Tread Carefully With Company Stock
Some retirement savers hold company stock in their 401 alongside their other investments. In that situation, if you roll over all your 401 assets to an IRA, you lose the potential to get a more favorable tax treatment on any growth those shares had while in your 401.
It gets a bit confusing, but the idea is that if the company stock has unrealized gains, you transfer it to a brokerage account instead of rolling it over to the IRA along with your other 401 assets. Upon transferring, you are taxed on the cost basis .
It’s a complex transaction, and if done incorrectly, the strategy loses its tax advantage.Melisssa BrennanFinancial planner with ARS Private Wealth
However, when you then sell the shares from your brokerage account whether immediately or down the road any growth the stock experienced inside the 401 would be taxed at long-term capital gains rates . This could be less than the ordinary-income tax treatment you’d face if the stock went into a rollover IRA and then were withdrawn.
Here’s an example: If the cost basis of your company stock is $10,000 and the gains on it were $20,000, you would pay ordinary taxes on the $10,000 when you transfer the shares to a brokerage account.
The $20,000 in gains, however, would be taxed at long-term rates once the stock is sold. Any further growth from the point of transfer to sale would be taxed as either short- or long-term gains, depending on how long you held it before selling.
Should I Rollover My 401k Into A Roth Ira
Not everyone is suited to a rollover. Rolling over your accounts has a few drawbacks:
- Risks to creditor protection Leaving money in a 401k may provide credit and bankruptcy protection, while IRA restrictions on creditor protection vary by state.
- There are no loan alternatives available. Its possible that the finances will be harder to come by. You may be able to borrow money from a 401k plan sponsored by your employer, but not from an IRA.
- Requirements for minimum distribution If you quit your job at age 55 or older, you can normally take funds from a 401k without incurring a 10% early withdrawal penalty. To avoid a 10% early withdrawal penalty on an IRA, you must normally wait until you are 59 1/2 years old to withdraw assets. More information about tax scenarios, as well as a rollover chart, can be found on the Internal Revenue Services website.
- There will be more charges. Due to group buying power, you may be accountable for greater account fees when compared to a 401k, which has access to lower-cost institutional investment funds.
- Withdrawal rules are governed by tax laws. If your 401K is invested in business stock, you may be eligible for preferential tax treatment on withdrawals.
Tax Implications Of Making A 401 Rollover
When doing a 401 rollover there are many different taxes that come into play regarding both withdrawals and contributions moving forward. First off, it is important to remember that all distributions taken prior to age 59 1/2 will result in a 10% penalty unless an exception applies.
In addition, it is important to remember that doing a 401 rollover will not change the taxation of your contributions as they are subject to normal income tax rates. It is only your contribution limits that will be affected moving forward after making a 401 rollover.
Doing the rollover via direct rollover will have the least amount of tax implications as the money technically never leave the account. If you do a 60-day rollover, on the other hand, you will be taxed on the withdrawal and then have another 60 days to put the money back into an IRA or employer plan.
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Expect Higher Taxes In Future
Since you pay income taxes on the funds you contribute to a Roth IRA, you wont pay taxes on the distributions. If you expect your income to increase in the future, it means you will be in a higher tax bracket in retirement. You can decide to pay taxes now so that future withdrawals will be tax-free.
Alternatives To Direct Rollovers
As mentioned, you have options when it comes to what happens to your old retirement accounts. Lets say you have an employer-sponsored retirement account worth $10,000 dollars.
- Indirect rollover: If you do an indirect rollover or 60-day rollover, the plan administrator withholds 20% as required for taxes and sends you a check for $8,000. You can still roll over the entire amount within 60 days tax-free, but youll need to make up the $2,000 from somewhere else.
- Roth conversion: If your funds are in a traditional IRA, you can transfer them to a Roth IRA, known as a Roth conversion. A Roth conversion is a taxable event, which means 20%, or $2,000, withholding is mandatory on the $10,000 transfer.
- Direct rollover: If you decide to do a direct rollover from plan to plan, or a trustee-to-trustee transfer , no taxes will be taken from the transfer amount. The full $10,000 will be transferred to your new account.
In the event that the plan account is $1,000 or less, the plan administrator will often pay it to you directly, minus 20% income tax withholding.
Each option has its benefits, but direct rollovers can be the most straightforward way to avoid tax penalties and hold on to as much of your money as possible.
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Topic No 413 Rollovers From Retirement Plans
A rollover occurs when you withdraw cash or other assets from one eligible retirement plan and contribute all or part of it, within 60 days, to another eligible retirement plan. This rollover transaction isn’t taxable, unless the rollover is to a Roth IRA or a designated Roth account from another type of plan or account, but it is reportable on your federal tax return. You must include the taxable amount of a distribution that you don’t roll over in income in the year of the distribution.
There Are Tax Consequences For 401 Rollovers To A Roth Ira
If you roll your 401 into a Roth IRA, you will have to pay taxes on that money. Unlike a pre-tax 401 and traditional IRA accounts, a Roth IRA is a post-tax account. This means that you pay taxes on the funds before you put them in the Roth IRA. A big advantage of the Roth IRA over the traditional IRA is that you can make withdrawals without paying additional taxes since the money has already been taxed.
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What Happens If I Cash Out My 401
If you simply cash out your 401 account, you’ll owe income tax on the money. In addition, you’ll generally owe a 10% early withdrawal penalty if you’re under the age of 59½. It is possible to avoid the penalty, however, if you qualify for one of the exceptions that the IRS lists on its website. Those include using the money for qualified education expenses or up to $10,000 to buy a first home.
What Are The Choices With A 401 Distribution
When you have a 401 with an employer and you decide to leave the company, you have four basic options:
Cash Out the Plan
If you choose this option, you simply direct the plan trustee to liquidate the account and send you a check.
The account will be closed out, and no further action is necessary.
Advantages: If the balance in the plan is relatively small, like a few thousand dollars, you may decide the money would be better used to pay off debt.
This can make sense if the tax liability on the distribution isnt too high, and the interest youre paying on the debt you intend to pay off is much higher than the investment return in the 401.
Disadvantages: Youll have to pay ordinary income tax on the amount of the distribution, which wont make sense if youre in anything higher than the 12% tax bracket.
But if youre under 59 ½ youll also have to pay the IRS 10% penalty on early distributions.
Keep the 401 with the Previous Employer
This is the simplest choice of all. You decide to do nothing, and leave the account where it is.
Unless the employer has some sort of rule requiring disposition of the account following separation, you can literally leave the money in the plan for the rest of your life.
Advantages: No action is required on your part. If youre satisfied with the investment options in the plan, as well as the plan performance, theres no need to move the money.
Roll the Previous Employer 401 into the New Employers Plan
Do a 401 Rollover to an IRA
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When You Don’t Roll Over
Cashing out your account is a simple but costly option. You can ask your plan administrator for a checkbut your employer will withhold 20 percent of your account balance to prepay the tax youll owe. Plus, the IRS will consider your payout an early distribution, meaning you could owe the 10 percent early withdrawal penalty on top of combined federal, state and local taxes. That could total more than 50 percent of your account value.
Think TwiceThe repercussions of taking money out now could be enormous: If you took $10,000 out of your 401 instead of rolling it over into an account earning 8 percent tax-deferred earnings, your retirement fund could end up more than $100,000 short after 30 years.
If your former employers plan has provided strong returns with reasonable fees, you might consider leaving your account behind. You dont give up the right to move your account to your new 401 or an IRA at any time. While your money remains in your former employers 401 plan, you wont be able to make additional contributions to the account, and you may not be able to take a loan from the plan. In addition, some employers might charge higher fees if youre not an active employee.
Further, you might not qualify to stay in your old 401 account: Your employer has the option of cashing out your account if the balance is less than $1,000 though it must provide for the automatic rolling over of your assets out of the plan and into an IRA if your plan balance is more than$1,000.
What Do You Do With Your 401 When You Leave Your Job
You may change jobs several times throughout your career, which means you could end up with several retirement accounts. Some options you have for an old 401 include:
Doing a 401 rollover into an individual retirement account or a ROTH IRA at an online brokerage or a robo-advisor.
Rolling over your old 401 into a new employer’s 401 plan.
Keeping it with your former employer.
» Can you have a Roth IRA and a 401? Yes, but there’s more to it than that.
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Choose Where To Open Your New Ira Account
You have a few different options here, but it is important to do your research to make sure you are getting the best deal. Most people choose online brokerages because they offer low-cost trading and a wide variety of investment options.
You may also opt for a full-service broker, but this will likely come at a higher cost. Finally, some people choose to set up their IRA account with their current bank.
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Rolling Over To A New 401
If your new employer allows immediate rollovers into its 401 plan, this move has its merits. You may be used to the ease of having a plan administrator manage your money and to the discipline of automatic payroll contributions. You can also contribute a lot more annually to a 401 than you can to an IRA.
Another reason to take this step: If you plan to continue to work after age 72, you should be able to delay taking RMDs on funds that are in your current employer’s 401 plan, including that roll over money from your previous account. Remember that RMDs began at 70½ prior to the new law.
The benefits should be similar to keeping your 401 with your previous employer. The difference is that you will be able to make further investments in the new plan and receive company matches as long as you remain in your new job.
But you should make sure your new plan is excellent. If the investment options are limited or have high fees, or there’s no company match, the new 401 may not be the best move.
If your new employer is more of a young, entrepreneurial outfit, the company may offer a Simplified Employee Pension IRA or SIMPLE IRAqualified workplace plans that are geared toward small businesses plans). The Internal Revenue Service does allow rollovers of 401s to these, but there may be waiting periods and other conditions.
Types Of Individual Retirement Accounts
There are several types of IRAs. The Roth IRA allows you to make after-tax contributions and affords tax-free withdrawals in retirement. A traditional IRA allows you to make pre-tax contributions into a tax-deferred account, and withdrawals are subject to taxes in retirement .
Take note that after-tax and pre-tax refers to your income. When it comes to a Roth IRA, it wont be taxed because you already paid taxes on your money , and with a traditional IRA, since your money hasnt been taxed yet, you pay later.
Either way, both the traditional and Roth IRAs are independently managed. You can choose whichever financial institution youd like to manage and service your retirement account, whether its an international bank or a local investment firm. The IRA owner can choose to place the retirement savings that constitute his IRA funds into the care of a plan administrator or choose to manage their own self-directed IRA.
A self-directed IRA should not be confused with a SEP IRA, which is an IRA geared toward self-employed individuals and may or may not be under the care of an IRA custodian.
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Take Caution With Indirect Rollovers
Rollovers may be done as direct or indirect, but they are not managed the same.
Direct – A direct rollover is where the funds are transferred directly from one retirement account to another as the owner you never touch the funds. Doing a direct rollover avoids this negative consequence that may come with an indirect rollover.
Indirect â As the owner you can receive a distribution of your account balance from the plan instead of arranging for a direct rollover. This might not be the best idea. If you take a distribution, the plan administrator typically withholds 20% of the distributable amount for federal income taxes. The 20% is returned in the form of a tax credit in the year the rollover process was completed. When you do this indirect rollover, you can increase the rollover amount, from your own funds, equal to the 20% withholding amount. If you roll over the amount of the check you receive without adding that 20% back, then the amount withheld will be treated as a taxable distribution. You will generally have to pay income taxes on that amount as well as a 10% penalty tax if you are younger than 59 1/2. Also, when you take the cash directly, the IRS only allows you 60 days from the date of receipt of the funds to rollover the funds to another plan or IRA.
Additional rollover caveats
Rolling Over Your Old 401 To A New Employer
Many companies offer 401 plans, so people often end up having multiple 401s over their years in the workforce. If youd rather keep your funds in a single 401 or dont want to open an IRA, you might have the option of transferring assets from your old 401 to your new one at your current job. If not, youll need to keep an eye on how each is performing individually.
The process for this is as simple as talking to both your current and past plan providers to make sure they will both accept a transfer of assets. While the providers can offer more specific instructions, youll likely use one of the methods above to complete the rollover.
Note that not all plan providers will accept employees past 401 funds as a rollover. This is because they may not be willing to add more assets to the plan, which could overwhelm it.
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