Given the recent economic situation, many people have been faced with job changes. If you have changed employers recently or even in the past, you may be contemplating what to do with your former employer’s sponsored retirement plan account. Our article this month will address this topic and some of the options you may have for your retirement plan at a former employer. Throughout the article, we will primarily discuss your options if you have a 401(k). However, if you have another form of an employer sponsored retirement account, you may have similar options to the ones discussed below. Whether someone leaves their job or retires, employees that participate in company sponsored 401(k) plans will have a choice on what to do with their 401(k) balance when they are no longer employed by the plan sponsor. Most individuals will consider rolling over their retirement account to an Individual Retirement Account (IRA) or another company sponsored plan at your current employer rather than leave the account in their former retirement plan.
A rollover is simply transferring assets from an employer sponsored retirement plan to another employer retirement plan or to an IRA. If the funds from a former employer’s retirement plan are sent directly to your current employer’s retirement plan or an IRA, it is considered a direct rollover and there should be no tax withholdings nor taxability on the funds that are transferred. If, however, the funds are sent to you personally via a check made out to you, instead of directly to a retirement account or to another custodian, the funds will be considered a distribution. If it is considered a distribution, the plan sponsor is required to withhold 20% of the distribution as an estimated tax payment, essentially the same as wage or W-2 withholding. To avoid having the distribution taxed, you will have to deposit the total amount of the distribution including the tax amount withheld into a retirement account within 60 days from the date of the distribution. This is why most people choose to have a direct plan to plan transfer or IRA rollover because of the required tax withholding and potential current taxability associated with a distribution.
The main advantage of rolling your retirement plan from a prior employer to an IRA account rather than leaving the funds in the prior employer’s plan or rolling the funds to a current employer’s plan, is to give yourself more control over your retirement accounts. In addition, there are potentially a larger number of investment options available in an IRA than the options in most employer sponsored plans. Most employer plans only have a limited number of investment options (10-20) available. Although a plan sponsor will try to provide a range of suitable options, the options can be limited to a select group of mutual funds. In addition, employers usually do not provide the option to buy individual stocks and bonds, except for the company stock if applicable. Assistance with selecting choices for investments is typically limited to online resources or web-based programs.
One exception to our recommendation of rolling over retirement plan funds to an IRA is when an employee separates from an employer and is between the ages 55 and 59 ½. If an employee leaves an employer after the age of 55 and needs income for the next 4 years from their current employer’s 401(k) assets, rolling over the entire balance may not be the best alternative. If a 401(k) is rolled over into an IRA and the employee is 55, a 10% penalty may be assessed on any amount of money that is withdrawn from the IRA, until the retiree reaches 59 ½. The IRS will allow some exceptions to this 10% withdrawal penalty under Internal Revenue Code Section 72(t) (72(t) for short). IRC Section 72(t) requires the account owner to take at least five equal periodic payments on an annual basis from the IRA where the rolled funds are located. These 72(t) payments must occur over five years or until the account owner turns 59 ½, whichever is longer. Though this avoids the 10% penalty, the annual distributions will still be taxed as regular income This method is rarely used, because it has a very specific application and may have adverse income tax effects. As an alternative to using a 72(t) election to make withdrawals from an IRA, the IRS allows for distributions of funds left in a company sponsored plan without the 10% early distribution penalty when you are between the ages of 55-59 ½ if the employee leaves the employer after the age of 55. If you find yourself in this situation, it may be beneficial to leave some or all the assets in a company 401(k) plan in order to avoid the 72(t) distributions and 10% penalty. Because this is a fairly technical method of avoiding the 10% early withdrawal penalty, you should consult your tax preparer for guidance if you are in the position.
Another possible reason not to roll over 401(k) funds involves owning appreciated employer stock in a 401(k). If you are in this situation, it may be advantageous to distribute the stock to a taxable investment account rather than an IRA. When an individual holds the stock of a former employer in their former employer’s retirement plan, they may have the ability to transfer that stockholding to a taxable investment account and only pay ordinary income taxes on the purchase price (or cost basis) of the stock, rather than the current market value of the stockholding which may be considerably higher than the cost. If the shares are sold outside of the retirement plan or IRA in the future, you, the stockholder, will only be required to pay taxes on the capital gains. Capital gain tax is based on the difference between the cost and the sales price of the stock. Currently, stocks held for more than 12 months qualify for long-term capital gains tax rates which are currently lower than ordinary income tax rates. For example, John owns company stock with a cost basis of $50,000 that now has a market value of $250,000. If John were to take a distribution of this stock and place it in a taxable investment account, then the ordinary income amount that is reported to the IRS upon distribution from the 401(k) would be $50,000, even though it has a $200,000 gain. If this stock was distributed and later sold in a taxable account, the $200,000 gain would be taxed at currently preferential capital gain rates. If instead the stock was transferred, sold, and then distributed from an IRA, the entire $250,000 would be taxed upon distribution at ordinary income tax rates.
Whether either of the above options will apply will be based largely on an individual’s specific situation. But you should speak with a qualified tax professional to see if which option may be right for your circumstances. In addition, this article largely focuses on 401(k) accounts, although a lot of these rules may apply to other employer provided retirement accounts. Please contact us if you have any questions about the article or retirement accounts in general.