Rolling Over an Old 401(k) – Beyond the Transfer

Steve Palm, CFP®

One great thing about employer retirement accounts is they are portable when you transition to a new employer or retire. But understanding the factors you need to be aware of and deciding what you should do with an old 401(k) is important. Below, we will identify your options for old accounts, address the reasons to transfer, and focus on the considerations and pitfalls to avoid.

There are three options when deciding what to do with your old retirement account. First, if your employer is not forcing you out of the retirement plan, you can keep the account and money invested where it is. Second, funds can be withdrawn from the account but are subject to income tax and possibly early withdrawal penalties. The last option is to transfer the money into the new employer’s 401(k) plan or your own IRA.

When looking to move your assets to a new retirement account, there are things to consider:

  • Support
    Most retirement plans do not offer fiduciary advice to participants. If you need guidance, your primary option is to transfer it to an IRA with a fiduciary financial advisor, preferably a Certified Financial Planner™, where you will get the assistance you need.
  • Investment Options
    401(k) accounts have limited investment choices. Learn about the options available to you in an IRA to determine which is a better fit for your needs.
  • Fees
    There can be layers of costs in a retirement plan. It is important to understand how those costs affect your investment performance. Determine if the fees on the account reflect the level of service offered.

When and where you move your money can impact your short- and long-term goals. Before you decide what to do with your old retirement account, there are several factors to think about to protect your retirement savings.

Taxes

Withdrawals from a pre-tax retirement plan are subject to income tax. The withdrawal will be added to your taxable income for the year; so be aware of the marginal tax rate you will pay for withdrawals. Consider if there is a better time, or year, to withdraw the money. To delay paying taxes, you must leave it or transfer to another pre-tax retirement account.

Penalties

In addition to taxes, withdrawals from retirement accounts are subject to a 10% early withdrawal penalty if you are younger than 59.5 years of age. See possible exception below.

If your account is a SIMPLE IRA and has been open for less than two years, you will be subject a 25% penalty for early transfer or withdrawal. Leave it there until after the two years has passed.

Exception to early withdrawal penalty

If you left your employer between the age of 55 and 59.5, there is a special allowance for distributions directly from a 401(k) without the 10% early withdrawal penalty. This allowance does not apply if you transfer it to an IRA before withdrawing. You also need to confirm the 401(k) plan’s distribution policy after separation from service to determine if they allow for multiple distributions.

457 Plans

Unlike 401(k), 403(b), and SIMPLE IRA accounts, a 457 plan allows for withdrawals prior to age 59.5 without penalty. If you have funds that you may need access to prior to age 59.5, consider keeping money in your 457 account to avoid the penalties that come with other types of retirement accounts.

Small Balance Force Out

If you are being forced out of your old 401(k) account due to the small account size (less than $1,000 or $5,000 in some cases), you may have a limited timeline to decide. If you are not eligible for your new employer plan, consider speaking with your former employer about delaying the impending deadline until you are able to transfer it once you become eligible. The backup option is to transfer it to an IRA.

Double Taxation

Make sure that post-tax contributions or Roth 401(k) balances are transferred to a Roth account. You do not want to pay income tax again on post-tax balances.

Roth 5-Year Clocks

There is a 5-year clock that starts the year you first deposit to a Roth 401(k) and a Roth IRA. If you do not already have a Roth IRA, the 5-year clock starts over when the Roth 401k is transferred to a new Roth IRA. Bypass the 5-year clock restart by opening a Roth IRA if you have a Roth 401(k) account.

Direct Transfers and Rollovers

When investment accounts are transferred directly from one custodian/trustee to the next, this is called a direct transfer and is the preferred method of processing a transfer.

A rollover is a transfer from a retirement account that is withdrawn and deposited into a person’s bank account before transferring to the new investment custodian. There are a few problems that can make rollovers challenging.

First, you only have 60 days to redeposit the money into a new account. Second, the IRS only allows you one rollover per year. Finally, you must redeposit the full gross amount including any portion that may have been withheld for taxes. For example, if you withdraw $20,000, the employer is required to withhold 20% for taxes, leaving a net amount to you of $16,000. You will need to add $4,000 of your own money along with the $16,000 from the 401(k) to avoid the 10% penalty on the amount not redeposited. A direct transfer will negate the complexity and frustration of this rollover process.

As you can see, there are many things you should consider before deciding what to do with an old retirement plan account. If you should have any further questions, please contact an advisor at HFG Trust.

 

Steve Palm, CFP®

Financial Advisor & 401(k) Specialist