When NOT to Rollover your 401k
Whether someone leaves his or her job or retires, employees that participate in company sponsored 401k plans will have a choice on what to do with their 401k balance when they are no longer employed by the plan sponsor. Most individuals will consider a rollover of their plan to an IRA account or another company sponsored plan rather than leaving the assets with his or her ex-employer.
A rollover is simply withdrawing assets from one qualified plan and depositing them into another. According to the current IRS rules, the deposit has to take place 60 days [other than a trustee to trustee transfer] from when the distribution is taken from the old plan or the distribution would be taxable as ordinary income. Additionally, the IRS requires that plan sponsors withhold 20% of the distribution for estimated taxes if the funds are being sent directly to the employee or account owner. To qualify for the 60 day rollover, the account owner would have to deposit 100% of the distribution amount to receive back the 20% withheld when their taxes are filed. Depositing less than 100% of the distribution amount may result in taxes and/or early withdrawal penalties. Obviously, coming up with the 20% withheld would be difficult for many participants if the account balance was substantial. The IRS allows this step to be avoided provided the 401k funds are sent “directly” to the new plan; thus the term “direct rollover” which is also called a “Trustee to Trustee transfer.”
The main advantage of doing a “direct rollover” into an IRA is to give the investor more control and the freedom to invest in a larger number of options than are usually available in a 401k plan. Most 401k plans have a limited number of investment options available. Although the plan sponsor will try to provide a range of options suitable for everyone, usually the options are limited to a select group of mutual funds. Most 401k plans usually do not provide the option to buy individual stocks and bonds, other than the company sponsor’s stock, and professional assistance is not always available from the plan sponsor. Plan sponsored assistance with selecting choices for investment is usually limited to online articles or web based programs.
Rolling over assets, especially larger amounts, to investment firms where personal assistance can provide professional guidance and personal service is usually the best choice.
One exception to this recommendation is when an employee retires and is over 55 years old. If an employee retires after the age of 55 and needs income from their 401k assets, rolling over the entire balance may not be the best alternative. If a 401k is rolled over into an IRA and the employee is 55, a 10% penalty on the amount of the withdrawal will be assessed until the retiree reaches 59 ½. If the funds are in an IRA, the IRS will allow an exception under Internal Revenue Code section 72(t) as long as the funds are taken as “substantial equal payments.” The rules to calculating 72(t) distributions can be cumbersome and rigid. Along with other disadvantages which go beyond the scope of this discussion, 72(t) distributions should be avoided if possible.
Fortunately, the IRS allows for distributions from a “company sponsored plan” before age 59 ½ without the 10% penalty as long as the employee retires after they reach the age of 55. If the employee retires before age 55, then this rule will not apply and distributions taken from a qualified plan may be subject to the 10% penalty or 72(t) distributions may be required.
Therefore, it may be beneficial to leave some or all assets in a company 401k plan in order to avoid the complexity of 72(t) distributions and the 10% penalty. To illustrate, assume John turns 55 in July and decides to retire in December. Due to his individual circumstance, he will need $3,000 of income per month from his 401k investments in order to meet his living expenses. John has $1.5 million in his 401k and is planning to roll over his 401k to a brokerage firm so that he may invest in a wide variety of investments. If John rolls over his entire balance to the brokerage firm, he would then need to setup 72(t) distributions in order to receive his needed income and avoid the 10% penalty.
This will need to remain in place for 5 years or until he reaches age 59 ½. The alternative strategy would be to leave enough funds ($180,000) in the 401k plan to fund the monthly distributions ($3,000 x 48 months = $180,000) and rollover the balance to the brokerage firm. The balance in the 401k would be invested in the most conservative choices available in the plan while the IRA can be invested according to their overall investment objectives. Unlike 72(t) distributions, this would allow John to have more flexibility in case the distributions amounts need to be changed. John may leave more in the 401k if he wants to account for unexpected expenses. After John turns 59 ½, he can then draw income from his IRA account once the 401k is depleted.
Another possible reason not to roll over 401k funds involves highly appreciated company stock held in a 401k. When an employee holds a large amount of company stock that has appreciated in value, it may be advantageous to take a distribution and pay the applicable taxes. One key factor used to determine if this strategy would be beneficial is the cost basis of the stock. If shares of company stock are distributed from a 401k, the amount included in ordinary income is the stock’s cost basis, not the current market value. For example, if John has $250,000 of company stock with a cost basis of $50,000, the taxable amount that is reported to the IRS is $50,000. Ordinary income tax rates would apply. The stock now has a cost basis of $50,000 and Net Unrealized Appreciation (NUA) of $200,000. When and if the shares are sold, the NUA is subject to the prevailing long-term capital gains rate (current maximum = 15%). If the shares were rolled over to an IRA, the proceeds from selling would eventually be taxed as ordinary income when a distribution is eventually taken.
Whether either of these situations will make sense clearly depends on each individual situation. Before taking any action, you should speak with a qualified tax professional to see the effects of either of these strategies on your individual situation. If you should have any questions, please call me at 504-835-1135 or email me at MNobile@CrescentSterling.com.