Where should I put my 401(k) retirement money that I had with my previous employer?
I am 55 years old. My previous employer informed me that I have a couple options for receiving my retirement funds. One option is a lump sum. I am considering the lump sum because I need the money for home improvements and high credit card debt payments. I know I have to pay the 20% tax, but will I have to pay the 10% penalty? Should I get a withdrawal and roll over the balance into a Roth IRA that I have with my current employer?
You’re in a good luck because you’re age 55. There’s a special rule of doing a rollover for age 55 employees separated from their employers. If you intend to use a portion of the lump-sum for home projects and paying off debts, you should allocate that portion before the rollover. There’s no 10% penalty, but you must pay the income tax. You can roll the remaining balance to an IRA, not Roth for you don’t want to pay the hefty tax for a large lump-sum conversion. Once the money is rolled into the traditional IRA, work with a CFP® and take your time to do the conversion so you don’t have to pay any extra tax. Best!
Does your current employer offer a 401(k) plan? If so, here's an alternative view rather than 'cashing in' your current 401(k) and having to pay, state, federal and IRS penalty (if you are under age 59 1/2 per IRS). If you do it your way, you would expect to loose about 30% (using your 20% tax bracket plus the 10% IRS penalty).
If you have a current 401(k) and your employer allows for loans, consider rolling to the new 401(k) and taking out a loan. Generally speaking, 401(k) loan rules are this, you can borrow up to 50% of your account value or $50,000, whichever is the lower amount.
When you take out a loan, you become your own bank so to speak. You earn the interest you are paying on the loan. Drawbacks? Yes, should you quit your job, want to close out, or transfer the 401(k), the loan must be repaid. This becomes problematic if the investor does not have the funds to repay the loan. At that point, the loan would become a 'taxable event' and you would have to pay tax on any of the unpaid loan balance. But since you are already considering doing this right now, this seems less problematic to you.
Something to consider, as I say, an alternative view.
Your previous employer is right - you have several options in this scenario.
First, you may take the withdrawal. This is typically subject to a 10% penalty, but provided that you stopped working there after you reached age 55, you will only pay the taxes (no penalty) on your withdrawal. Keep in mind the withdrawal amount will add to your taxable income, which could put you into a higher income tax bracket. It is generally best to leave retirement funds untapped for as long as possible, and use them as a last resort pre-retirement.
You can also roll the funds over into another retirement account. Keep in mind that the tax-status must be the same from one account to another. In other words, if your old 401k was a Roth 401k (post-tax), then the funds need to be rolled to a Roth IRA or Roth 401k. If the funds were pre-tax, then they need to be rolled to a pre-tax (Traditional) IRA, or 401k.
It is usually wise to keep retirement funds in retirement accounts, and leave them untapped until retirement. When deciding where to roll the account (to an IRA, or to a new 401k if available from your current employer), some factors to consider are the fees and investment options that will be available to you in either case. Generally an IRA will have more investment options, and zero to little fees if you manage it on your own. However, if you chose to have an Advisor manage the IRA for you, then their fee would also need to be considered.
There's a lot to unpack with your question. Most advisors will tell you to roll over your 401(k) into an IRA that they manage. In your case, and many others, that may not be the best option. I wrote a two-part blog series on the Six Options When Moving Retirement account money. It may be helpful for you to read part 1 - https://www.leamnsoncapital.com/blog-01/six-options-when-moving-retirement-account-money-part-1.
Taking a lump sum distribution is a taxable event. As you rightly point out, the employer is required to withhold 20% of that distribution for taxes. Depending on the amount of the distribution, this may also put you into a higher tax bracket that raises your tax rate above that amount. That means you may have to pay more tax than what is withheld when you file your 2017 taxes. Because you are age 55, and moving from a 401(k), the IRS gives you a special exemption from the 10% penalty.
As for transferring to your employer's Roth IRA, I think you mean a Roth 401(k). It is unlikely you can do that. You would likely have to roll the money into a traditional IRA and then convert it to a Roth IRA. Whichever way it's transferred, the entire amount moved would be taxable in the year of the conversion. That's a potentially huge tax hit.
If your current employer has a regular 401(k), check with them to see if they accept rollovers from former employer's plans. Also, see what their loan provisions are. If you can transfer your old plan to your current employer's plan and take a loan for the things you describe, that may be a better option. Make sure you understand the loan provisions and payback terms prior to doing that. I generally don't recommend borrowing against retirement money.
Depending on the equity in your home, consider a home equity loan to pay off credit cards and do your home improvements. The interest for the loan is tax deductible, reducing the cost of the loan. It leaves your retirement money alone so it can do what it is meant to do for you. Granted, there is a payment involved with the home equity loan which you would need to pay. It's likely the interest rate and payment terms on the home equity loan will be much less than the credit card interest and payments you're currently making.
Be very careful with this decision. There are pros and cons of each option. Consult with an independent financial advisor to help you sort through the options, including calculating the 401(k) options, taxes, payments, and investment choices for each option. Good luck!