Whether you are just starting out in your career or nearly retired, many people will choose to rollover their 401(k) plan to an IRA at least once in their lifetime.* Of course, the more you have saved, the more you have at stake as you could be rolling over what might be a six or seven-figure sum from your 401(k). However, no matter your financial situation or age, it is best to first weigh the pros and cons of your options before you decide when and how to rollover your funds to help you may avoid common and costly mistakes.
Option #1 – Leave it where it is. If you have more than $5,000 in your 401(k) account, you can keep your money in your previous employer’s plan.
Option #2 – Move it to your new 401(k). It may make sense to roll from one 401(k) plan to another if your plan from your new employer has better selection of investment options, and/or lower fees than your previous one. It is important to note that distributions are subject to a mandatory 20 percent federal income tax withholding, unless directly rolled to another eligible plan. So you will want to arrange a direct plan to plan rollover.
Option #3 – Move it to an IRA. There are also specific advantages of rolling your funds out of a 401(k) directly into an IRA. First of all, with most employer qualified retirement plans, the plan Trust is the owner and participants are bound by the constraints of the plan. On the other hand, IRA account holders are the owners of their plans and may have more flexibility.
You can’t borrow from an IRA, but they typically offer a greater number of investment options. IRAs can also provide more beneficiary options and other advantages such as control and flexibility. With IRAs, you also have the option to roll it back over again to a 401(k) plan with your new employer if your new employer’s plan allows it.
Furthermore, with IRAs, when you are eligible, you may have more options on how to take distributions. While considering your options, there are also some very common mishaps to watch out for including:
Mistake #1: Spending It. It may sound obvious to say do not cash a lump sum out of your current plan and spend it or take premature distributions, but that is exactly what many people do. Not only will you owe income taxes on the money you withdraw but also a 10 percent penalty if you are under 59 ½. If you are 59 ½ or if you separate from service the year you turn 55, you can access your 401(k) assets without a 10 percent penalty.
Mistake #2: Failing to Properly Designate an Account Beneficiary. Should you name your spouse as a beneficiary or instead name your children? Learn the tax consequences of choosing one beneficiary over the other or naming a trust.
Mistake #3: Neglecting to Pay Back Outstanding 401(k) Loans. Failing to pay back a loan taken from your 401(k) before rolling the account over could cause you to pay income tax on the outstanding loan. Furthermore, you may have to pay a 10 percent penalty on the value of the loan if you are not 59 ½.
Mistake #4: Failing to Coordinate a Direct Rollover. Distribution proceeds paid directly to 401(k) participants are subject to 20 percent federal withholding tax. Withholding tax can simply be avoided with direct rollovers coordinated from one plan to another. However, if a participant receives a check from their previous employer, and they deposit the funds with their new employer’s plan or an IRA within 60 days, they can avoid paying current taxes. Just keep in mind that the full amount of the distribution – including the 20 percent tax withheld by the employer – must be transferred within this 60 day period.
Mistake # 5: Relying too heavily on Employers. Most employers are not qualified or licensed to give financial advice, yet many employees look to them for direction on considerations such as distribution options. Choosing the wrong distribution option could cost you a lot of money and headaches. Be sure to seek the professional advice of a qualified financial advisor who can help you make important rollover decisions and integrate them into a personalized financial plan.
Mistake # 6: Rolling over highly appreciated Company Stock. If you own company stock that has appreciated significantly, you could end up paying ordinary income tax instead of long term capital gains. Depending on what tax bracket you are in, the difference could more than double the taxes that you pay. This is a fairly complicated tax issue known as Net Unrealized Appreciation, and it is important that you execute your rollover correctly so that you do not lose this benefit.
The Registered Investment Advisory firm of Benedetti, Gucer & Associates is based in Atlanta, GA and provides comprehensive wealth management for clients across the United States. Their fee-based, fiduciary advisors can help you develop a holistic plan to manage your investments in a more tax-efficient manner.
*To rollover a 401(k) plan there needs to be a triggering event, such as changing employers, to allow a participant to rollover their accounts.
The views expressed represent the opinions of Benedetti, Gucer & Associates and are subject to change. These views are not intended as a forecast, a guarantee of future results, investment recommendation, or an offer to buy or sell any securities. The information provided is of a general nature and should not be construed as investment advice or to provide any investment, tax, financial or legal advice or service to any person.
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