Rolling 401k into IRA – Things to Consider Before You Rollover to IRA, Avoid Transfer Penalties, Move Employer Stock, Consider Retirement Age

When you quit your current job and move to a new employer, and if you have maintained a 401(k) retirement plan with your past employer, the above questions posed in the title will attack you; so knowing what to do in such cases is the best way to go. Conventional investors will tell us that when you leave your job, you should rollover your 401(k) to an Individual Retirement Account (IRA). IRA rollovers allow you to continue deferring taxes and avoid early-withdrawal penalties which can be up to 240! However, if you have a really good 401k plan with your old employer, maybe you would prefer to leave your money there, or rollover the funds to your new company’s 401k plan? Here is how you can decide if a 401k rollover to an IRA is the right choice for you.

i) Consider 401k Rollover Fees

The IRS estimates that Americans transferred over $195 billion from 401(k) plans to IRAs in 2006. However, it only makes sense to do an IRA rollover if the fees charged by the IRA plan are lower than those charged by the old employer’s 401k or the new employer’s 401k. Most of the times, if the 401k is of a small to medium sized enterprise, an IRA is a better alternative as small businesses do not have a 401k plan administration team like large corporations do. Also, be sure to consider the fees that your new potential IRA plan charges because rolling over a low cost 401(k) plan to a high fee IRA can also impact your retirement nest egg and you will end up with less money. According to the Human Resources giant, Hewitt Associates, rolling over to a high-cost IRA plan can be very expensive for investors. Consider an investor who is 35 years old and changes jobs and leaves behind $33,000 in a 401(k) (assuming an annual rate of return of 8%) would have $404,105 by age 70 according to Hewitt. If the same investor leaves behind $33,000 in a typical retail IRA with 8% annual return, he would only have $366,424 at age 70 years. Both these numbers are after fees are deducted from the plans. As you can see, the retail IRA would leave you behind with $37,681 lesser!

ii) Explore Further Investment Opportunities

IRAs offer more investment choices than 401(k) plans; that’s a sure thing. The advantage of rolling retirement funds from a 401k to an IRA is diversification; specifically; in an IRA, you can invest in individual stocks, low cost mutual funds, or US Treasuries or Bonds. You can also have the option of investing in exchange traded funds or low cost index funds. However, employees who participate in their employer’s 401k plan may be restricted to investing in only company stock or other individual stocks and not diversify in to other investment areas. However, David Wray, president of the Profit Sharing/401(k) Council of America says if you are satisfied with the # of investments available to you, then stick to that plan and do not make major changes.

iii) Avoid Transfer Penalties

You obviously knew this was coming! There are certain penalties you should watch out for when rolling over from a 401k plan to an IRA. If you’re doing an IRA rollover, it is best to get your former employer to wire transfer the cash to your new financial institution that is housing or hosting your IRA. The advantage to doing this is it saves time, and there are an unlimited number of IRA rollovers you can do in a single year. If you decide to cash out your 401(k), meaning you get your old employer to wire transfer the funds directly to your bank account, then you must rollover this money to a qualified tax-deferred retirement plan within 60 days. Also note that initially your employer will only send you 80% of your total retirement savings, because 240 is withheld for income taxes, in case you decide to keep the cash. And if you do decide to keep the cash, your former employer will submit the 240 withheld to the IRS, which means you will have to come up with an additional 240 cash to fully rollover all your funds to an IRA. Also, you are restricted to only 1 such rollover in a 1 year period.

iv) Don’t Move Employer Stock

When you purchase stock of your former employer, there is a special tax treatment applied when you leave it in your employer sponsored 401k plan. This is because any tax on this capital is paid when you sell the stock upon retirement, thus giving you years of tax-deferral and compounding interest and gains. For instance consider an employee who purchases $20,000 worth of his company’s stock which appreciates to $40,000 in 2 years. If this entire $40,000 is rolled over to an IRA, then it will be taxed at nominal tax rates, up to 35% for high income earners. However, there is a better alternative and that is to withdraw the stock from the retirement plan. This means you would be withdrawing the original $20,000 you contributed to the stock and would get taxed as ordinary income during the year of distribution. The remaining $20,000 will not get taxed until you sell the stock and make a capital gain. And then, this would be taxed at the long term capital gains tax rate of 15%

v) Look at Your Retirement Age

If you withdraw funds from your IRA before the age of 59 and ½, there is a 10% early withdrawal penalty. On the other hand, investors can withdraw money from their 401k after the age of 55, thus giving you 4 and ½ years withdrawal leverage. Thus if you are a senior investor at age 56 and think you might need to tap in to your 401k account sometime soon, an IRA rollover is best to avoid. At the age of 70 and ½, retirees must begin taking minimum required distributions (MRDs) from their 401k or IRA plans. The only exception to this is if you are still working at age 70 and ½, unless you own 5% or more of a particular company, then you will have to take MRDs.