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When Not To Rollover 401k Blog Post

When Not to Rollover Your 401(k)

After leaving an employer, you will be faced with the decision of what to do with the money saved in your employer-sponsored retirement plan such as a 401(k) or 403(b). Your first instinct is likely to roll the funds into an IRA, but it is important to take a step back and look at the available options and your particular situation before making any moves. Because the majority of companies in the financial services industry stand to profit from your move to an IRA due to their business model and how they are compensated, their advice is likely to be biased. Equipping yourself with an understanding of your options and the factors to consider will help you make a more informed decision.

What are your options?

After leaving an employer, there are commonly four options for the money held within a retirement plan.

1) Leave the money in the existing plan

Although you have left your employer, that does not necessarily mean you must also leave their retirement plan. If you have enough saved—typically greater than $5,000—you can elect to keep your money in the existing plan. Accounts with small balances are often required to be moved out of the plan as they can be considered administratively burdensome for the prior employer to maintain.

2) Move the funds to your new employer’s plan

If you are changing employers, you may have the option to roll the funds into your new employer’s plan. Not all companies allow this, however, so check with your new employer’s Human Resources department. The Summary Plan Description (SPD) will also contain this information.

3) Rollover the funds into an IRA or Roth IRA

The third option is to roll the funds into an Individual Retirement Account (IRA) or Roth IRA that either you or a financial advisor can manage.

4) Cash out the account

Finally, there is the option to cash out the retirement fund, but be warned, this option can have major downfalls. For those who take this option, any pre-tax funds held in a traditional retirement account will be taxed as ordinary income at their marginal tax bracket. For instance, say an individual has $10,000 in their traditional 401(k) and they decide to receive a check for the amount rather than keep the money in a qualified account because they would like to pay down some debt. If that person is in the 22% marginal tax bracket, they will face $2,200 in income taxes and that $10,000 is now only $7,800.

Not only will taxes eat into your withdrawal, but the result gets even worse if you haven’t attained age 59 ½ or met very certain criteria that allows for the distribution to be considered qualified. Examples of a qualified distribution include death, disability, $10,000 for first time homebuyers, educational expenses incurred that year for you or certain relatives, and high medical costs in relation to your Adjusted Gross Income (AGI). For nonqualified distributions, on top of paying ordinary income taxes on the amount withdrawn, you also owe a 10% penalty. Continuing the illustration from above, if this individual is hit with the 10% penalty, the $10,000 withdrawal after taxes and penalties will net them a mere $6,800.

For those with Roth funds in their employer sponsored retirement plan, they will not face any taxes on the Roth contributions, but will on any earnings withdrawn if they have not reached the age of 59 ½ and began contributing to their Roth 401(k) or 403(b) five years previously or met other criteria to be deemed a qualified distribution. Those earnings can also be subject to a 10% penalty.

The funds distributed from a traditional (pre-tax) retirement plan will show up as income on your tax return. Because so many tax benefits are affected by your Adjusted Gross Income (AGI) or taxable income, cashing out your retirement plan could inadvertently cause you to not qualify for certain benefits, such as healthcare subsidies, lower capital gains rates, and the ability to contribute to tax advantaged accounts, just to name a few.

You will also miss out on the benefits of a tax advantaged account and compounded returns. Unless you absolutely must have the funds and there aren’t other options, cashing out a retirement plan should be a last resort.

How Do You Choose an Option?

How do you decide the best option between your prior employer’s plan, your current employer’s plan, and an IRA? Take the following into consideration:

Simplicity and Convenience

It can be useful to have your retirement savings in one place. Having fewer accounts makes it easier to keep track of how much you have saved overall. It also makes it easier to make cohesive investment decisions which can get more complicated when having to consider multiple accounts and investment options. Especially if you change employers fairly frequently, it can be good to consolidate the accounts rather having funds sitting in each past employer’s plan. As you age and are thinking about the estate you will be leaving your family, it can also be helpful to simplify your situation as much as possible for those who will be left to handle it.

Investment Options and Fees

Are you satisfied with the investment selection of either your prior or current employer? There are wonderful employer retirement plans with low fees and great investment options, as well as employer plans with high-cost, poorly performing funds. If you are faced with the latter, there is a strong case for rolling the funds into an IRA.

If you roll the funds into an IRA, you still need to be conscious of fees. If you feel comfortable managing your own investments, there are several discount brokers where you can find great options at low costs. If you are working with a financial advisor, ensure you understand how they get paid and what services you receive for that pay. Financial advisors are not all the same, so do your homework and find one that fits your needs.

When Will You Need Access to the Funds?

Consider when you may need access to the funds. If there is a possibility that you could leave your employer between the ages of 55 and 59 ½ and will need to pull from the account, you may want to keep the funds in your qualified retirement plan (such as a 401(k) or 403(b)). According to the IRS “Rule of 55,” distributions made to you after you separate from service with your employer if the separation occurred in or after the year you reached age 55 are not faced with the 10% penalty for early withdrawals. This is only allowed for withdrawals from employer-sponsored retirement plans. As soon as the funds are rolled into an IRA, the Rule of 55 can no longer be utilized.

If you want access to the funds prior to retirement, you will want to know if your current employer’s plan allows for in-service withdrawals. In-service withdrawals are when you withdraw money from your employer-sponsored plan while still working for the company. Per IRS rules, in-service withdrawals are allowed, but not all employers offer them. The criteria around allowable in-service withdrawals can also be different, so contact your HR department or obtain the Summary Plan Description for more information.

Do You Have Pre- or Post-Tax Funds?

For rollovers of Roth (post-tax) funds, you must consider the 5-year rule. If you rollover funds from an employer sponsored plan to an IRA, you can have immediate access to your contributions tax-free, but in order to withdraw the earnings tax free, you must meet two criteria (barring a few other qualified distribution situations): 1) You have attained age 59 1/2 and 2) You have had a Roth IRA account open for at least 5 years. This can be any Roth IRA account, not necessarily the one you will be withdrawing the funds from.

Roth 401(k) and 403(b) funds are subject to required minimum distributions (RMDs) once you attain the age of 72 if you are no longer working for that company. Roth IRAs are not subject to RMDs, so rolling the funds over to a Roth IRA prior to age 72 can be advantageous.

Other Special Circumstances

Some individuals, because of income restrictions, do not qualify for Roth IRA contributions. They can, however, utilize the “backdoor Roth” strategy by making nondeductible contributions to a traditional IRA and then converting them to a Roth IRA. If you take advantage of this strategy or may need to in the future, you will likely be best served by keeping your traditional funds with either your previous or current employer and not rolling them into an IRA. If you have any other traditional IRA funds, even in a separate account, you must take into consideration pro rata rules which make the backdoor Roth strategy very cumbersome and limits the benefits of implementing the strategy.

If you have employer stock held within an employer plan, you will want to consider electing net unrealized appreciation (NUA) treatment. The IRS offers a provision that allows for a more favorable capital gains tax rate on the NUA of employer stock upon distribution, after certain qualifying events. Electing NUA treatment would result in you moving the funds to a non-qualified investment management account rather than an IRA, but is highly dependent on one’s personal situation.

Indirect vs. Direct Rollovers

If you’ve decided your best option is to rollover your funds to a new employer or an IRA, you will likely be given the option of doing an indirect rollover or a direct (‘’trustee-to-trustee”) rollover. With an indirect rollover, a check is issued made payable to you, that you are responsible for depositing into your new employer’s plan or IRA. With a direct or “trustee-to-trustee” transfer, the check is made payable to the new employer’s plan or IRA for your benefit. If possible, choose the direct rollover for the following reasons.

60 day rule – If you elect an indirect transfer and do not deposit the check into a qualified plan (employer or IRA) within 60 days, it will be considered a withdrawal and you will be faced with ordinary income tax on the amount withdrawn and potentially a 10% penalty. You do not want to take any chances that you forget about the check, have something occur in your life that derails your plan, or the check gets lost in the mail.

Mandatory withholding – With indirect rollovers, your employer is required by the IRS to withhold 20% of the withdrawal amount for tax purposes in the instance that you do not successfully roll over the entirety of the funds you withdrew into another qualified plan. You will get those funds back once you file your taxes the following year, but you will be out 20% for some time period.

An extremely important, but often missed rule, is that if you do not fund the new account (either employer plan or IRA) with the check made payable to you and additional funds to make up for that 20% that was withheld, it will be considered a distribution and you must pay ordinary income taxes and potentially a penalty. For example, an individual elects to do an indirect rollover in the amount of $100,000. The employer will withhold 20% or $20,000 for taxes and the individual will receive a check for $80,000. Within 60 days, they will need to deposit the check for $80,000 and an additional $20,000 from their savings into a qualified retirement account. If they only deposit the $80,000 check they receive, they will be taxed on the $20,000 that was deemed a withdrawal and could be faced with $2,000 in penalties.

If for some reason, an indirect transfer is your only option, it is important to have adequate cash on hand. You should also consider doing any indirect rollovers late in the calendar year, so that you will be “reimbursed” within the next few months after filing your tax return. If you complete an indirect rollover early in the year, you will have to wait an entire year or more for your refund, potentially missing out on gains you could have made on the funds in the meantime.

Still Hesitant in Choosing an Option?

It can be reassuring knowing which actions can be undone and which cannot.

Actions that cannot be undone: If you close your prior employer retirement plan, you cannot reopen it.

Actions you can undo, if you completed in a certain time frame: If you decide to cash out the plan, you are able to change your mind if you get the funds rolled into your new employer’s plan or an IRA within 60 days.

Actions that aren’t necessarily final: You can keep the money in your prior employer’s plan until you decide what to do with it. Unless you have a very small account balance and will be forced out of the plan, or the plan is terminating, you can take your time and not feel as if you must decide right away.

If you move the funds into your new employer’s plan, you can roll those funds and their respective earnings out into an IRA or Roth IRA at a later date.

If you roll them into an IRA or Roth IRA, you can roll them into a current employer’s plan, if offered, or move the accounts to a different brokerage firm or financial advisor.

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Danielle Harrison, MBA, CFP®, CFT-I™ is the Founder and Lead Financial Advisor at Harrison Financial Planning a fee-only financial planning firm based in Columbia, MO.