As we kick off 2021 and you begin thinking about money moves you want to make this year, we want to provide you with some insights on a common rollover and some costly mistakes associated with it.
First, we want to distinguish the rules that differ between 401k plans and IRA’s. If the rollover process is done incorrectly, it could be considered a distribution, which would make it subject to taxation and, possibly, an early withdrawal penalty. If you’re not careful, you could make costly errors or lock yourself into a move that can’t be easily undone.
Both 401(k) plans and IRAs have the common purpose of letting you put away tax-advantaged money savings for retirement. However, there are some rules that differ between the two. Even the rollover process itself can come with snags if you’re not careful.
Here are some things to be aware of before initiating a rollover. These apply to traditional 401(k) plans and IRAs, whose contributions are generally made pre-tax.
The rollover process
Once you’ve decided to move your retirement money to an IRA, it’s best to avoid receiving a check made out directly to you from the 401(k) plan, even if it is sent to you.
Assuming you have the rollover account set up and ready to receive the funds from the 401(k), the check should be made out to the IRA custodian or the benefit of you. In this case, there is no tax withholding.
If the check is payable to you, though, it is initially considered a distribution. That means your 401(k) plan is required to withhold 20% for taxes. Otherwise, that withheld amount is considered a distribution and potentially subject to an early withdrawal penalty if you are younger than age 59½. You have 60 days from the date you receive an IRA or retirement plan distribution to roll it over to another plan or IRA. The IRS may waive the 60-day rollover requirement in certain situations if you missed the deadline because of circumstances beyond your control.
Next, make sure you are specifying that you want to do a direct rollover. Some retirement savers hold company stock in their 401(k) alongside other investments. In that situation, if you roll over all those assets to an IRA, you lose the potential to get a more favorable tax treatment on any growth those shares had while in your 401(k).
It gets a bit confusing, but the idea is that if the company stock has unrealized gains, you transfer it to a brokerage account instead of rolling the money over to the IRA along with your other 401(k) assets. Upon transferring, you are taxed on the cost basis (the value of the stock when you first acquired it in your 401(k).
However, when you then sell the shares from your brokerage account — whether immediately or down the road — any growth the stock experienced inside the 401(k) would be taxed at long-term capital gains rates (0%, 15% or 20%, depending on the rest of your income). This could be less than the ordinary-income tax treatment you’d face if the stock went into a rollover IRA and then were withdrawn.
The rule of 55
If you leave your job at age 55 or older and want to access your 401(k) money, the Rule of 55 allows you to do so without penalty. Whether you’ve been laid off, fired or simply quit doesn’t matter—only the timing does. Per the IRS rule, you must leave your employer in the calendar year you turn 55 or later to get a penalty-free distribution. (The rule kicks in at age 50 for public safety workers, such as firefighters, air traffic controllers and police officers.) So, for example, if you lost your job before the eligible age, you would not be able to withdraw from that employer’s 401(k) early; you’d need to wait until you turned 59½.
It’s also important to remember that while you can avoid the 10% penalty, the rule doesn’t free you from your IRS obligations. Distributions from your 401(k) are considered income and are subject to federal taxes.
What spouses should know
If you are the spouse of someone who plans to roll over their 401(k) balance to an IRA, be aware that you’d lose the right to be the sole heir of that money. With the workplace plan, the beneficiary must be you, the spouse, unless you sign a waiver. Once the money lands in the rollover IRA, the account owner can name any beneficiary they want without their spouse’s consent.
Here’s another potential misstep: Making a withdrawal from your 401(k) to give to your ex-spouse as dictated in a divorce agreement. That won’t work — the money will be considered a distribution to you, subject to taxation, as well as potentially a penalty if you’re under age 59½.
In a divorce, retirement assets that are awarded to the ex-spouse can only be distributed penalty-free via a qualified domestic relations order, or QDRO. That document is separate from the divorce decree and must be approved by a judge.
When rolling over money to an IRA, there are many steps and factors to think about. In many instances, it may be best to consider seeking the guidance of a financial professional. If you find yourself in this situation, we would be happy to help and walk you through your rollover. To inquire more, schedule a free 30-minute consultation on our site.