What are my options for my 401(k) when leaving my job? This is a common question asked by many people, regardless of the reason they are leaving their job. There are several options to consider, but the important thing is that you make an affirmative decision regarding your 401(k) plan account. This money is an important component of your retirement nest egg, your decision about what to do with these funds when leaving your job is an important one.
There are a number of options you can consider. We will look at these options as well as some other issues surrounding this decision.
Rolling over to an IRA
Rolling your 401(k) account over to an IRA account at an outside custodian is often a good choice for many investors. Unlike with many 401(k) plans, an IRA will provide you with a virtually unlimited number of investment choices including mutual funds, ETFs, stocks, bonds and others.
In many cases, investors will find they are able to invest at a lower cost than they were inside of their old 401(k), unless the plan was well-run with low cost investments.
Additionally, rolling these assets over to an IRA can allow an investor to consolidate these assets into their overall investment strategy for assets held outside of the 401(k), whether they are investing on their own or through a financial advisor.
When going this route, be sure that you understand and follow all rules and requirements of both the 401(k) administrator and the custodian of the IRA account to which the plan assets will be transferred.
When doing the rollover, do a trustee-to-trustee transfer if at all possible. This means that the money in your 401(k) account is transferred directly to the IRA custodian without you taking possession of the money. Often this will be a direct online transfer of the funds to the IRA custodian. In some cases, the 401(k) rollover will be in the form of a check made payable to your new custodian (Fidelity, Schwab or Vanguard for example), FBO (for the benefit of) of your name. This is still a direct trustee-to-trustee transfer, but you are required to forward the check to your IRA custodian for deposit into your IRA account. There is no requirement for taxes to be withheld and 100% of your account balance goes into the IRA account.
On the other hand, if you take the funds from your 401(k) as a cash distribution with the intent of rolling the money over, the 401(k) administrator is obligated by law to withhold 20% for taxes. You will have 60 days to deposit the amount received into your account, plus you will need to come up with the 20% that was withheld and deposit that amount into your IRA account in order for the money to retain its tax-deferred status.
It is important that you understand all rules associated with doing a rollover to ensure that you don’t inadvertently trigger an unwanted and expensive taxable distribution. Unfortunately we’ve seen this happen all too often over the years.
Traditional 401(k) to traditional IRA
This is a common rollover scenario. The money in the traditional 401(k) account will have the same characteristics once it is rolled over to a traditional IRA in terms of retaining the tax-deferred status of the investments in the account, as well as the taxability of distributions when they are taken.
If any of the contributions to your 401(k) plan were made on an after-tax basis, you will want to keep track of them to ensure they are not taxed later on when you take withdrawals from the IRA account.
Traditional 401(k) to a Roth IRA
Another option is to roll some or all of your traditional 401(k) account over to a Roth IRA. This is a form of a Roth conversion. This can be a solid strategy for those who earn too much to contribute to a Roth IRA annually. It can also be a good strategy to consider for current and future tax planning reasons.
If this is a good option for you, it’s important to ensure that you have the cash available outside of the 401(k) account to pay any additional taxes generated by this conversion.
Roth 401(k) to Roth IRA
A Roth 401(k) account must be rolled over to a Roth IRA account if you decide to go the rollover route with your 401(k) account. One aspect of Roth 401(k)s to consider is that they are subject to required minimum distributions. While these RMDs are not taxable if you meet the requirements of a qualified Roth distribution, the money will still be out of the account. Rolling this money over to a Roth IRA solves this issue as Roth IRA accounts are not subject to RMDs.
Rolling over to a new employer’s plan
If you are leaving an employer to take another job, rolling your old 401(k) to a 401(k) with your new employer might be an option to consider. The first thing to consider is whether or not your new employer’s plan will accept these types of rollovers as not all plans do.
If they do accept these types of rollovers, you will need to decide if this is the best option for you. Some reasons to consider this option include:
· Your money will continue to grow on a tax-deferred (or tax-free basis in the case of a Roth account) basis until needed in retirement.
· Consolidating all of your 401(k) assets into one plan can make managing this portion of your retirement nest egg easier. No matter how well-intentioned we might be, having one less account to manage will make your life easier.
· If the new employer’s plan offers low overall costs, plus a menu of low cost top notch investment options, this can be a solid choice.
· Money held inside of a 401(k) plan benefits from federal rules offering broad protections against creditors.
An additional advantage of going this route comes into play if you are working at the time you must commence required minimum distributions. If your employer’s plan adopts this rule, the money in their current employer’s plan is exempt from this requirement. They must not be owners of 5% or more of the company to qualify.
By rolling an old 401(k) balance into this new plan, these funds would also be exempt from RMDs. Note that all other retirement accounts, such as an IRA or an old 401(k), would still be subject to RMDs.
In evaluating this option for your 401(k) money, it’s critical that you evaluate the quality of the plan’s investment menu and the overall costs of the plan. While convenience is a nice feature, the main consideration should be the quality of the plan and deciding if this is a good place for this portion of your retirement nest egg.
Keeping your money in your old 401(k)
If you have at least $5,000 in your plan account, your old employer cannot force you to take your money out of the plan. If your balance is below that level, they may automatically distribute your balance to you.
If your account is large enough, keeping your money in the plan is an option. Reasons that you might consider this option include:
· If the plan offers an excellent, low cost investment menu, this might be a good alternative.
· This might be a temporary solution while you decide what to do with the money on a longer term basis.
· Money in a 401(k) plan benefits from broad creditor protection under federal rules.
Some potential downsides of going this route include:
· This can add to the number of retirement and investment accounts that you will need to manage. All too often, we see people with a number of old 401(k) accounts left at former employers that do not receive the attention that they deserve.
· Your old employer may move your account balance to another platform with a custodian that they use for former employees with account balances. They don’t need your consent to do this.
Taking a distribution
Taking a distribution from your 401(k) account will result in generating taxable income, and in some cases, a 10% penalty. Distributions for a traditional 401(k) account are always taxable. If you take the distribution prior to reaching age 59 ½, the distribution will generally be subject to the penalty. Certainly if you need the money this might be an option, but we generally discourage this approach.
There are two methods to avoid the penalty, but not the taxes, if you are under age 59 ½ and want to take your 401(k) balance as a distribution when leaving your job.
Rule of 55 (source link http://www.irs.gov/pub/irs-pdf/p575.pdf)
This exception to any penalties normally assessed on distributions prior to age 59 ½ only pertains to those who leave their employer in the calendar year they reach age 55 or later. This rule only pertains to money held in the 401(k) account of this employer. Note that some employers might require you to withdraw the entire balance from your plan, which could trigger a larger tax bill than you had planned on.
This exception does not apply to money held in any other former employer’s 401(k) account. It would apply if you had rolled money from a former employer into the plan of the employer that you will be leaving. This exception also does not apply to IRA accounts.
In some cases, the age is 50 for some police officers and public servants, and the exception generally applies to similar plans such as a 403(b).
In all cases, if you are looking to use the rule of 55, be sure to discuss all rules and any restrictions with your employer.
Substantially equal periodic payments (source link http://www.irs.gov/pub/irs-pdf/p575.pdf))
Another route to avoid the early withdrawal penalties is by taking a series of substantially equal periodic payments. This is also known as a Section 72(t) distribution.
Under this arrangement, you must take a series of substantially equal withdrawals from the 401(k) account until you reach age 59 ½, and for at least a minimum of five years. The substantially equal payments are calculated based upon your life expectancy.
These payments will be taxable but will not be subject to the 10% early withdrawal penalty. One issue to consider, it’s important to ensure that the account doesn’t run out of money prior to satisfying the five-year or age 59 ½ requirement. This could happen if the market experiences a significant downturn while you are doing the 72(t) distributions. This could trigger an expensive and unwanted tax situation for you.
Net unrealized appreciation (NUA)
Net unrealized appreciation is a technique that can be applied if you hold shares of your employer’s stock inside of your 401(k) at the time you are leaving the company. The NUA rules state that you can treat the shares of stock differently than you treat the rest of the money in your account. The NUA rules make sense if the shares of the company stock inside of the 401(k) account have a low cost basis and are highly appreciated.
The shares of company stock can be taken as an in-kind taxable distribution, while you roll the remaining assets in the account over to an IRA account. If you are under age 59 ½, or under age 55, you may be subject to a 10% on the amount of the in-kind distribution.
Under NUA, the cost basis of the shares, not the current market value, is taxed as ordinary income at the time of the distribution. The shares can then be held in a taxable brokerage account. If they are held for at least a year, any capital gains will be taxed at preferential long-term capital gains rates when sold.
There is the risk that the shares won’t hold their value. However, if you feel that the shares will stay at current levels or appreciate, using the NUA technique can result in substantial tax savings. Rolling the shares into an IRA account would result in taxes being paid at ordinary income tax rates when you take distributions from the account and could result in a much higher tax liability.
Conclusion
One of the most important decisions that you will make when leaving a job, for whatever reason, is what to do with your 401(k) account. This money is a critical piece of your retirement nest egg, you should consider your options carefully.
We regularly help our clients make decisions about their old 401(k) plan accounts in the context of their overall financial and retirement planning situation. Please give us a call to discuss your options for your 401(k), we’d love to be of help.
This content is developed from sources believed to be providing accurate information and provided by Riverbend Wealth Management. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Stratos Wealth Partners and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
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