Rolling over your 401k sounds pretty straightforward, right? You just call the number on your statement and ask them to send you a check – not so fast. All retirement accounts are subject to a number of different tax rules. In today’s workplace, it can be typical for employees to change jobs as frequently as every 3 years. 

Whether you are retiring or changing jobs, there is usually a lot going on. For most of us, rolling over our 401k becomes an afterthought. In most cases, it’s not time-sensitive and not many people know the benefits of a 401k rollover.

However, retirement accounts are one of the primary sources for creating income in retirement. Due to the favorable tax treatment of these accounts, there is also a lot of tax complexity. It’s crucial to understand how these tax rules apply to 401k rollovers or other similar employer-sponsored plans such as 403b and 457 plans. 

Additionally, there are a number of different benefits to rolling over a 401k and also some drawbacks. Before doing anything, make sure that the decision is consistent with your financial goals.

(Note: There are some unique changes to distributions from retirement accounts in 2020 due to the CARES Act).

Types of 401k Rollovers

Direct Rollover

A direct rollover is when your 401k provider issues a check made out to the custodian where your IRA is held. For example, if your IRA was held at Charles Schwab, the check would be payable to: “Charles Schwab fbo John Smith.”

This is the most popular 401k rollover option since no taxes are withheld and is most likely the best option for you. Plain and simple, this method has the least margin of error.

Indirect Rollover

An indirect rollover is when your 401k provider issues a check made out to you. You typically want to avoid this option because done incorrectly, it can cause a tax nightmare.

First, indirect rollovers are subject to a mandatory federal tax withholding of 20%. So if you requested an indirect rollover for an account balance of $100,000, you will receive a check for $80,000.

Second, you have 60 days to roll these funds over to an IRA or another qualified plan. If you fail to deposit the funds during the 60-day timeframe, the entire amount of the check becomes income taxable, and you are assessed a 10% early withdrawal penalty (prior to age 59 ½) by the IRS.

The Benefits

Consolidation Makes Investing Easier

When you have multiple retirement accounts at different institutions, it’s difficult to manage a unified investment strategy. You will typically have a lot of overlapping asset classes. This can create a lack of diversification in your portfolio.

Asset Allocation attempts to balance risk versus reward by adjusting the percentage of each asset class in an investment portfolio. It is established taking into account the investor’s risk tolerance, goals and investment time frame.

While there are many different investment philosophies and strategies,  most financial experts agree that asset allocation is extremely important. An inconsistent allocation among old 401k accounts can have a profound adverse impact on long-term investment performance.

Increased Investment Choices

Most 401k plans will typically offer anywhere between 10-25 available mutual funds to choose from. In some cases, you may have an asset class that offers only one fund to invest in.

A 401k rollover to an IRA provides the flexibility to invest in almost any security in the investment universe. As an example, if you have a passive investment philosophy, you will have the option to invest in the entire universe of index funds and exchange-traded funds (ETF’s).

Fees are another critical component that heavily influences investment performance. Some funds have expense ratios north of 1%, which is a steep price to pay. Especially if they are under-performing their market index, which is largely the case with actively-managed funds.

By rolling your 401k over to an IRA with a custodian such as TD Ameritrade, Charles Schwab or Fidelity, you can control the fees in your portfolio. But these fees won’t show up on your statement. To find out what your funds are costing you, you can look up the expense ratios of the funds through a simple web search.

Roth Conversions

A Roth Conversion can be a strategy that makes sense if your income is lower than usual in a given year. It’s a strategy whereby you convert pre-tax retirement funds to tax-free funds. While there are some 401k plans that allow you to process a conversion within the 401k, some do not.

When you roll over a 401k to an IRA, there are no limitations on whether you can convert your Traditional IRA to a Roth IRA.  However, you should understand the tax implications of a Roth Conversion before performing one. Work closely with your financial advisor to determine if it makes sense for you.

Deferral of Required Minimum Distributions

Once you reach age 72, you are required to take required minimum distributions (RMDs) from your retirement accounts. Whether it’s an old 401k, 403b or Traditional IRA, you must start your RMDs at age 72 or face a 50% penalty of the amount required to be distributed.

However, you may qualify for an exception from taking RMDs from your current employer-sponsored retirement account if:

  • You’re still working
  • You do NOT own more than 5% of the business you work for
  • You have an employer-sponsored retirement account with the business you work for

If you meet all the criteria above, you may delay taking an RMD from the account until April 1st of the year after you retire.

Net Unrealized Appreciation Strategy

If you’ve purchased your own company’s stock in your 401k, you may benefit from using the Net Unrealized Appreciation (NUA) strategy. This strategy allows you to transfer your company stock (without liquidating it) to a non-retirement account while avoiding the early 10% withdrawal penalty. 

But the real benefit is the tax savings. Let’s say you own $200,000 of your company stock, but your total cost basis is $50,000. With NUA, you would pay ordinary income tax on $50,000 by transferring the company stock to your brokerage account. 

However, you don’t have to pay tax on the $150,000 gain until you sell the stock. When you do, the gain will be subject to capital gains tax rates, which are always more favorable than higher income tax rates. If you have any capital losses, you can use those losses to offset the capital gain.

Reasons Not To Roll Over

The IRS Rule of 55

By now you should know that nearly every qualified retirement plan assesses a 10% tax penalty for early withdrawals before the age of 59 ½ (with a few exceptions).

The IRS Rule of 55 applies to an employee who is laid off, fired, or who quits a job between the ages of 55 and 59 ½. It allows the employee to pull money out of their 401k or 403b plan without the early withdrawal penalty. This applies to workers who leave their jobs anytime during or after the year of their 55th birthdays. 

However, there are a few limitations. The rule only applies to assets in your current 401k or 403b—not older plans held with previous employers. Also, the distribution is subject to the mandatory 20% federal tax withholding. Nevertheless, this can be a useful strategy for those retiring before age 59½.

Creditor Protection

Creditor protection can also be an added benefit provided by 401k plans, depending on the financial circumstances. In 2005, a federal law was passed that provided retirement accounts with strong bankruptcy protection, no matter what state you live in.

So in the event of bankruptcy, rolling over your 401k funds into an IRA shouldn’t diminish protection from creditors. However, in a non-bankruptcy situation, creditor protection is mostly governed by state law.

If you live in a state that offers strong protection to IRAs in non-bankruptcy situations (which most states do), then you’re probably not giving up too much by rolling over your 401k to an IRA.

If, on the other hand, you live in a state that does not offer a similar level of protection, you have to decide how important of an issue creditor protection is for you. If it’s not a concern and the benefits of an IRA rollover are more important to you, have at it! 

401k Rollover Mistakes To Avoid

Cashing Out

Unless it’s a last resort, cashing out your 401k isn’t something you really want to consider. Again, it can be very costly with the early withdrawal penalty of 10%. In addition, the entire balance of your plan becomes taxable in the year of distribution.

Additionally, your retirement accounts have favorable tax benefits, which help their compound growth in the long run. With limitations on the amounts you can contribute each year, cashing out retirement accounts really sets you back. 

In 2020, contribution limits for 401k’s are $19,500 and $6,000 for IRA’s. Those over the age of 50 can put in another $6,000 in the form of a catch-up contribution. As you can see, these limitations make rebuilding retirement funds challenging.

Rolling over to the wrong IRA

When rolling over pre-tax 401k funds, you want to ensure that the receiving account is another pre-tax retirement account such as a Traditional IRA or 401k. If you were to roll these funds directly into a Roth IRA, you will cause a taxable distribution.

Conversely, if you have after-tax funds in a 401k from contributing more than the annual contribution limit, you wouldn’t want to roll these over to a Traditional IRA.

The reason is that you have already paid taxes on these funds making them eligible to be rolled over to a Roth IRA where the growth is tax-free. The same applies to Roth 401k funds.

The Bottom Line

Ultimately, there are a number of different benefits to rolling over your 401k plan. Enhanced investment options, lower fees and more tax planning opportunities are some of the primary reasons you want to consider a rollover. 

There are also some very valid reasons why you may want to keep funds in your 401k, especially if you plan on early retirement. Like with any financial decision, it’s important to weigh the pros and cons.

Not only does the decision need to be consistent with your financial goals, but it also needs to make sense from a tax perspective.

As always, make sure you work with your financial advisor and/or tax professional to ensure that you are making the best financial decisions and avoid costly mistakes.

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