When you change jobs, you can make a tax-free rollover of your 401(k) to an IRA. Often, that’s a good idea. IRAs generally offer broader investment choices than you get in a 401(k). Moreover, if you switch jobs several times during your career, your retirement savings will be easier to manage if you consolidate the money in one place.
Yet while a rollover often makes sense, rules governing such transfers are complicated and unyielding. Make a mistake and you could pay penalties and taxes and negate the benefits of moving to the IRA in the first place. Consider these pitfalls:
Failing to do a direct rollover. It’s your last week at work, and when your personnel department asks what to do with your 401(k) balance, you request a check. As long as you redeposit the account’s full value in an IRA within 60 days, you won’t owe income tax or a 10% penalty for withdrawing retirement money before age 59½. (If you’re at least 55 when you leave your job, you can keep the money without penalty.) However, your employer must withhold 20% on the amount of your check—and if you have, say, $500,000 in your 401(k), that means your check will be for just $400,000. Yet to avoid taxes and penalties, you’ll have to deposit the full $500,000 in your rollover IRA. Where will the extra money come from? Unless you have that much sitting in a bank account, you may have to sell investments in a taxable account to raise the cash, and that could generate capital gains taxes. Assuming you do meet the 60-day deadline, you’ll eventually get back much of the $100,000 your employer withheld, but not until the following year, after you’ve filed your federal taxes. (Whether you get the full amount depends on your overall tax situation for the year.) A better way: You could direct your company plan to roll over the money directly to your IRA and avoid this problem.
Rolling over company stock. Stock in your company that’s held in your retirement plan is often eligible for special treatment when you leave a job. So moving the shares to a taxable account may be better than cashing out and rolling over the proceeds to an IRA. If you take the shares, you’ll owe regular income tax on what you paid for them. And if you are under 59½ , you will also owe a 10% IRS early-withdrawal penalty. Assuming you are over 59½, in the 35% tax bracket, and that your original cost for the stock was $100,000, you’ll owe $35,000 if you withdraw the shares and place them in a taxable account. But suppose the shares are now worth $200,000. That, as well as any further appreciation, could be taxed at the more favorable long-term capital gains rate of 15%—and only after you sell the stock. So your tax on the appreciation would be just $15,000. And if you never sell, your heirs get a step-up in basis on any appreciation in the stock that occurred after the transfer to the taxable account. If you roll over your shares to an IRA, however, their full value will eventually be taxed as income. So your total bill on the IRA withdrawal, again assuming a 35% rate, would be $70,000 instead of $50,000.
Borrowing from the wrong account. Sometimes people with a temporary cash crunch use the 60-day rollover window to withdraw cash from a former employer’s plan, returning it to a rollover IRA. Yet because of the 20% withholding requirement, this strategy may only exacerbate problems. A better idea is to take the money from a rollover IRA you’ve already established (rather than a 401(k)). Here, too, you have 60 days to return the money without penalty, but there’s no withholding. You’re allowed to make such a transaction once a year.
In these and many other rollover-related transactions—including, for example, the nightmare scenario of splitting a rollover in a divorce settlement—it’s all too easy to get it wrong. If you’re considering a rollover, we can help you avoid mistakes and chart a course that fits your financial situation.