By Scott Tschappat
Wallace D. Wattles, author of The Science of Getting Rich, said, “It is essential to have good tools, but it is also essential that the tools should be used in the right way.” When it comes to retirement savings tools, nothing compares to a 401(k); but are you maximizing its potential?
For example, what happens to the money in your 401(k) when you switch jobs? The days of employees sticking with one company for their entire career are long gone (the average working adult changes jobs 12 times during their career), (1) so chances are you’ll need to make a decision when your current employer becomes your former employer.
Now’s the time to consider a 401(k) rollover. On the path to a fulfilling retirement, it’s best to streamline your financial portfolio as much as possible (and pay less in fees and have more investment options) while also still tailoring it to your specific situation. Let’s cover the basics.
What Is a 401(k) Rollover?
A 401(k) rollover is an option you have when you leave a company and want to transfer your investments into an individual retirement account (IRA). Normally people do this if they are leaving a company, switching to a new company, or retiring, but you can also do a 401(k) rollover into another 401(k) with a new employer. (2)
Pros of a Rollover
The main benefits of a rollover from a 401(k) to an IRA are the following:
- More options. Most 401(k) plans have a limited selection of mutual funds and bonds to invest in. IRAs offer those plus other options, such as stocks, exchange-traded funds, and income-producing real estate. (3)
- Lower expenses and management fees. This will vary depending on your 401(k), but usually having an IRA decreases management fees, administrative fees, and expenses related to each fund you have.
- Convert from a tax-deferred account to a Roth account. Contributions to a 401(k) plan or traditional IRA are made using pre-tax dollars, which means distributions are taxed at the time of withdrawal. Rolling money from a traditional 401(k) into a Roth IRA gives you the option of paying taxes now so that you will not have any taxes due at the time of withdrawal in the future. If this is an option you are considering, you should discuss with your advisor and your tax professional to consider current and future forecasted tax rates to see which pathway makes the most sense.
Cons of a Rollover
Some potential cons of a 401(k) rollover include:
- Creditor protection risks. Leaving your funds in a 401(k) might provide creditor and bankruptcy protections, which might not be the case with an IRA, depending on your state’s IRA rules.
- Less accessibility. Although it might be possible to get a loan from an employer-sponsored 401(k) account, you cannot from an IRA, which means the funds may be less accessible.
- Account fees. You may be hit with higher account fees compared to a 401(k), which has access to lower-cost institutional investment funds due to group buying power. (4)
Required Minimum Distributions (RMDs)
Tax-deferred retirement plans are subject to required minimum distributions (RMDs). Taxes are due at the time of withdrawal. The SECURE Act changed the timeline for taking RMDs for both IRAs and 401(k) plans. For IRAs, anyone who reached age 70½ on or after January 1, 2020, will not be required to begin taking RMDs until April 1st of the year after they reach age 72. (5) Failure to take RMDs at the appropriate time will result in a hefty 50% penalty on any distributions you fail to take on time. (6)
Some 401(k) plans (but not all) allow you to leave money in the plan until you retire, effectively delaying RMDs, as long as you are still working for the employer who sponsored your 401(k) plan. If you leave any 401(k) funds in your prior employer’s account, the exception will not apply to those funds. (7) The exception also does not apply to IRAs; if you have funds in an IRA, you must start taking RMDs when you reach the age limits regardless of when you retire.
Both IRAs and 401(k)s include a 10% penalty if you withdraw money before the age of 59½. The 10% penalty is in addition to taxes that you will owe on the money no matter what. There is one exception for 401(k) plans, known as the Rule of 55; if you retire at 55 or later, you can take penalty-free withdrawals from your current 401(k) sponsored retirement plan. The Rule of 55 does not apply to IRAs, nor does it apply to 401(k) plans still housed in a prior employer’s account.
How to Execute a Rollover
Thankfully, rollovers are pretty simple. Once you have chosen a bank, financial institution, or online investing platform, you contact your 401(k) plan administrator to let them know where you want your funds transferred. (8) You can choose to do either a direct or indirect rollover. A direct transfer is generally recommended because it is the simplest form of getting money from one point to the next, and you do not have to worry about how or when to deposit funds.
You also have the option of doing an “indirect rollover,” where your employer cuts you a check and you are responsible for depositing the funds into a new tax-deferred investment account within 60 days. Your employer will be required to withhold 20% of the funds to pay taxes due (this 20% comes back to you in the form of a tax credit when you file your return). That means you will only receive a check for 80% of the value of your 401(k), and you will need to replace the 20% withheld amount from your personal funds or another source. (9) If you fail to deposit the funds to a tax-deferred account within 60 days, the transfer will be treated as an early withdrawal and the entire amount will be subject to an additional 10% penalty.
Is a Rollover Right for You?
Tools are created to ease burdens and maximize efficiency, so why not make the most of your trusty 401(k)? Although there’s a lot of flexibility with rollover options, like many financial decisions, it can be confusing to know which path to choose. Your situation is unique, so a one-size-fits-all solution won’t work. Before you pull the trigger, it’s best to consult a financial professional.
We at Acute WealthCare would love to answer your questions and help you evaluate your options. After getting to know you and your unique situation, we will determine if a 401(k) rollover makes sense and create a retirement road map to help you reach your financial goals.
We strive to simplify the complex into easy-to-understand concepts so you can feel confident in your overall financial plan. To get started, reach out to us by scheduling a 15-minute introductory phone call.
Scott Tschappat is a wealth advisor at Acute WealthCare, an independent, fee-based comprehensive financial management firm with over 20 years of experience. Scott is committed to helping his healthcare worker clients create a financial plan that brings them peace, security, and dignity. Scott learned the importance of proper financial management and making a plan for the unexpected at a young age when his father passed away suddenly and he watched his mother use the life insurance money wisely to take care of their needs, both present and future. He strives to steward his clients’ money well, as if it were his own mother’s, and help them every step on the journey to their financial future.
Scott lives in Highlands Ranch, CO, with his wife, Bridget, a school counselor at All Souls Catholic School, and their two daughters, Sarah and Emily. He loves sports and has been lucky enough to coach both of his daughters’ basketball teams. In the spring and summer, you can find Scott getting his hands dirty gardening and enjoying live music at Red Rocks or another local venue. To learn more about Scott, connect with him on LinkedIn. You can also register for his latest webinar on What We Do & How We Help.