I met Brian and Joan at the end of the day. Both have 401k plans provided by their employers, and both will be retired by the end of 2018. They’ve saved aggressively for retirement, and their employers have offered generous matching contributions.
Brian’s and Joan’s burning question was one I am asked quite often:
“How do we do a 401k rollover, Ryan? We’re hoping you can walk us through this.”
I sure can. But the better question is this: “Does a 401k rollover make sense for Brian and Joan?”
You see, Brian and Joan had recently read my article in which I talked about Roth conversions in light of the many changes brought about by the Tax Cut and Jobs Act. And they were interested in how they, too, might take advantage of a Roth conversion.
But like I said in that article, there is no one-size-fits-all solution to retirement planning. What had worked great for Scott and Aubrey might not be the best course of action for Brian and Joan.
With this in mind, let’s go ahead and take an in-depth look at 401k rollovers.
What retirement means for your 401k
I’m surprised by how many people don’t know what happens to their 401k savings when they reach retirement. Over the years, I’ve heard people who thought they would receive a check for their entire savings, others who believed their former employers would continue contributing, and so on.
But you can’t blame them.
Despite living in the richest nation on earth, financial education doesn’t seem to be a priority. And that’s especially true of preparing for retirement. You would think that more companies would sit their employees down and walk them through the 401k in greater detail. Unfortunately, that’s rarely the case.
So, what does happen to your 401k when you retire?
In many cases, nothing at all. Your savings will usually just sit there as you left them. If your money was allocated over a handful of three mutual funds, for example, it will remain invested in those funds and continue to perform accordingly.
However, you will have decisions to make:
1. Should you begin taking distributions?
If you are age 59-1/2 years or older at retirement, you can begin to take distributions from 401k immediately without the 10% early withdrawal fee. You will need to think about this carefully, though. If you don’t yet need the money, it might be a good idea to hold off on drawing from this income source until you do need it. Delaying distributions could help reduce the chances you run out of money in retirement.
Different employers have different rules, too, when it comes to distributions. Some companies may require you to take regular distributions, usually on a monthly schedule. Others might allow you to take lump sums only as you need them. It is important to know your company’s policy on distributions. And keep in mind that these rules can often change, forcing you to rethink your retirement income strategy.
Lastly, don’t forget that your 401k distributions will be subject to income taxes. It gets added on as income and depending on what your other sources of retirement income may be, these distributions could force you into a higher tax bracket. So, do your homework.
2. What is the 401k “55 Rule?”
If you have retired early – at least 55 years of age – you don’t need to wait until you’ve reached age 59-1/2 to begin enjoying distributions. Few people are familiar with the 55 Rule, as it allows you to retire earlier with an income while avoiding the 10% early withdrawal penalties. If you are 55 or older and lost your job, you can still use this rule to provide an income.
However, there is an exception. The 55 Rule allows you to take distributions only from the 401k provided by the employer from which you retired (or lost your job). In other words, if you have additional 401k savings with previous employers, you are not eligible to take distributions from those accounts without incurring penalties.
3. Should you leave your 401k as it is?
We will answer this question more thoroughly in the section on “Leveraging your 401k savings.” For now, though, the simple answer is that you could just leave it alone if that’s what you want to do.
As we discussed earlier, many companies will allow you to let your 401k remain as it was without taking distributions. Of course, this doesn’t mean that your former employer will continue making contributions to your savings. But allowing your money to continue within the plan is certainly an option.
Your decision here, as with all these points, will depend on the unique circumstances of your retirement needs. Even if you leave your savings alone, 401k rules will eventually force you to take required minimum distributions (RMDs) beginning on April 1 after the year you turned 70-1/2 years of age. This is also true for any Traditional IRA accounts as well.
4. Should you cash your 401k out?
As often as I’ve heard people shrug and say, “Well, I’m just going to cash out my 401k when I retire,” you would think I would’ve gotten used to it by now. But, no. It still feels like a punch in the gut every time.
Yes, you can certainly do this. You can certainly demand your 401k custodian cut you a check for your 401k savings, but please, avoid this!
The moment they oblige this request, the IRS will be right there to take their full cut. And just think about this a moment. If your 401k is worth $100,000, the IRS is going to make you add that to your income for the year and so it will be subject to income taxes.
In other words, you are going to lose a very, very large piece of that pie you worked for so many years to prepare.
Now, I know that things happen. Hardships may arise and seem to leave you with little alternative than to cash your 401k. But please, please speak with a qualified retirement planner before making a costly decision like this. If you have other savings or assets, a professional can help you make a more informed and less costly choice.
Hopefully, you have made up your mind about these decisions well in advance of retirement.
Let’s now take a look at how to get the most from your 401k dollars…
Leveraging your 401k savings
You don’t want to wait until you’re already into your retirement before thinking about how to get the most from your retirement savings. Unfortunately, I see too many people putting these decisions off until retirement.
If this is your mentality, then I really encourage you to think differently. After all, we’re talking about making your money last the rest of your life, and the sooner you have developed a strategy, the better your chances of reaching the desired destination. I mean, you can’t hit a target if you don’t have one.
So, let’s get right to it.
If your company’s 401k is like most, you probably aren’t going to have much freedom as far as available investment options. Typically, a 401k offers a limited amount of mutual funds – and that’s it. Why? Because you don’t own the 401k plan. Your employer does, and that means they get to choose the available options.
This is just one of the many reasons that doing a 401k rollover can make a lot of sense at retirement or even just when you change jobs.
If you aren’t familiar with what a 401k rollover is, it is transferring your retirement savings from the employer-owned plan to another tax-sheltered retirement savings plan that you own yourself. In other words, an individual retirement account (IRA).
Because you own and manage an IRA yourself (or with the help of a trusted retirement specialist), you will often enjoy much more freedom in tailoring the plan to better suit your specific retirement needs.
Let’s look at some of the advantages now…
Rollover decisions – Traditional vs. Roth
While employed, the 401k has one obvious advantage over IRA plans, and that is employer contribution, assuming your employer participates. After retirement or when you leave your job, however, an IRA will more often than not make a lot of sense.
But the big 401k rollover question is whether to roll your 401k into a Traditional IRA or a Roth IRA. To help us determine which is more appropriate for you, let’s touch on the basics.
What is the Traditional IRA?
As I said earlier, the IRS will require that you pay income taxes on your 401k distributions when you begin taking them for retirement income. That, of course, is because you funded your 401k with pre-tax dollars – and Uncle Sam has been waiting a very long time take his share of your savings.
The same is true of a Traditional IRA, which is also funded with money that has not yet been subject to income tax. And a Traditional IRA is similar to the 401k in a few other regards, too. For example, you will be forced by the IRS to begin taking RMDs at 70-1/2 years of age.
The key advantage of the Traditional IRA over a 401k, though, is that you will have much more options available to you for allocating the money, such as a greater selection of mutual funds, exchange traded funds, and more which may be more appropriate to your retirement needs.
What is the Roth IRA?
Unlike a 401k or Traditional IRA, the Roth is funded with money that has already been taxed as income by the IRS. This means any qualifying distributions you take from a Roth are exempt from federal income taxes.
On the other hand, you will need to pay income taxes on any savings you rollover from your pre-tax 401k plan to a Roth IRA. So, there are several points you will need to consider before making this move:
Will this rollover force me into a higher tax bracket for the year? It might. You will need to consider your income from all sources for the tax year and make your decision from there. If your 401k is well-funded, you may want to convert the savings over the period of a few years or more to reduce your income tax obligations.
What if my account takes a loss after the rollover? You will be taxed on the full amount of the money rolled over to a Roth IRA, even if your account suffers a loss perhaps because of investment losses later in the year. For example, if you roll $10,000 over from your 401k to a Roth IRA in May, and then your account drops to $8,500 in June, the IRS will still demand income taxes on the full $10,000. This wasn’t always the case, but the new Tax Cut and Jobs Act has eliminated the chance for do-overs after a loss.
Can I rollover my 401k savings to both a Traditional and Roth IRA? Yes, you can. You aren’t limited to an either/or decision here. This approach might help you strike the right balance as to what would be taxable now versus later. Over time, you could then convert some or all of your Traditional IRA to a Roth IRA if it makes sense within the scope of your overall retirement plan. By doing smaller partial conversions it can help to manage your your tax liability.
Another important point to consider when rolling a 401k over to a Roth IRA is the “5-year rule.” The IRS requires that you own the Roth IRA for 5 tax years before taking distributions. Otherwise, you would be subject to early-withdrawal penalties. Also, know that each Roth Conversion starts a new 5 year period. This works differently than the 5 year period for Roth Contributions. So, you must think about how soon you are going to need access to your savings before doing a full rollover.
How to rollover your 401k
If you’re thinking about doing your 401k rollover by yourself, you need to proceed with caution. Sure, you can do what’s called an indirect rollover, but I would not recommend it. Things can get complicated if you do. An indirect rollover is where you liquidate your 401k savings and have a check made out to you. However, by doing so more than likely 20% of the funds in your 401k will get withheld. Eventually you will get the money back only as long as you follow some pretty strict federal tax rules.
Instead of getting into all those rules here’s the bottom line. I like keeping things simple.
I don’t recommend you have a check sent to you that is made out to you. In other words I do not recommend doing an indirect rollover.
Instead, ask the 401k custodian to make a check out to the custodian of your IRA for the benefit of you. For instance, it might say pay to the order of “TD Ameritrade FBO John Smith.”
Sometimes the 401k custodian will mail that check directly to your IRA custodian. This is preferred way to do it. This is called a trustee to trustee transfer. You never even touch the check and it makes things very easy.
Sometimes they will mail the check to you. If they mail the check to you then you can just go ahead and mail the check that you receive to your IRA custodian.
Taking the next step
Now, I know there has been a lot of information to absorb in this article. And I’m sure you probably have a lot of questions – as you should. A 401k rollover is far too important to make a decision about on your own, and I could probably include a list of 100 frequently asked questions without addressing all your concerns.
This is because every individual’s needs are unique. What makes sense for one person might not make sense for you.
So, before you take the next step in your 401k rollover, consult with a qualified retirement specialist, preferably one with a lot of experience in these matters. That is my best advice.
Here at Milestone Wealth Management, this is what I do every day. I have helped countless people just like you with evaluating their retirement needs, including 401k rollovers. And if a rollover isn’t right for you, I’ll let you know.