What is a 401(k) Rollover?
Changing Jobs? Consider a 401k distribution and Rollover.
Unfortunately, these tough economic times have brought about significant layoffs at companies throughout the country. If you’ve been affected by a layoff or are simply considering a job change, you may be wondering what will happen to the money you’ve saved in your employer-sponsored retirement plan. With several options available to you, how do you know which is the right one?
When you leave an employer, you have several options:
Leave your money in the existing plan. If your balance exceeds $5,000, plan providers are required to allow you to keep your money in your 401(k) account even after you’ve left the company. This is a simple option, because it requires no action on your part and avoids the penalties associated with taking a cash payout. Leaving your funds in a 401(k) plan may also offer benefits such as low fees and discounts on investment-related expenses due to the large size of the plan. However, despite the simplicity of this option, the disadvantages may outweigh the advantages.
First of all, you won’t be able to contribute any additional dollars to your former employer's plan. And, by leaving your money in your previous employer’s 401(k), you limit your investment options to those available through the plan and must rely on your former employer to manage your 401(k) investment options. The company you’ve left may make changes to their plan that could adversely affect your account, and if your old company suddenly goes bankrupt or merges with a competitor, things could get even more complicated. Some plans even assess an annual fee to terminated participants. Finally, leaving your money in your previous employer’s plan makes it easy to forget about it, especially if you decide to participate in your next employer’s 401(k) plan. You would also be responsible for furnishing beneficiary or address changes to each plan as they occur. It’s not uncommon for frequent job changers to have money in several different 401(k) plans, and in many cases,those funds are invested in vehicles that may conflict with each other or contradict your overall investment strategy. By having all of your retirement investments in one place, it is easier to ensure that each investment is part of a properly balanced portfolio.
Rollover your 401(k) money into an IRA. For many investors, a rollover into an IRA offers more flexibility. First of all, by rolling retirement dollars into an IRA, investors can choose from a much wider variety of investments than simply the limited number of options available through a 401(k) plan.
The rollover may be combined with other qualified retirement dollars as well. For example, if you have worked at multiple jobs and have several 401(k) accounts, you can use a rollover to consolidate them into a single IRA account. And once you’ve established a rollover IRA, you can continue making contributions to it in the future. The 2016 contribution limit for IRAs is $5,500. However, for individuals age 50 or older, the contribution limit is $6,500.
For those investors whose 401(k) holdings are heavily weighted with shares of employer stock, an IRA rollover provides an excellent opportunity to diversify. If your plan remains in shares of employer stock, you could potentially save a significant amount in taxes by making a Net Unrealized Appreciation (NUA) election. With this election, shares are distributed from the plan “in kind” and just the basis of the stock will be taxed as ordinary income at the time of distribution. The appreciation will not be taxed until you liquidate the shares and will be taxed at the capital gains rate. This could save you a substantial amount on taxes if your stock is highly appreciated and you are in a high tax bracket.
And of course, an IRA rollover shields you from the taxes and penalties associated with a direct payout. With a rollover IRA, you don’t pay taxes until you withdraw the money.
Once you’ve completed the IRA rollover, it’s important to familiarize yourself with its characteristics, which are the same as those of a traditional IRA. With a traditional IRA, there is no earned income ceiling for eligibility to contribute. Your contributions may be tax-deductible depending on active participant status in an employer-sponsored retirement plan, so if you decide to contribute to your new employer’s plan after performing the rollover, it may affect your ability to deduct any future IRA contributions. Contributions are not allowed after the IRA holder reaches age 70 ½, and required minimum distributions must begin at age 70 ½. Distributions are generally taxable to the IRA holder or beneficiaries at ordinary income rates.
If you qualify, you may find that a Roth IRA is better for your personal situation. A Roth IRA is a unique investment opportunity due to its tax advantages. With the Roth IRA, contributions to the plan are not deductible, but distributions can be withdrawn tax-free under certain conditions. Ordinary income tax is due on the amount converted from your 401(k) in the year of conversion. For some, paying the tax up-front can offer significant tax savings later.
Avoiding Tax Withholding in a 401k Rollover
The key to avoiding the 20 percent tax withholding is arranging for a direct rollover. This is also known as a “trustee-to-trustee” transfer. This means that the distribution check from your previous employer’s retirement plan must be made payable to the custodian of the IRA account or the new employer’s retirement plan in which you wish to transfer the funds for the rollover. If performing an IRA rollover, your Financial Advisor can provide you with specific instructions for the check.
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