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Oftentimes when folks are considering leaving employment, the decision to rollover 401(k) to an IRA is a no-brainer. After all, why would you leave your retirement funds at the mercy of the constricted, expensive investment choices and other restrictions of your old company’s 401(k) administrator, when you can be free to invest in any (well, most any) investment you choose, keeping costs down, and completely within your own control in an IRA?
Well, for some folks this decision isn’t the straightforward choice that it seems to be, for the very important reason of access to the funds before reaching age 59½ (see this article for more info about The Post-55 Exception to the 10% Penalty for Withdrawals from 401(k)). Since only within a 401(k) (or other employer-sponsored plans) can you take advantage of this early withdrawal exception, it might be in your best interests to think about your rollover choice before automatically rolling over into an IRA. This is only important if you are under age 59½, of course – and much more important if you’re under age 55 when you leave your old employer.
Why it’s important
If you are under age 59½ and you have a sudden need for the funds that you’ve saved over the years in your old 401(k), and you’ve rolled over the funds into an IRA, you will have to pay a 10% penalty in addition to the ordinary income tax on your withdrawal, unless you meet one of the other exceptions to the early withdrawal penalty.
However, if you rollover the old 401(k) into another 401(k) (or 403(b), et al), you will preserve your opportunity to withdraw those funds if you leave employment at the job associated with the new 401(k) plan after you’ve reached age 55.
How can this work in your favor?
If you start work with another employer, as long as the new employer offers a 401(k) plan that accepts “roll-in” of 401(k) plan money and IRAs, you can rollover those old plans into the new plan, which will keep your options for access open should you need them upon leaving employment after age 55.
That’s not really under your control so much, is it? How about this: as you’re leaving employment at the old employers, if you have the opportunity to start your own business – such as consulting, or perhaps some part-time business – you can start your own Solo 401(k) plan and rollover the funds from your old plan(s) and IRAs if you have them. Then, on the chance that you’d need the money later on after you’re at least age 55 (but not yet 59½), assuming that you can end your employment in your consultancy or other self-employment activity, you can then have access to those funds in your Solo 401(k) plan without penalty.
If you go the self-employment route, you need to make sure that the business that you’ve created is valid and legitimate. The IRS doesn’t at all take this lightly – if your business isn’t making money (or at least validly attempting to make money), your actions in creating a 401(k) plan and everything else associated with the business can be considered fraud.
This also applies to the dissolution of the business in order to have access to the retirement funds. If it’s deemed that the only reason you did this was simply to have access, this action could be considered fraud as well. This could come about if you dissolved the original business and then shortly afterward started a similar business again, for example.
Of course, as with attempts to “work the system” in your favor, there are usually downsides to the matters. In addition to the concerns about fraud mentioned before, there is the matter of control. If you roll-in your funds from the old employer to another 401(k) plan and you remain employed with that new job past age 59½ you will give up access to those funds unless the new plan allows in-service distributions.
Say for example you left an old company at age 50 and started work with a new company, rolling over your money from old employer’s 401(k) plan to the new plan. Then you work until age 65 at the new employer. Unless the new employer’s 401(k) plan allows in-service distributions, you can’t get to the funds until you retire at age 65. Had you left the money at the old employer (or rolled it over to an IRA) you would have had access to the money from the old plan free of penalty or restriction once you reached age 59½.
What do you think? Do you see any other downsides to this type of plan? How about other ways to use these rules to your advantage? I’d love to see your thoughts on the subject – leave a comment below.