Employees who participate in their corporate 401(k) plans have a few different options available to them when they leave the company, and the tax consequences that they face will depend upon which option they choose. While the traditional rules that have always governed this type of transaction can be somewhat complex in some cases, recent legislation has made some aspects of this even more restrictive.
It is important to understand these rules in order to avoid costly tax errors that can substantially disrupt your retirement plan. (For more, see: 8 Reasons to Roll Over Your 401(k) to an IRA.)
401(k) plan participants have three general alternatives to choose from once they leave their employers. A different set of tax rules pertains to each option.
- Cash out. This is perhaps the most straightforward choice when it comes to taking money out of a 401(k) or other retirement plan. The check from the plan is either made payable directly to the plan owner or else is deposited directly into the owner’s bank or retail investment account. This is also the most expensive option, as the participant will pay tax at ordinary income rates on the balance that is withdrawn. Participants who are under age 59.5 years of age will also face an additional 10% penalty for early withdrawal of funds. When you factor in state taxes, the total tax bill can easily reach 45% or higher, depending upon which tax bracket the participant is in. But the real cost of this choice comes from the lost opportunity for that money to continue growing tax-free or deferred, and this can reduce the participant’s nest egg in their later years by tens or even hundreds of thousands of dollars. (For more, see: Will I Have to Pay Taxes on my 401(k) Plan if I Quit my Job?)
- Leave it alone. This is obviously the simplest option, as the participant simply does nothing and leaves the plan with the former’s employer’s plan custodian. There is no tax consequence for this.
- Roll it over. This is probably the most common choice made by former plan participants. Those who choose to do this will direct the plan custodian to send their money either to another qualified plan if they become employed at a company that offers a plan that accepts rollovers from other plans or else to an IRA. If the rollover funds come to the participant in the form of a check, then the check will be made out to the next plan or account custodian and not the participant. The participant then has 60 days to deposit the money with that custodian. If the participant fails to do this, then the entire amount of the check will be considered a distribution by the IRS and subject to all applicable taxes and penalties. Those who wish to avoid this possible dilemma can do so by electing to have the money rolled directly over into the new plan or account, where no check will be mailed to the participant. For this reason, most financial planners and retirement plan experts endorse direct rollovers over the indirect method.
Indirect 401(k) plan rollovers also now face another restriction that was recently enacted by Congress. Plan participants who elect the indirect rollover method resulting in a check being made out to them can now only do so once in a 12-month period. If they do this again before a year has elapsed, then the entire balance of the second rollover will be counted as a distribution. This time limit must be met in between every single indirect rollover and does not go by calendar year. (For more, see: Rolling Over a 401(k)? Consider the Fees.)
Although most withdrawals from 401(k) or other qualified plans by participants who are under age of 59.5 are subject to the 10% early withdrawal penalty, there are five exceptions to this rule. Penalty-free withdrawals are allowed in the following instances:
- Withdrawals that are used to pay off back taxes to the IRS
- Distributions made to the participant’s estate after his or her death
- Distributions made to a participant who has become permanently disabled
- Distributions taken by the participant to pay for unreimbursed medical expenses that exceed 10% of the participant’s adjusted gross income for that year
- Distributions that are taken as part of a series of substantially and equal payments that have been approved by the IRS
The NUA Rule
Employees who purchased shares of their company’s stock inside their 401(k) plan are eligible to receive favorable tax treatment on their shares at the time that they roll over the rest of their plan balances as long as certain rules are followed. The Net Unrealized Appreciation rule (NUA) allows employees to sell all of the shares inside their plans in a single transaction at the time of rollover and pay the lower long-term capital gains rate of tax on the gain of all shares that have been held for at least a year to the day. This rule can substantially lower the overall tax bill for employees who have accumulated large numbers of shares in their company plan over time, and there is never a reason not to use it for those who own company shares in their 401(k) plans.
The Bottom Line
The tax rules for 401(k) rollovers can be very simple for those who elect to either take cash distributions or leave their plan balances where they are. The rules for those who decide to preserve the tax-advantaged status of their plan balances can be somewhat complex in some instances, but opting for a direct rollover will usually steer the participant clear of any potential tax pitfalls. For more information on the tax rules for 401(k) plans, visit the IRS website at www.irs.gov or consult your retirement plan custodian or financial advisor. (For more, see: How to Rebalance 401(k) Assets.)