in the 401(k) plan if your balance is over $5,000. And if you’re changing jobs, you may also be able to roll your account over to your new employer’s 401(k) plan.
- Though IRAs typically offer significantly more investment opportunities and withdrawal flexibility than 401(k) plans, your 401(k) may give you access to investments that can’t be replicated in an IRA (or that can’t be replicated at an equivalent cost). On the other hand, some 401(k) plan expenses and fund expenses can be much higher than you incur when you purchase investment on your own or with the help of an advisor.
- 401(k) plans offer virtually unlimited protection from your creditors under federal law (assuming the plan is covered by ERISA; solo 401(k)s are not), whereas federal law protects your IRAs from creditors only if you declare bankruptcy. Any IRA creditor protection outside of bankruptcy depends on your particular state’s law.
- Some 401(k) plans allow employee loans.
2. Make sure your distribution can be rolled over to an IRA. Not all distributions can. For example, required minimum distributions cannot be rolled over to an IRA. Neither can hardship withdrawals or certain periodic payments. Rollover these types of distributions and you may have an excess contribution to deal with. In general, excess contributions are subject to a 6% tax. You must pay the 6% tax each year on excess amounts that remain in your traditional IRA at the end of your tax year.
3. Use direct rollovers and avoid 60-day rollovers. While it may be tempting to give yourself a free 60-day loan, it’s generally a mistake to use 60-day rollovers instead of direct (trustee to trustee) rollovers for this purpose. If the plan sends the money to you, then it’s required to withhold 20 percent of the taxable amount. If you later want to roll the entire amount of the original distribution over to an IRA, you’ll need to use other sources to make up the 20 percent that the plan withheld. In addition, there’s no need to risk inadvertently violating the 60-day limit.
4. Remember the 10 percent penalty tax. Taxable distributions that you receive from a 401(k) plan before reaching age 59½ are normally subject to a 10 percent early distribution penalty. However, a special rule lets you avoid the tax if you receive your distribution as a result of leaving your job during (or after) the year you turn age 55 (age 50 for qualified public safety employees). But, this special rule doesn’t carry over to IRAs. If you roll your distribution over to an IRA, you’ll need to wait until age 59½ before you can withdraw those dollars from the IRA without incurring the 10 percent penalty (unless another exception applies). So if you think you may need to use the funds before reaching age 59½, rolling over to an IRA could be a costly mistake.
5. Learn about net unrealized appreciation (NUA). If your 401(k) plan distribution includes employer stock that’s appreciated over the years, rolling that stock over into an IRA could be a serious mistake. Normally, distributions from 401(k) plans are subject to ordinary income taxes. But, a special rule applies when you receive a distribution of employer stock from your plan: You pay ordinary income tax only on the cost of the stock at the time it was purchased for you by the plan. Any appreciation in the stock generally receives more favorable long-term capital gains treatment, regardless of how long you’ve owned the stock. (Any additional appreciation after the stock is distributed to you is either long-term or short-term capital gains, depending on your holding period.) These special NUA rules don’t apply if you roll the stock over to an IRA.
6. Understand the consequences of rolling over Roth 401(k) dollars to a Roth IRA… If your Roth 401(k) distribution isn’t qualified (tax-free) because you haven’t yet satisfied the five-year holding period, be aware that when you roll Roth 401(k) dollars into your Roth IRA, that money will now be subject to the Roth IRA’s five-year holding period–no matter how long those dollars were in your 401(k) plan. For example, if you establish your first Roth IRA to accept your rollover, you’ll have to wait five more years until your distribution from the Roth IRA will be qualified and tax-free.
As with most wealth management decisions, rollover decisions may impact your investments, taxation, estate planning and other personal finance areas. Always work with an advisor who is well versed in all areas of wealth management and who will always make decisions with your best interests in mind.