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.

The SECURE Act which went into effect on January 12, 2020 made a number of changes to laws that will effect the retirement of nearly every American. Most notable was the elimination of Stretch IRA’s, which will now force most non-spouse beneficiaries to withdraw inherited IRA balances in a 10 year timeframe. Other significant IRA changes was increasing the age that Required Minimum Distributions (RMD’s) must begin from 70 ½ to 72 as well as repealing the age limit for making Traditional IRA contributions. Additionally, many changes were passed that will effect employer-sponsored qualified plans along with many other miscellaneous changes. In this article, we outline the key changes in the act and what they mean to you.

TITLE I: Expanding and Preserving Retirement Savings

Section 102.  Simplification of Safe Harbor 401(k) Rules 

The legislation changes the nonelective contribution 401(k) safe harbor to provide greater flexibility, improve employee protection and facilitate plan adoption. The legislation eliminates the safe harbor notice requirement, but maintains the requirement to allow employees to make or change an election at least once per year.  The bill also permits amendments to nonelective status at any time before the 30th day before the close of the plan year.  Amendments after that time would be allowed if the amendment provides (1) a nonelective contribution of at least four percent of compensation (rather than at least three percent) for all eligible employees for that plan year, and (2) the plan is amended no later than the last day for distributing excess contributions for the plan year, that is, by the close of following plan year. 

Section 103.  Increase Credit Limitation for Small Employer Pension Plan Start-Up Costs 

Increasing the credit for plan start-up costs will make it more affordable for small businesses to set up retirement plans. The legislation increases the credit by changing the calculation of the flat dollar amount limit on the credit to the greater of (1) $500 or (2) the lesser of (a) $250 multiplied by the number of nonhighly compensated employees of the eligible employer who are eligible to participate in the plan or (b) $5,000. The credit applies for up to three years. 

Section 104.  Small Employer Automatic Enrollment Credit  

Automatic enrollment is shown to increase employee participation and higher retirement savings. The legislation creates a new tax credit of up to $500 per year to employers to defray startup costs for new section 401(k) plans and SIMPLE IRA plans that include automatic enrollment.  The credit is in addition to the plan start-up credit allowed under present law and would be available for three years.  The credit would also be available to employers that convert an existing plan to an automatic enrollment design. 

Section 105.  Treat Certain Taxable Non-Tuition Fellowship and Stipend Payments as Compensation for IRA Purposes  

Stipends and non-tuition fellowship payments received by graduate and postdoctoral students are not treated as compensation and cannot be used as the basis for IRA contributions. The legislation removes this obstacle to retirement savings by taking such amounts that are includible in income into account for IRA contribution purposes. The change will enable these students to begin saving for retirement and accumulate tax-favored retirement savings. 

Section 106.  Repeal of Maximum Age for Traditional IRA Contributions 

The legislation repeals the prohibition on contributions to a traditional IRA by an individual who has attained age 70½.  As Americans live longer, an increasing number continue employment beyond traditional retirement age.   

Section 108.  Portability of Lifetime Income Options  

The legislation permits qualified defined contribution plans, section 403(b) plans, or governmental section 457(b) plans to make a direct trustee-to-trustee transfer to another employer-sponsored retirement plan or IRA of lifetime income investments or distributions of a lifetime income investment in the form of a qualified plan distribution annuity, if a lifetime income investment is no longer authorized to be held as an investment option under the plan.  The change will permit participants to preserve their lifetime income investments and avoid surrender charges and fees. 

Section 109.  Treatment of Custodial Accounts on Termination of Section 403(b) Plans 

Under the provision, not later than six months after the date of enactment, Treasury will issue guidance under which if an employer terminates a 403(b) custodial account, the distribution needed to effectuate the plan termination may be the distribution of an individual custodial account in kind to a participant or beneficiary. The individual custodial account will be maintained on a tax-deferred basis as a 403(b) custodial account until paid out, subject to the 403(b) rules in effect at the time that the individual custodial account is distributed. The Treasury guidance shall be retroactively effective for taxable years beginning after December 31, 2008. 

Section 111.  Allowing Long-term Part-time Workers to Participate in 401(k) Plans 

Under current law, employers generally may exclude part-time employees (employees who work less than 1,000 hours per year) when providing a defined contribution plan to their employees.  As women are more likely than men to work part-time, these rules can be quite harmful for women in preparing for retirement.  Except in the case of collectively bargained plans, the bill will require employers maintaining a 401(k) plan to have a dual eligibility requirement under which an employee must complete either a one year of service requirement (with the 1,000-hour rule) or three consecutive years of service where the employee completes at least 500 hours of service. In the case of employees who are eligible solely by reason of the latter new rule, the employer may elect to exclude such employees from testing under the nondiscrimination and coverage rules, and from the application of the top-heavy rules. 

Section 112.  Penalty-free Withdrawals from Retirement Plans for Individuals in Case of Birth or Adoption  

The legislation provides for penalty-free withdrawals from retirement plans for any “qualified birth or adoption distributions.” 

Section 113.  Increase in Age for Required Beginning Date for Mandatory Distributions 

Under current law, participants are generally required to begin taking distributions from their retirement plan at age 70 ½. The policy behind this rule is to ensure that individuals spend their retirement savings during their lifetime and not use their retirement plans for estate planning purposes to transfer wealth to beneficiaries.  However, the age 70 ½ was first applied in the retirement plan context in the early 1960s and has never been adjusted to take into account increases in life expectancy.  The bill increases the required minimum distribution age from 70 ½ to 72. 

Section 115.  Treating Excluded Difficulty of Care Payments as Compensation for Determining Retirement Contribution Limitations 

Many home healthcare workers do not have a taxable income because their only compensation comes from “difficulty of care” payments exempt from taxation under Code section 131.  Because such workers do not have taxable income, they cannot save for retirement in a defined contribution plan or IRA.  This provision would allow home healthcare workers to contribute to a plan or IRA by amending Code sections 415(c) and 408(o) to provide that tax exempt difficulty of care payments are treated as compensation for purposes of calculating the contribution limits to defined contribution plans and IRAs.   

TITLE II: Administrative Improvements

Section 201.  Plans Adopted by Filing Due Date for Year May Be Treated as in Effect as of Close of Year  

The legislation permits businesses to treat qualified retirement plans adopted before the due date (including extensions) of the tax return for the taxable year to treat the plan as having been adopted as of the last day of the taxable year.  The additional time to establish a plan provides flexibility for employers that are considering adopting a plan and the opportunity for employees to receive contributions for that earlier year and begin to accumulate retirement savings. 

 Section 202.  Combined Annual Reports for Group of Plan 

The legislation directs the IRS and DOL to effectuate the filing of a consolidated Form 5500 for similar plans.  Plans eligible for consolidated filing must be defined contribution plans, with the same trustee, the same named fiduciary (or named fiduciaries) under ERISA, and the same administrator, using the same plan year, and providing the same investments or investment options to participants and beneficiaries.  The change will reduce aggregate administrative costs, making it easier for small employers to sponsor a retirement plan and thus improving retirement savings. 

Section 204.  Fiduciary Safe Harbor for Selection of Lifetime Income Provider 

The legislation provides certainty for plan sponsors in the selection of lifetime income providers, a fiduciary act under ERISA.  Under the bill, fiduciaries are afforded an optional safe harbor to satisfy the prudence requirement with respect to the selection of insurers for a guaranteed retirement income contract and are protected from liability for any losses that may result to the participant or beneficiary due to an insurer’s inability in the future to satisfy its financial obligations under the terms of the contract.  Removing ambiguity about the applicable fiduciary standard eliminates a roadblock to offering lifetime income benefit options under a defined contribution plan. 

 Section 205.  Modification of Nondiscrimination Rules to Protect Older, Longer Service Participation  

The legislation modifies the nondiscrimination rules with respect to closed plans to permit existing participants to continue to accrue benefits. The modification will protect the benefits for older, longer service employees as they near retirement. 

TITLE III: Other Benefits

Section 302.  Expansion of Section 529 Plans 

The legislation expands 529 education savings accounts to cover costs associated with registered apprenticeships; homeschooling; up to $10,000 of qualified student loan repayments (including those for siblings); and private elementary, secondary, or religious schools.  

TITLE IV: Revenue Provisions

Section 401.  Modifications to Required Minimum Distribution Rules  

The legislation modifies the required minimum distribution rules with respect to defined contribution plan and IRA balances upon the death of the account owner.  Under the legislation, distributions to individuals other than the surviving spouse of the employee (or IRA owner), disabled or chronically ill individuals, individuals who are not more than 10 years younger than the employee (or IRA owner), or child of the employee (or IRA owner) who has not reached the age of majority are generally required to be distributed by the end of the tenth calendar year following the year of the employee or IRA owner’s death.   

Section 402.  Increase in Penalty for Failure to File  

The legislation increases the failure to file penalty to the lesser of $400 or 100 percent of the amount of the tax due.  Increasing the penalties will encourage the filing of timely and accurate returns which, in turn, will improve overall tax administration.