One of the biggest decisions many of our clients face is what to do with their 401(k) plan when they leave their employer. There is no clear cut answer as to whether you should roll over your 401(k) plan to an IRA, another employer’s 401(k) plan, or simply to leave it where it is, because it involves several different factors, including long term investment costs and the availability of investment options within the plans. Both can impact the long term performance of your retirement plan. However, the most critical factor that can have a big impact, both short and long term, are the tax implications of a rollover. Understanding these implications is essential before making any decision regarding your 401(k) plan.
Here are some of the more common tax complications that arise from a rollover:
Taxation of Indirect Rollovers
An indirect rollover occurs when you take a distribution from your 401(k) plan with the intent of rolling it into an IRA or a new 401(k) plan. With some exceptions, any distribution from 401(k) plan is subject to ordinary income taxes; and, if a distribution is made before age 59 ½, a 10 percent penalty may apply. If your intent is to roll your distribution from a 401(k) plan into an IRA, it must be done within a 60 day period to avoid the tax and penalty. It’s not uncommon for someone to take a distribution from a 401(k) plan with the intent of rolling it over into another plan and miss the deadline.
The big tax complication comes when the plan sponsor, as they are required to do, withholds 20 percent of your distributions for tax purposes regardless of your intent to roll it over into an IRA. As a result, you would then be rolling just 80 percent of your funds into the new plan. Even though you would eventually get it back through an IRS refund, the other 20 percent that is withheld must be made up by you within the 60 day time limit in order to avoid the tax and penalty on the entire distribution.
To avoid this possibility, the better course, is to fill out proper distribution forms from your current 401(k) plan to request a check to be made payable to your new custodian for the benefit of your IRA and choose no tax withholdings. You must have an IRA account opened at your new custodian first. Instruct the check to be mailed directly to your new custodian and specify the account number. If the check is mailed to you, then you must forward this check to your new custodian for deposit.
Depending on your income level and tax circumstances, you may decide to roll your 401(k) plan into a Roth IRA. With a Roth IRA your funds grow tax free and they can be withdrawn tax free. That’s because a Roth IRA takes only before-tax dollars as contributions. So, when you transfer 401(k) funds into a Roth IRA, you must first pay the taxes on the distribution to the extent of the amount being rolled over less any after-tax contributions included in the amount being rolled over. But once your funds are inside the Roth IRA you will enjoy both tax free accumulation and tax-free withdrawals.
You can also choose to rollover 100% of 401(k) pre-tax balance to an IRA at a new custodian first and then sign a Roth IRA conversion form to convert the balance from the IRA to a Roth IRA. If you do not want to convert all at once, this way allows you to only convert the amount you specify to Roth IRA, spreading taxable income over several years may make more sense to you.
As more companies offer both Roth 401(k) and pre-tax 401(k) in the past a few years, if you have both Roth 401(k) balance and pre-tax 401(k) balance inside your 401(k) plan, then you will have two rollover checks: the Roth 401(k) balance goes to your Roth IRA and the pre-tax 401(k) balance goes to your IRA.
Rolling Over Company Stock (Net Unrealized Appreciation)
If your 401(k) plan includes company stock, you should consider the tax implications of rolling it into an IRA or transferring instead to a non-qualified brokerage account (your individual account or your trust account). Here’s why: When you distribute assets (money or stock) from your IRA, you pay income taxes on the portion comprised of pre-tax contributions and earnings. When company stock is issued to 401(k) plan, the difference between its value at that time and the time it is distributed is referred to as “net unrealized appreciation.” That means that stock assets which have appreciated will be taxed as ordinary income instead of at the more favorable capital gains tax rate.
If, instead, you were to withdraw your company stock from your 401(k) and place it in a taxable brokerage account, you can still benefit from capital gains taxation versus ordinary income taxation on the appreciation. Ordinary income tax rates are generally much higher (federal maximum of 39.6%) than long term capital gains tax rates (federal maximum of 23.8%). You will be required to pay the ordinary income taxes on the original pre-tax value of the stock, but your capital gains tax is deferred until you actually sell the stock. This NUA strategy is especially beneficial if the net unrealized appreciation is significant as you can choose to pay ordinary income tax on the very low pre-tax value of the stock and the current and future appreciation are subject to long term capital gain tax rate when you sell the stock inside your individual or trust account.
Net unrealized appreciation is a complicated provision of the tax code and should only be considered with the guidance of a tax professional. Most companies do not match company stock in the 401(k) plan any more, but if you have worked for the same company for many years and did not sell the company stock inside your 401(k) plan to diversify, then this strategy may apply to you.
Early Retirement Withdrawal
If you foresee yourself retiring early and need to use the money inside this account very soon, you may not want to roll over your entire 401(k) plan to an IRA. With a 401(k) plan, you can begin taking withdrawals as early as age 55 without penalty. If you roll your funds into an IRA, you will lose that option; although the IRA does allow for the Substantially Equal Periodic Payment rule, a somewhat complicated formula for withdrawing funds prior to age 59 ½.
Deciding what to do with your 401(k) plan after leaving an employer must take into consideration many factors – your current circumstances, your personal financial outlook for the future and the tax consequences of any of the options you may choose. You should always consult with a tax advisor and work with a trusted financial advisor to determine both the tax consequences and the benefits of an IRA Rollover.