By Jon L. Ten Haagen, CFP ®
You are about to receive a distribution from your 401(k) plan, and you’re considering a rollover to a traditional IRA. While these transactions are normally straightforward and trouble free, there are some pitfalls you’ll want to avoid and with good guidance you can.
First consider the pros and cons of a rollover. The first mistake some make is failing to consider the pros and cons of a rollover to an IRA in the first place. You can leave your money in the 401(k) plan if your balance is over $5,000. And if you are changing jobs, you may also be able to roll your distribution over to your new employer’s 401(k) plan.
Though IRAs typically offer significantly more investment opportunities and withdrawal flexibility, your 401(k) plan may offer investments that can’t be replicated in an IRA (or can’t be replicated at an equivalent cost).
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.
401(k) plans may allow employee loans. Usually up to 50 percent of the value and must be paid back within five years.
And most 401(k) plans don’t provide an annuity payout option, while some IRAs do.
Not every distribution can be rollover over to an IRA. For example, Required Minimum Distributions (RMDs) can’t be rolled over. Neither can hardship withdrawals or certain periodic payments. Do so and you may have an excess contribution to deal with.
Use direct rollovers and avoid 60-day rollovers. It may be tempting to give yourself a free 60-day loan, it’s generally a mistake to use 60-day rollovers rather than a direct (trustee to trustee) rollovers. If the plan sends you the monies, it is required by law 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 the plan withheld. In addition, there’s no need to taunt the rollover gods (IRS) by risking inadvertent violation of the 60-day limit.
Remember the 10-percent penalty tax. Taxable distributions you receive from a 401(k) plan before age 59.5 are normally subject to a 10-percent early distribution penalty, but 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 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 59.5 before you withdraw those dollars from the IRA without the 10-percent penalty (unless another exception apply). So if you think you may need to use funds before age 59.5, a rollover to an IRA could be a costly mistake.
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 to an IRA could be a serious mistake. Normally, distributions from 401(k) plans is 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. This would be a very serious and costly mistake.
IF YOU ARE 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 those dollars into your ROTH IRA, they’ll now be subject to the ROTH IRA five year holding period, no matter how long those dollars were in the 401(k) plan. So, for example, if you established 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 always, we wish you the best of fortune with your investing success. If you find you need or want guidance with your travels toward a successful retirement, reach out and ask for help. We are here to help you succeed. Have a great week and if we do not talk before, have a wonderful Thanksgiving surrounded by and sharing with your family and friends.
Huntington’s Jon L. Ten Haagen, CFP, runs Ten Haagen Financial Services, Inc., a full-service independent financial planning firm, and he is here to answer your questions. In this bi-monthly column, Ten Haagen will answer your financial questions and help you with his expert financial advice. Don’t be shy, our expert is here for you, so feel free to ask away! Email your questions to firstname.lastname@example.org today, and let our expert help you.
*Ten Haagen is an Investment Advisor Representative offering securities and advisory services offered through Royal Alliance Associates, Inc., member of FINRA/SIPC, and a registered investment advisor. He is also an active community member, serving on several nonprofit boards and as executive officer of the Greater Huntington Boating Council.
**BACK IN HUNTINGTON: The offices of Ten Haagen Financial Services, Inc. have moved back to 191 New York Ave., Huntington. Friends and clients are welcome to stop by, check out the new office and share a cup of coffee with the expert!