Watch Out for These Six Potential 401(k) Rollover Pitfalls

You’re about to receive a distribution from your 401(k) plan, and you’re considering a rollover to a traditional IRA. While these transactions are normally straightforward and trouble free, there are some pitfalls you’ll want to avoid.

401kRollovertoIRA1. The first mistake some people make is failing to consider the pros and cons of a rollover to an IRA in the first place. You can leave your money in the 401(k) plan if your balance is over $5,000. And if you’re changing jobs, you may also be able to roll your distribution over to your new employer’s 401(k) plan.

Though IRAs typically offer significantly more investment opportunities and withdrawal flexibility, your 401(k) plan may offer investments that can’t be replicated in an IRA (or can’t be replicated at an equivalent cost).

401(k) plans offer virtually unlimited protection from your creditors under federal law (assuming the plan is covered by ERISA; solo 401(k)s are not), whereas federal law protects your IRAs from creditors only if you declare bankruptcy. Any IRA creditor protection outside of bankruptcy depends on your particular state’s law.

401(k) plans may allow employee loans.

And most 401(k) plans don’t provide an annuity payout option, while some IRAs do.

2. Not every distribution can be rolled over to an IRA. For example, required minimum distributions can’t be rolled over. Neither can hardship withdrawals or certain periodic payments. Do so and you may have an excess contribution to deal with.

file0002903222023. Use direct rollovers and avoid 60-day rollovers. While it may be tempting to give yourself a free 60-day loan, it’s generally a mistake to use 60-day rollovers rather than direct (trustee to trustee) rollovers. If the plan sends the money to you, it’s required to withhold 20% of the taxable amount.

If you later want to roll the entire amount of the original distribution over to an IRA, you’ll need to use other sources to make up the 20% the plan withheld. In addition, there’s no need to taunt the rollover gods by risking inadvertent violation of the 60-day limit.

4. Remember the 10% penalty tax. Taxable distributions you receive from a 401(k) plan before age 59½ are normally subject to a 10% early distribution penalty, but a special rule lets you avoid the tax if you receive your distribution as a result of leaving your job during or after the year you turn age 55 (age 50 for qualified public safety employees). But this special rule doesn’t carry over to IRAs.

If you roll your distribution over to an IRA, you’ll need to wait until age 59½ before you can withdraw those dollars from the IRA without the 10% penalty (unless another exception applies). So if you think you may need to use the funds before age 59½, a rollover to an IRA could be a costly mistake.

5. Learn about net unrealized appreciation (NUA). If your 401(k) plan distribution includes employer stock that’s appreciated over the years, rolling that stock over into an IRA could be a serious mistake. Normally, distributions from 401(k) plans are subject to ordinary income taxes. But a special rule applies when you receive a distribution of employer stock from your plan: You pay ordinary income tax only on the cost of the stock at the time it was purchased for you by the plan.

Any appreciation in the stock generally receives more favorable long-term capital gains treatment, regardless of how long you’ve owned the stock. (Any additional appreciation after the stock is distributed to you is either long-term or short-term capital gains, depending on your holding period.) These special NUA rules don’t apply if you roll the stock over to an IRA.

6. And if you’re rolling over Roth 401(k) dollars to a Roth IRA…If your Roth 401(k) distribution isn’t qualified (tax-free) because you haven’t yet satisfied the five-year holding period, be aware that when you roll those dollars into your Roth IRA, they’ll now be subject to the Roth IRA’s five-year holding period, no matter how long those dollars were in the 401(k) plan. So, for example, if you establish your first Roth IRA to accept your rollover, you’ll have to wait five more years until your distribution from the Roth IRA will be qualified and tax-free.

Converting Your After-Tax 401(k) Dollars to a Roth IRA

Here’s the dilemma: You have a traditional 401(k) that contains both after-tax and pre-tax dollars. You’d like to receive a distribution from the plan and convert only the after-tax dollars to a Roth IRA. By rolling over/converting only the after-tax dollars to a Roth IRA, you hope to avoid paying any income tax on the conversion.

piggy-bank-661969_1280For example, let’s say your 401(k) plan distribution is $10,000, consisting of $8,000 of pre-tax dollars and $2,000 of after-tax dollars. Can you simply instruct the trustee to directly roll the $8,000 of pre-tax dollars to a traditional IRA and the remaining $2,000 of after-tax dollars to a Roth IRA?

In the past, many trustees allowed you to do just that. But in recent years the IRS had suggested that this result could not be achieved with multiple direct rollovers. Instead, according to the IRS, each rollover would have to carry with it a pro-rata amount of pre-tax and after-tax dollars. The legal basis for this position, however, was not entirely clear.

And while some experts suggested that it might be possible to achieve a tax-free Roth conversion of after-tax dollars using 60-day rollovers, the process was fairly complicated, and it required taxpayers to have sufficient funds outside the plan to make up the 20% mandatory withholding that would apply to the taxable portion of the distribution.

IMG_0920IRS Notice 2014-54
Thankfully, in Notice 2014-54 (and related proposed regulations), the IRS has backed away from its prior position. The Notice makes it clear that you can split a distribution from your 401(k) plan and directly roll over only the pre-tax dollars to a traditional IRA (with no current tax liability) and only the after-tax dollars to a Roth IRA (with no conversion tax). The IRS guidance, which took effect January 1, 2015, also applies to 403(b) and 457(b) plans.

When applying Notice 2014-54, it’s important to understand some basic rules (also outlined in the Notice). First, you have to understand how to calculate the taxable portion of your distribution. This is easy if you receive a total distribution–the nontaxable portion is your after-tax contributions, and the taxable portion is the balance of your account. But if you’re receiving less than a total distribution, you have to perform a pro-rata calculation.

This is best understood using an example. Assume your 401(k) account is $100,000, consisting of $60,000 (six tenths) of pre-tax dollars and $40,000 (four tenths) of after-tax dollars. You request a $40,000 distribution. Of this $40,000, six tenths, or $24,000, will be taxable pre-tax dollars, and four tenths, or $16,000, will be nontaxable after-tax dollars.

What this means is that you can’t, for example, simply request a distribution of $40,000 consisting only of your after-tax dollars. The Notice requires that you treat all distributions you receive at the same time as a single distribution when you perform this pro-rata calculation (even if you subsequently roll those distributions into separate IRAs).

Taking this example a step further, could you now direct the trustee to directly transfer the $16,000 of after-tax dollars to a Roth IRA (with no conversion tax) and send the remaining $24,000 to you in a taxable distribution? The answer is no, and this leads to a second basic rule described in the Notice:

Any rollovers you make from a 401(k) plan distribution are deemed to come first from your pre-tax dollars, and then, only after these dollars are fully used up, from your after-tax dollars. If you’re rolling your distribution over into several different accounts, you get to decide which retirement vehicle receives your pre-tax dollars first.

It’s these new rules that allow you to accomplish your goal of rolling over only the after-tax portion of your 401(k) plan distribution into a Roth IRA. Going back to our example, these rules make it clear that you can instruct the 401(k) plan trustee to transfer only your pre-tax dollars–$24,000–to your traditional IRA, leaving the remaining $16,000–all after-tax dollars–to be rolled over to your Roth IRA in a tax-free conversion.

Should You Rollover a 401(k) to an IRA?

If you’re entitled to a distribution from your 401(k) plan (for example, because you’ve left your job, or you’ve reached age 59½), and it’s rollover-eligible, you may be faced with a choice. Should you take the distribution and roll the funds over to an IRA, or should you leave your money where it is?

Across the universe
file000290322202In contrast to a 401(k) plan, where your investment options are limited to those selected by your employer (typically mutual funds or employer stock), the universe of IRA investments is virtually unlimited. For example, in addition to the usual IRA mainstays (stocks, bonds, mutual funds, and CDs), an IRA can invest in real estate, options, limited partnership interests, or anything else the law (and your IRA trustee/custodian) allows.*

You can move your money among the various investments offered by your IRA trustee, and divide up your balance among as many of those investments as you want. You can also freely move your IRA dollars among different IRA trustees/custodians–there’s no limit on how many direct, trustee-to-trustee IRA transfers you can do in a year. This gives you the flexibility to change trustees as often as you like if you’re dissatisfied with investment performance or customer service. It also allows you to have IRA accounts with more than one institution for added diversification.

However, while IRAs typically provide more investment choices than a 401(k) plan, there may be certain investment opportunities in your employer’s plan that you cannot replicate with an IRA. And also be sure to compare any fees and expenses.

Know the Distribution Rules
The distribution options available to you and your beneficiaries in a 401(k) plan are typically limited. And some plans require that distributions start if you’ve reached the plan’s normal retirement age (often age 65), even if you don’t yet need the funds.

file000478245189With an IRA, the timing and amount of distributions is generally at your discretion. While you’ll need to start taking required minimum distributions (RMDs) from your IRA after you reach age 70½ (and your beneficiary will need to take RMDs after you die), those payments can generally be spread over your (and your beneficiary’s) lifetime. (You aren’t required to take any distributions from a Roth IRA during your lifetime, but your beneficiary must take RMDs after your death.) A rollover to an IRA may let you and your beneficiary stretch distributions out over the maximum period the law permits, letting your nest egg enjoy the benefits of tax deferral as long as possible.

The RMD rules also apply to 401(k) plans–but a special rule allows you to postpone taking distributions until you retire if you work beyond age 70½. (You also must own no more than 5% of the company.) This deferral opportunity is not available for IRAs. Note: Distributions from 401(k)s and IRAs may be subject to federal income tax, and a 10% early distribution penalty (unless an exception applies). (Special rules apply to Roth 401(k)s and Roth IRAs.)

Gimme shelter – Don’t Forget About Creditor Protection
file000419755272Your 401(k) plan may offer better creditor protection than an IRA. Assets in most 401(k) plans receive virtually unlimited protection from creditors under a federal law known as ERISA. Your creditors cannot attach your plan funds to satisfy any of your debts and obligations, regardless of whether you’ve declared bankruptcy. (Note: individual (solo) 401(k) plans and certain church plans are not covered by ERISA.)

In contrast, traditional and Roth IRAs are generally protected under federal law only if you declare bankruptcy. Federal law currently protects your total IRA assets up to $1,245,475 (as of April 1, 2013)–plus any amount you roll over from your 401(k) plan. Any creditor protection your IRA may receive in cases outside of bankruptcy will generally depend on the laws of your particular state. If you’re concerned about asset protection, be sure to seek the assistance of a qualified professional.

Let’s stay together
Another reason to roll your 401(k) funds over to an IRA is to consolidate your retirement assets. This may make it easier for you to monitor your investments and your beneficiary designations, and to make desired changes. However, make sure you understand how Federal Deposit Insurance Corporation (FDIC) and Securities Investor Protection Corporation (SIPC) limits apply if you keep all your IRA funds in one financial institution.

Fools rush in
While some 401(k) plans provide an annuity option, most still don’t. By rolling your 401(k) assets over to an IRA annuity, you can annuitize all or part of your 401(k) dollars. Many 401(k) plans have loan provisions, but you can’t borrow from an IRA. You can only access the money in an IRA by taking a distribution, which may be subject to income tax and penalties.

Making the Most of Your 401(k) Plan

A 401(k) plan represents one of the most powerful retirement savings opportunities available today. If your employer offers a 401(k) plan and you’re not participating in it, you should be.

Contribute as much as possible
The more you can save for retirement, the better your chances of enjoying a comfortable retirement. If you can, max out your contribution up to the legal limit ($17,500 in 2013, $23,000 if you’re age 50 or older). If you need to free up money to do that, try to cut certain expenses. (Note: some plans limit the amount you can contribute.)

Why invest your retirement dollars in a 401(k) plan instead of somewhere else? One reason is that your pretax contributions lower your taxable income for the year. This means you save money in taxes immediately when you contribute to the plan–a big advantage if you’re in a high tax bracket. For example, if you earn $100,000 a year and contribute $17,500 to a 401(k) plan, you’ll only pay federal income taxes on $82,500 instead of $100,000.

Another reason is the power of tax-deferred growth. Any investment earnings compound year after year and aren’t taxable as long as they remain in the plan. Over the long term, this gives you the opportunity to build an substantial sum in your employer’s plan. (Your pretax contributions and any earnings will be taxed when paid to you from the plan.)

Consider Roth contributions
Your 401(k) plan may also allow you to make after-tax Roth contributions. Unlike pre-tax contributions, Roth contributions don’t lower your current taxable income so there’s no immediate tax savings. But because you’ve already paid taxes on those contributions, they’re free from federal income taxes when paid from the plan. And if your distribution is “qualified” (that is, the distribution is made after you satisfy a five-year holding period, and after you reach age 59½, become disabled, or die) any earnings are also tax free.

If your distribution isn’t qualified, any earnings you receive are subject to income tax. A 10% early distribution penalty may also be imposed if you haven’t reached age 59½ (unless an exception applies).

Capture the full employer match
Many employers will match all or part of your contributions. If you can’t max out your 401(k) contributions, you should at least try to contribute as much as necessary to get the full employer match. Employer matching contributions are basically free money. By capturing the full benefit of your employer’s match, you’ll be surprised how much faster your balance grows. If you don’t take advantage of your employer’s generosity, you could be passing up a significant contribution towards your retirement.

Access funds if you must
Another beneficial feature that many 401(k) plans offer is the ability to borrow against your vested balance at a reasonable interest rate. You can use a plan loan to pay off high-interest debts or meet other large expenses, like the purchase of a car. You typically won’t be taxed or penalized on amounts you borrow as long as the loan is repaid within five years. Immediate repayment may be required, however, if you leave your employer–if you can’t repay the loan, you may be treated as having taken a taxable distribution from the plan.

And remember that when you take a loan from your 401(k) plan, the funds you borrow are generally removed from your plan account until you repay the loan, so you may miss out on the opportunity for additional tax-deferred investment earnings. So loans (and withdrawals if available) should be a last resort.

Evaluate your investment choices
Choose your investments carefully. The right investment mix could be one of your keys to a comfortable retirement. That’s because over the long term, varying rates of return can make a big difference in the size of your 401(k) plan account.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2013

The Economics of Borrowing from Your 401(k) Plan

When times are tough, that pool of dollars sitting in your 401(k) plan account may start to look attractive. But before you decide to take a plan loan, be sure you understand the financial impact. It’s not as simple as you think.

The basics of borrowing
A 401(k) plan will usually let you borrow as much as 50% of your vested account balance, up to $50,000. (Plans aren’t required to let you borrow, and may impose various restrictions, so check with your plan administrator.) You pay the loan back, with interest, from your paycheck. Most plan loans carry a favorable interest rate, usually prime plus one or two percentage points. Generally, you have up to five years to repay your loan, longer if you use the loan to purchase your principal residence. Many plans let you apply for a loan online, making the process quick and easy.

You pay the interest to yourself, but… When you make payments of principal and interest on the loan, the plan generally deposits those payments back into your individual plan account (in accordance with your latest investment direction). This means that you’re not only receiving back your loan principal, but you’re also paying the loan interest to yourself instead of to a financial institution. However, the benefits of paying interest to yourself are somewhat illusory. Here’s why.

To pay interest on a plan loan, you first need to earn money and pay income tax on those earnings. With what’s left over after taxes, you pay the interest on your loan. That interest is treated as taxable earnings in your 401(k) plan account. When you later withdraw those dollars from the plan (at retirement, for example), they’re taxed again because plan distributions are treated as taxable income. In effect, you’re paying income tax twice on the funds you use to pay interest on the loan. (If you’re borrowing from a Roth 401(k) account, the interest won’t be taxed when paid out if your distribution is “qualified”–i.e., it’s been at least 5 years since you made your first Roth contribution to the plan, and you’re 59½ or disabled.)

…consider the opportunity cost
When you take a loan from your 401(k) plan, the funds you borrow are removed from your plan account until you repay the loan. While removed from your account, the funds aren’t continuing to grow tax deferred within the plan. So the economics of a plan loan depend in part on how much those borrowed funds would have earned if they were still inside the plan, compared to the amount of interest you’re paying yourself. This is known as the opportunity cost of a plan loan, because by borrowing you may miss out on the opportunity for additional tax-deferred investment earnings.

Other factors
There are other factors to think about before borrowing from your 401(k) plan. If you take a loan, will you be able to afford to pay it back and continue to contribute to the plan at the same time? If not, borrowing may be a very bad idea in the long run, especially if you’ll wind up losing your employer’s matching contribution.

Also, if you leave your job, most plans provide that your loan becomes immediately payable. If you don’t have the funds to pay it off, the outstanding balance will be taxed as if you received a distribution from the plan, and if you’re not yet 55 years old, a 10% early payment penalty may also apply to the taxable portion of that “deemed distribution.”

Still, plan loans may make sense in certain cases (for example, to pay off high-interest credit card debt or to purchase a home). But make sure you compare the cost of borrowing from your plan with other financing options, including loans from banks, credit unions, friends, and family. To do an adequate comparison, you should consider:

1) Interest rates applicable to each alternative
2) Whether the interest will be tax deductible (for example, interest paid on home equity loans is usually deductible, but interest on plan loans usually isn’t)
3) The amount of investment earnings you may miss out on by removing funds from your 401(k) plan

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. The tax information provided is not intended to be a substitute for specific individualized tax planning advice. We suggest that you consult with a qualified tax advisor.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2013

Changing Jobs? Take Your 401(k) and … Roll It!

If you’ve lost your job, or are changing jobs, you may be wondering what to do with your 401(k) plan account. It’s important to understand your options.

What will I be entitled to?
If you leave your job (voluntarily or involuntarily), you’ll be entitled to a distribution of your vested balance. Your vested balance always includes your own contributions (pretax, after-tax, and Roth) and typically any investment earnings on those amounts. It also includes employer contributions (and earnings) that have satisfied your plan’s vesting schedule.

In general, you must be 100% vested in your employer’s contributions after 3 years of service (“cliff vesting”), or you must vest gradually, 20% per year until you’re fully vested after 6 years (“graded vesting”). Plans can have faster vesting schedules, and some even have 100% immediate vesting. You’ll also be 100% vested once you’ve reached your plan’s normal retirement age.

It’s important for you to understand how your particular plan’s vesting schedule works, because you’ll forfeit any employer contributions that haven’t vested by the time you leave your job. Your summary plan description (SPD) will spell out how the vesting schedule for how your particular plan works. If you don’t have one, ask your plan administrator for it. If you’re on the cusp of vesting, it may make sense to wait a bit before leaving, if you have that luxury.

Don’t spend it, roll it!
While this pool of dollars may look attractive, don’t spend it unless you absolutely need to. If you take a distribution you’ll be taxed, at ordinary income tax rates on the entire value of your account except for any after-tax or Roth 401(k) contributions you’ve made. And, if you’re not yet age 55, an additional 10% penalty may apply to the taxable portion of your payout. (Special rules may apply if you receive a lump-sum distribution and you were born before 1936, or if the lump-sum includes employer stock.)

If your vested balance is more than $5,000, you can leave your money in your employer’s plan until you reach normal retirement age. But your employer must also allow you to make a direct rollover to an IRA or to another employer’s 401(k) plan. As the name suggests, in a direct rollover the money passes directly from your 401(k) plan account to the IRA or other plan.

This is preferable to a “60-day rollover,” where you get the check and then roll the money over yourself, because your employer has to withhold 20% of the taxable portion of a 60-day rollover. You can still roll over the entire amount of your distribution, but you’ll need to come up with the 20% that’s been withheld until you recapture that amount when you file your income tax return.

Should I roll over to my new employer’s 401(k) plan or to an IRA?
Assuming both options are available to you, there’s no right or wrong answer to this question. There are strong arguments to be made on both sides. You need to weigh all of the factors, and make a decision based on your own needs and priorities. It’s best to have a professional assist you with this, since the decision you make may have significant consequences–both now and in the future.

Reasons to roll over to an IRA:
• You generally have more investment choices with an IRA than with an employer’s 401(k) plan. You typically may freely move your money around to the various investments offered by your IRA trustee, and you may divide up your balance among as many of those investments as you want. By contrast, employer-sponsored plans typically give you a limited menu of investments (usually mutual funds) from which to choose.

• You can freely allocate your IRA dollars among different IRA trustees/custodians. There’s no limit on how many direct, trustee-to-trustee IRA transfers you can do in a year. This gives you flexibility to change trustees often if you are dissatisfied with investment performance or customer service. It can also allow you to have IRA accounts with more than one institution for added diversification. With an employer’s plan, you can’t move the funds to a different trustee unless you leave your job and roll over the funds.

• An IRA may give you more flexibility with distributions. Your distribution options in a 401(k) plan depend on the terms of that particular plan, and your options may be limited. However, with an IRA, the timing and amount of distributions is generally at your discretion (until you reach age 70½ and must start taking required minimum distributions in the case of a traditional IRA).

• You can roll over (essentially “convert”) your 401(k) plan distribution to a Roth IRA. You’ll have to pay taxes on the amount you roll over (minus any after-tax contributions you’ve made), but any qualified distributions from the Roth IRA in the future will be tax free.

Reasons to roll over to your new employer’s 401(k) plan:
• Many employer-sponsored plans have loan provisions. If you roll over your retirement funds to a new employer’s plan that permits loans, you may be able to borrow up to 50% of the amount you roll over if you need the money. You can’t borrow from an IRA–you can only access the money in an IRA by taking a distribution, which may be subject to income tax and penalties. (You can, however, give yourself a short-term loan from an IRA by taking a distribution, and then rolling the dollars back to an IRA within 60 days.)

• A rollover to your new employer’s 401(k) plan may provide greater creditor protection than a rollover to an IRA. Most 401(k) plans receive unlimited protection from your creditors under federal law. Your creditors (with certain exceptions) cannot attach your plan funds to satisfy any of your debts and obligations, regardless of whether you’ve declared bankruptcy. In contrast, any amounts you roll over to a traditional or Roth IRA are generally protected under federal law only if you declare bankruptcy. Any creditor protection your IRA may receive in cases outside of bankruptcy will generally depend on the laws of your particular state. If you are concerned about asset protection, be sure to seek the assistance of a qualified professional.

• You may be able to postpone required minimum distributions. For traditional IRAs, these distributions must begin by April 1 following the year you reach age 70½. However, if you work past that age and are still participating in your employer’s 401(k) plan, you can delay your first distribution from that plan until April 1 following the year of your retirement. (You also must own no more than 5% of the company.)

• If your distribution includes Roth 401(k) contributions and earnings, you can roll those amounts over to either a Roth IRA or your new employer’s Roth 401(k) plan (if it accepts rollovers). If you roll the funds over to a Roth IRA, the Roth IRA holding period will determine when you can begin receiving tax-free qualified
distributions from the IRA. So if you’re establishing a Roth IRA for the first time, your Roth 401(k) dollars will be subject to a brand new 5-year holding period. On the other hand, if you roll the dollars over to your new employer’s Roth 401 (k) plan, your existing 5-year holding period will carry over to the new plan. This may enable you to receive tax-free qualified distributions sooner.

When evaluating whether to initiate a rollover always be sure to (1) ask about possible surrender charges that may be imposed by your employer plan, or new surrender charges that your IRA may impose, (2) compare investment fees and expenses charged by your IRA (and investment funds) with those charged by your employer plan (if any), and (3) understand any accumulated rights or guarantees that you may be giving up by transferring funds out of your employer plan.

What about outstanding plan loans?
In general, if you have an outstanding plan loan, you’ll need to pay it back, or the outstanding balance will be taxed as if it had been distributed to you in cash. If you can’t pay the loan back before you leave, you’ll still have 60 days to roll over the amount that’s been treated as a distribution to your IRA. Of course, you’ll need to come up with the dollars from other sources.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. The tax information provided is not intended to be a substitute for specific individualized tax planning advice. We suggest that you consult with a qualified tax advisor.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2013