Rolling Over a 401(k)? Avoid These Common Mistakes
Did you take a new job recently? If so, you may be wondering what to do with your old 401(k) account. Should you roll your old account into your new employer’s 401(k) or a different type of retirement account? Before you make any decisions, do your homework first, or consider enlisting the help of your financial advisor to help determine what’s best for your situation. Among the items you’ll want to consider:
- How the fees and expenses in your new employer’s plan compare to other options, such as an IRA;
- The available services, investments, or products offered;
- Whether your new employer offers to match your contributions and, if so, to what extent;
- Any tax consequences now or in the future;
- Beneficiary designations;
- How distributions under the plan would work;
- Whether the plan offers the internal ability to make 401(k) to Roth 401(k) rollovers;
- Whether you should pursue a rollover strategy outside your new employer’s 401(k).
If you do decide that rolling over your old 401(k) to your new employer’s 401(k) plan is your best option, making that transition can also be tricky. Here are five common mistakes people often make with their 401(k) rollovers:
1 – Failing to take action.
When it comes to rolling over a 401(k), doing nothing is, in effect, doing something – and it may not be in your best interests, but it may be the best immediate solution until you have time to consider if the new plan is best for you. If you leave your 401(k) with your previous employer, you can no longer contribute or receive matching dollars (if previously offered), but it doesn’t prohibit you from contributing to a new employer plan and obtaining any match that an employer offers. Just remember, if you leave orphan accounts at past employers, you may not remember where all of your accounts live, and it becomes more difficult to manage a comprehensive strategy with multiple accounts.
2 – Failing to complete your rollover within 60 days.
Rollovers of retirement plans must take place within a 60-day window, according to the IRS. A direct rollover, from your previous employer’s plan to your new employer’s plan, can be the fastest way to make the transfer and ensures you won’t be taxed on the amount as if it were a distribution. A direct rollover may be a custodian-to-custodian transfer, or it may be a check made out to your IRA.
3 – Using an “indirect rollover” to transfer your money.
If you elect to have your previous employer distribute your rollover money directly to you, your employer must withhold taxes, even if you intend to deposit the money into your new retirement account within 60 days. You would also have to make up the difference of that withheld amount out-of-pocket when you complete your full rollover to avoid having the IRS treat the difference in amounts as a taxable event, which could also include a 10% penalty if you don’t meet age or other exceptions. Doing a direct rollover is easier and helps you avoid worrying about tax implications or coming up with cash out-of-pocket to do so.
4 – Simply withdrawing the money in your 401(k) account.
As you leave your previous employer, you may be tempted to use the money in your old 401(k) account to pay bills or make a major purchase, but doing so may cost you more than you think. First, the IRS will impose a 10% penalty if you are below the age of 59 ½, unless you qualify under the plan for early retirement (which many plans consider age 55), but you must meet separation requirements to avoid the distribution penalty (see 5 below). Next, you’ll need to pay taxes on your withdrawal. If the withdrawal amount is significant, it could push you into a higher tax bracket, which could increase your tax rate. Depending on the requirements of your previous employer’s plan and IRS guidelines, you may be able to withdraw a specific amount to satisfy an “immediate and heavy” financial need, such as medical or funeral expenses or a home purchase or repair, which could save you from paying a 10% penalty. Before you decide to take a withdrawal, be sure you understand the tax and other cash flow needs and consequences of your decision.
5 – Misplaced timing of your rollover.
If you’re considering or are forced by your employer into early retirement, you may not want to roll your 401(k) to another account. That’s because different rules for withdrawals apply when you turn 55. If you leave your money with your previous employer, you may be able to take distributions without having to pay the 10% penalty as early as age 55. However, if you roll the money to a new employer’s 401(k), an IRA, or a different qualified plan, you lose that ability and potentially “lock up” these funds for an additional 4.5 years, squashing or severely limiting your early retirement opportunity. If you have retired early and meet the distribution requirements of your prior employer plan, it may be advisable to leave your plan assets there in case you need a stream of income to augment cash flow in early retirement or between jobs. (By the way, this is one of the most significant missed opportunities we see related to 401(k) rollover scenarios.)
The rules around 401(k) rollovers contain a number of conditions and exceptions but can be fairly straightforward for those who are mid-career and simply changing jobs. If you are considering retiring early and need to withdraw money from your old 401(k), your financial or tax advisor can provide guidance on any potential penalties or tax consequences or complexities you may face.
A client or prospective financial advisory client leaving an employer typically has four options regarding an existing retirement plan (and may engage in a combination of these options): (i) leave the money in the former employer’s plan, if permitted, (ii) roll over the assets to the new employer’s plan, if one is available and rollovers are permitted, (iii) roll over to an Individual Retirement Account (“IRA”), or (iv) cash out the account value (which could, depending upon the client’s age, result in adverse tax consequences). If the financial advisor recommends that a client roll over their retirement plan assets into an account to be managed by the advisor, such a recommendation creates a conflict of interest if the advisor will earn new (or increase its current) compensation as a result of the rollover. When acting in such capacity, a registered investment advisor serves as a fiduciary under the Employee Retirement Income Security Act (“ERISA”), or the Internal Revenue Code, or both. No client is under any obligation to roll over retirement plan assets to an account managed by a financial advisor.
Wayne B. Titus
Financial Advisor / Managing Director