Posted by Income Taxes and Bookkeeping LLC

What is a 401k Rollover?

What is a 401k Rollover?

If you lose or quit your job, your 401k retirement savings can come with you. There are options for your 401k funds when this happens, and one is to switch to an Individual Retirement Account (IRA). The IRS allows you to direct the rollover to another plan or IRA. Sometimes it helps to have a financial advisor to help you clarify your options and make decisions.


Know your options

When you quit your job, there are four options for your 401(k) account. You can:

  • Keep your money in the current plan if your employer allows it (some don't, especially for low-balance accounts).

  • Switch to your new employer's pension plan (if available).

  • Roll it over to an IRA.

  • Take the money. You can consult your accountant before proceeding. After receiving the money, you may have to pay distribution taxes, including a 10% penalty if you are under age 55, which can reduce your retirement savings. When you receive money directly, the IRS only allows 60 days from the date the funds are received to roll over the funds to another plan or IRA.

If you leave your money in the current employer plan or switch to a new employer plan, you will be limited by the rules of that plan and the options it offers. Typically, you can withdraw funds without a 10% prepayment penalty from a 401K if you leave your employer at age 55 or older. With an IRA, you usually have to wait until age 59 and a half to withdraw funds and avoid a 10% early withdrawal penalty. Also, if you leave your money in your current plan, you will not be able to make contributions or take out loans in most cases. And you may need to pay additional services or administrative fees, as well as the option of transaction limits.

Depending on the circumstances, keeping the funds with your former employer may be a good idea.


Rollover to an IRA may mean delayed tax increases.

If you switch to an IRA, you can have a wide variety of investment options, including options that employers may not offer, such as mutual funds, annuities, and certificates of deposit. This option allows your funds to continue to grow on a tax-deferred basis. And you can make your financial life easier by moving your account to a company where you already have funds or even an existing IRA.

If you choose a Traditional IRA, you won't pay taxes when you renew. If you roll the money to a Roth IRA, you will be charged the money you deposited into your account, but you will not pay federal income tax when you withdraw the money (after you turn 59½ and have had the account for five or more years). Money from a Roth 401k can be transferred to a Roth IRA for free.

When rolling over a 401k balance to an IRA, it is important to make a thorough comparison of the differences in collateral and protection offered by each type of account and the differences in liquidity/loan, types of investments, costs, and any penalties.


Steps to rollover 401k to an IRA

The process is simple:

  • Find an IRA investment that's right for you (like an annuity, bank CD, or mutual fund). You will need to do some research or talk to someone in the financial industry to find out which options are right for you.

  • Contact your former employer's plan administrator and arrange for a direct transfer to your new IRA custodian. The exact procedure may vary slightly from company to company, but don't worry, they have dealt with this request before.

  • Sign the documents to roll over funds directly to your new account. The funds will then arrive in your IRA for investment.


Beware of an indirect rollover

Rollovers can be done directly or indirectly, but they are not managed in the same way.

Direct: A direct rollover is when funds are transferred directly from one retirement account to another; as the owner, you never touch the funds. Performing a direct rollover avoids this negative consequence that can result from an indirect rollover.

Indirect: As an owner, you can receive a distribution of your plan account balance instead of arranging a direct rollover. It might not be the best idea. If you accept a distribution, the plan administrator typically withholds 20% of the distributable amount for federal income tax. 20% is returned in the form of a tax credit in the year the process was completed. By performing this indirect rollover, you can increase the rollover value, with your resources, equal to the withholding value by 20%. If you renew the amount of the check received without adding this 20%, the amount withheld will be treated as a taxable distribution. You will generally have to pay income tax for this amount, plus a 10% penalty if you are not up to 59½. Additionally, when you receive money directly, the IRS only allows 60 days from the date the funds are received to roll over the funds to another plan or IRA.


Additional rollover warnings

  • Only one indirect rollover is authorized per 12 month period (not a calendar year).

  • Rollovers must be made from one account to another, not to multiple accounts.


Exceptions

While most cancellations of 401(k) or other qualifying plans by participants under the age of 59.5 are subject to a 10% early cancellation fee, there are five exceptions to this rule. Withdrawals are permitted without penalty in the following cases: 

  • Withdrawals to pay IRS taxes

  • Distributions to the participant's estate after death

  • Distributions to a participant with a permanent disability

  • Distributions for unreimbursed medical expenses that exceed a maximum of 10% of the participant's adjusted gross income for that year.

  • Distributions taken as part of a series of substantially equal recurring payments approved by the IRS


The Net Unrealized Appreciation (NUA) Rule

Employees who bought shares in your company under the 401(k) plan may receive favorable tax treatment on their shares when they roll over the remainder of the plan balances, provided certain rules are followed.

If your account includes publicly traded stocks of the company you work for, you can remove them from 401(k) and place them in a taxable brokerage account for more favorable tax treatment. The difference between the value of shares at the time of purchase and their current value, also known as net unrealized appreciation (NUA), is only subject to capital gains, not income tax higher.

This rule can reduce the total tax collection for employees who have accumulated a large number of shares in their business plans over time.


Conclusion

The tax rules for 401(k) rollover can be straightforward for those who choose to receive cash distributions or leave the plan balances where they are. The rules for those who choose to retain the tax benefit status of their plan balances can be complex, but opting for a direct rollover will generally remove any tax trap for the participant. 


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