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When Rolling Over a 401(k) to an IRA Isn’t a No-Brainer

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Stibnite-121128 (Photo credit: Wikipedia)

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.

Some Cautions

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.

The Downside

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.

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Exceptions to the 10% Early Withdrawal Penalty from IRAs and 401(k)s

English: A clock made in Revolutionary France,...

English: A clock made in Revolutionary France, showing the 10-hour metric clock. (Photo credit: Wikipedia)

When you take money out of your IRA or 401(k) plan (or other qualified retirement plan, such as a 403(b) plan), if you’re under age 59½ in most cases your withdrawal will be subject to a penalty of 10%, in addition to any taxes owed on the distribution.  There are many exceptions to this rule though, and the exceptions are not the same for all types of plans.  IRAs have one set of rules, and 401(k)s have another set of rules.

The exceptions are always related to the purpose for which the money was withdrawn.  The exact same dollars withdrawn do not have to be used for the excepted purpose, just that the excepted expense was incurred.

IRA Exceptions

It is important to know that all distributions from your traditional IRA are subject to ordinary income tax, but some distributions are not subject to the early withdrawal penalty.  The list of exceptions for early withdrawals from IRAs is as follows:

Death of the owner of the IRA – if the owner of the IRA dies, the beneficiaries of the IRA can (in fact, must) take withdrawals from the plan without paying the 10% penalty.

Total and permanent disability of the owner of the IRA – if the owner of the IRA is deemed to be totally and permanently disabled.   You are considered disabled if you can furnish proof that you cannot do any substantial gainful activity because of your physical or mental condition. A physician must determine that your condition can be expected to result in death or to be of long, continued, and indefinite duration.

SOSEPP – With a Series of Substantially Equal Periodic Payments, lasting at least five years or until age 59½ (whichever is longer), there is no 10% penalty applied.

Medical Expenses – if you have medical expenses greater than 7.5% of your Adjusted Gross Income, a distribution from your IRA to cover these expenses (the excess above 7.5% of AGI) will not be subject to the penalty.  Any amounts paid by insurance toward the medical expenses reduces the overall expense counted toward the excepted expenses.

Health Insurance Premiums – if you’re unemployed, you can take a distribution from your IRA to cover your health insurance premiums without paying the penalty.

Qualified higher education expenses – amounts withdrawn from your IRA to pay for tuition, fees, books, supplies, and equipment needed for enrollment or attendance of a student at an eligible higher education institution are not subjected to the penalty.  In addition, if the student is at least a half-time student, room and board expenses paid for with an IRA distribution would not be subject to the penalty.  The amount of education expenses is reduced by any scholarships, grants, and qualified 529 plan distributions; any amount applied to an IRA penalty exception is also not eligible to be used toward education credits, such as the American Opportunity Credit or the Lifetime Learning Credit.

First-time home purchase – amounts withdrawn from your IRA up to $10,000 that are used toward a qualified first-time home purchase are an exception to the penalty.

Qualified reservist distributions – if a reservist who is called to active duty after September 11, 2001 for a period of 179 days or more takes a distribution from an IRA (after the start of active duty and before the end of active duty) the distribution will not be subject to the 10% penalty.

Rollovers – both direct, trustee-to-trustee transfers and 60-day indirect transfers are exempted from the penalty.

Excess contributions – if you have contributed too much to your IRA, you can take out the excess contribution without penalty.  However, any growth that is attributed to the amount that you over-contributed will be subject to the 10% penalty and taxes when withdrawn.

401(k) Exceptions

As with the IRA, most withdrawals from a 401(k) or other qualified retirement plan are subject to taxation.  Early withdrawals before age 59½ are also subject to a 10% penalty, with some exceptions.  The exceptions are as follows:

Death of the participant – this is the same as the exception for an IRA above.

Total and permanent disability of the participant – same as with an IRA.

SOSEPP – same as with an IRA.

Medical Expenses – same as with an IRA.

Qualified reservist distributions – same as with an IRA.

Rollovers – same as with an IRA.  However, an indirect 60-day rollover (not a trustee-to-trustee transfer) is subject to mandatory 20% withholding.  If the withheld 20% is not transferred within 60 days, this amount may be subject to both taxation and the 20% early withdrawal penalty.

Corrective distributions – just like with an IRA, if you have contributed too much to your 401(k), you can take out the excess contribution without penalty. However, any growth that is attributed to the amount that you over-contributed will be subject to the 10% penalty and taxes when withdrawn.

Separation from service after age 55 – if you leave employment after the age of 55, you are eligible to take distributions from your 401(k) or other QRP without penalty.  This is only valid while the funds are still in the 401(k) – if you rollover the funds to an IRA, this option is no longer available.  If the participant is a public safety employee (police, fire, or emergency medical technicians), the age is 50 or older.

Qualified Domestic Relations Order (QDRO) – in the event of a divorce, if the 401(k) is to be divided or distributed to the ex-spouse of the participant, withdrawals from the plan by the ex-spouse are not subject to the 10% penalty.

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Rolling Over a 401(k) into a New Employer’s Plan

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When you change jobs you have a choice to make regarding your retirement plan at former employer.  If the plan is a 401(k), 403(b), or other qualified plan of that nature, you may have the option to roll the old plan into a plan at your new employer.

The new employer’s plan must allow rollovers into the plan – this isn’t always automatic.  Most plans will allow rollover of former employer’s plans, but not all.  Once you’ve determined that the plan will accept a rollover, you should review the new plan to understand whether or not it makes sense to roll your old plan into it, or choose another option.  Other options may be: rollover the old plan into an IRA, convert the old plan to a Roth IRA, leave the old plan where it is, or take a distribution from the old plan in cash.

In this article we’ll just deal with rolling over the old plan to your new plan.

If the new plan has some compelling features, such as access to very low cost institutional investments or attractive closed investment options, or if the plan has very low overhead and great flexibility, you might want to rollover your old plan into it.  Other reasons that might compel you to rollover the old plan might be – to have access to loan features (IRAs don’t have this), access to your funds when leaving your employer after age 55 but before age 59½, and ERISA protection against creditors.

There may be reasons to leave your old plan at the old employer though.  The two that come to mind are NUA treatment of stock of the old employer, and if you think you’ll need access to the funds before you leave the new employer (especially if you’ve left that employer after age 55).

So after reviewing the options and features, you’ve decided to rollover the old plan to the new employer’s plan.  It’s a relatively straightforward process:  you contact the old plan’s administrator and request a rollover distribution form. You should have already contacted the new plan’s administrator to ensure that the new plan will accept a rollover.  Once you have the rollover distribution form from the old employer, get any pertinent information from the new employer, such as your employee id, or an account number for the new plan.

On the rollover distribution form, you’ll have the option to send the distribution directly to the new plan – called a trustee-to-trustee transfer.  In this manner, the funds never come into your possession.  This is important, because if you take distribution in cash from the old plan, the IRS requires that 20% is automatically withheld from the distribution.  You could still send the distribution to the new plan – but you’d have to come up with the 20% that was withheld in order to make the transfer “whole”.  It’s not required that you make a complete transfer, but if you take any of the funds in cash, including the withheld 20%, this money will be taxable as ordinary income, and if you’re under age 59½ it will likely also be subject to an additional 10% penalty.

After all of this has occurred, your new plan will have the additional old plan money rolled into the account.  Most likely this will be entirely in cash when it arrives in the account – so you will need to make investment allocation choices for the new addition to the account.

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What Options Are Available for a Surviving Spouse Who Inherits an IRA?

First Spouse Program bronze medal
First Spouse Program bronze medal (Photo credit: Wikipedia)

When the owner of an IRA dies and leaves the IRA to his or her spouse as the sole beneficiary, there are some unique options available for handling this inherited IRA.  Keep in mind that these options are only available to a spouse a beneficiary – a non-spouse beneficiary has much more limited options available.

Options for a Spousal Beneficiary of an IRA

The first and easiest option is for the spouse to leave the IRA exactly where it is and do nothing.  In this manner, the IRA will continue to exist as belonging to the deceased spouse – for a time.  If the deceased spouse was over age 70½ years of age and subject to Required Minimum Distributions (RMDs), the surviving spouse could elect to continue receiving those RMDs using his or her late spouse’s lifetime as the distribution factor.

On the other hand, if the deceased spouse was not subject to RMDs, the surviving spouse could also begin receiving RMDs from the inherited IRA based upon his or her own age.  This is a viable option as well.

On the third hand, after leaving the IRA in the name of the deceased spouse the surviving spouse could also opt to not take RMDs from the account at all – in this case the inherited IRA would be considered to be owned by and controlled by the surviving spouse, no longer an inherited IRA.  If the surviving spouse is over age 70½, he or she will need to begin receiving RMDs from the account based on his or her age.

Another option available to a spousal beneficiary of an IRA is to rollover the account into an IRA in his or her own name.  This would give the surviving spouse the same result as the “third hand” mentioned above.

In other words, both of these last two options results in the IRA being treated as if it was owned by the surviving spouse.  He or she is eligible to make contributions to the account, take withdrawals if over age 59½ (or if one of the exceptions applies) without penalties, rollover the account to another IRA or Qualified Retirement Plan, and convert the account to a Roth IRA.

Why Would the Spouse Choose One Option Over Another?

In some instances, it could be advantageous to leave the IRA in the name of the deceased spouse.  For an example, let’s say Jane died leaving John (her husband) as the sole beneficiary of her IRA.  Jane was 70 years old and not yet subject to RMD, but eligible for penalty-free distributions.  John is 57 years old, and as such he’s not yet eligible to take IRA distributions from a regular IRA in his own name.  Once the time has passed when Jane would have reached age 70½, John will be subject to RMDs from the account based upon Jane’s age (since it’s still in her name) but if he needs the income he has it available without penalty.  If he rolls over the account to his own name at age 57 he will not have penalty-free access to the funds for 2½ more years.

So, leaving the account in Jane’s name will allow John to take withdrawals from the account without penalty.  Once John reaches age 59½ he can rollover the account to an account in his own name, which will allow him to name beneficiaries of the account on his own (otherwise the original beneficiary designations that Jane made are still controlling the account).

Another situation that might make sense for the surviving spouse to leave the account in the name of the deceased spouse is if the surviving spouse is older.  From our example, if Jane and John’s ages were switched (Jane, the deceased was 57 and John is 70) then John could benefit from leaving the account in Jane’s name. This is because he could take distributions from the account without penalty (death benefits are penalty-free) without being required to take distributions (when he reaches 70½).

At the point in the future when Jane would have been age 70½, John could rollover the IRA into an account in his own name, again so that he can name his own beneficiary for the account.  This way he didn’t have to take RMDs until that point.

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What types of accounts can I rollover into?

OMG IRA
OMG IRA (Photo credit: girlonaglide)

When you have money in several accounts and you’d like to have that money consolidated in one place, the question comes up – Which type of account can be tax-free rolled over into which other type of accounts?

Thankfully, the IRS has provided a simple matrix to help with this question. At this link you’ll find the matrix, sourced from IRS Publication 590.

In terms of explanation, here are a few rules to remember:

You can generally rollover one account of any variety (IRA, Roth IRA, 401(k), and so on) into another account of the exact same type.

You can rollover a Traditional IRA into just about any other tax-deferral plan, including 401(k), 403(b), 457(b), as well as a SEP IRA.  The same goes for each of the accounts in reverse as well as between all of these types of accounts.  In general, employer plans such as 401(k), 403(b) and 457(b) plans are not eligible to rollover until the employee has left the job.

You can also rollover any of these accounts into a Roth IRA – but you’ll have to pay tax on the rollover amount.  This is known as a Roth Conversion.

A SIMPLE IRA generally cannot accept a rollover of any other type of account (other than another SIMPLE IRA) into the account.  On the other hand, a SIMPLE IRA can be rolled over into any of the other tax-deferred plans – IRA, 401(k), 403(b), 457(b) or SEP IRA – but only after the SIMPLE IRA has been established for at least two years.

A Designated Roth Account (DRAC), which is part of a 401(k), 403(b), or 457(b) plan, can only be rolled over into another DRAC or a Roth IRA.  Likewise, a Roth IRA is only eligible to be rolled over into another Roth IRA.

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The Rollover

A Chevrolet Malibu involved in a rollover crash
Image via Wikipedia

You’ve heard it millions of times – on the radio or tv – “when you leave your job, you should roll over your retirement account”. You may know that it makes sense (or at least you assume it makes sense, otherwise why would these folks admonish you to do so?), but do you know why it’s important? And do you have the first clue as to how to accomplish a rollover?

Why rollover? Among the reasons that it is important to rollover your retirement account when you leave employment is that you want to have control over your money. If you leave the account with the former employer, you are effectively handing over a portion of the control of your money to the administrator.

This administrator’s primary job is to ensure that the plan remains as effective and efficient as possible, for your former employer. Your interests are not taken into account at all, and in fact, many activities that the administrator undertakes (and subsequently charges the cost of to the plan accounts) are of no benefit to you whatsoever, as a former employee. By rolling your funds over to a self-directed IRA, you can make sure that the costs associated with your account’s maintenance are directly benefiting your own account.

In addition, by rolling over your retirement funds into an IRA, you now have more flexibility in the investment choices that you can utilize. Remember how your employer’s qualified plan only had five or ten mutual funds to choose from? Now, you can invest in just about any fund, stock, bond, or ETF available in the marketplace, plus some that you can dream up on your own.

How to roll over? We’ve covered (albeit briefly) the “why”, so now we’ll cover the “how”. It’s actually pretty simple, as long as you follow a couple of important rules. Both of these are related to maintaining the tax-deferred nature of your investment.

The first rule is that you should always have an account set up to receive the monies before requesting the withdrawal from your current plan. If you don’t have a place to put the money, the plan administrator will assume that you’re taking a “cash out” distribution, and they’ll withhold 20% tax on the withdrawal. The way to resolve this is to ensure that your withdrawal paperwork (with your old account) indicates a “direct rollover” is occurring. At the same time, your deposit paperwork with your new account will indicate the same. The old plan administrator may still send a check to your home address, but it will be made out to the new account custodian.

The second rule is related to the first, but this is one that you can foul up even if you’ve gotten the paperwork filled out correctly: your rollover must occur within the span of 60 days, or you’ll be penalized as if you withdrew the money to cash out the plan – 10%, plus ordinary income tax on the withdrawal.

As I indicated earlier, the current (old) plan administrator may send you a check for your rollover, made out to the new custodian – but it’s up to you to make sure that you get the check sent to the new plan custodian as soon as possible, so that there’s no danger of taking more than 60 days to complete the roll over.

The entire process is simple enough, following the steps below:

1. establish your new account
2. request a “direct rollover” withdrawal from your old plan
3. receive the rollover check
4. submit the check with the appropriate “direct rollover” deposit slip at your new account.

As you can see, the process is straightforward, but if you don’t pay close attention to what’s going on, or if one of your plan administrators (either the new one or your old one) has a special “twist” to the process, it can become a mess.

Note: steps 3 and 4 are not required if the transfer is done in a trustee-to-trustee manner, meaning that the old account administrator sends the funds directly to the new account trustee, and you never see a check.  This is one of the most common ways to ensure that you don’t miss the 60-day window. For more information, see An IRA Owner’s Manual.

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