It’s not uncommon to speak with someone who has worked for several different companies over the last 10 years, which is indicative of a fast-paced corporate world and its tumultuous tendency to show more favor to the bottom line than to the people who drive it.
If you’ve participated in a company-sponsored plan and your employment ends, whether voluntarily or not, you likely have a plan sitting in investment limbo. If you do, you need to choose what to do with it and a rollover is one option.
- Rolling money over from a 401(k) doesn't happen as frequently as people think.
- Examine all of your options before you decide whether a rollover is right for you.
- Make sure you understand how the plan fees will change if you roll over your funds.
- Consider the possibility of a Roth conversion, which changes pre-tax to after-tax dollars.
- Consult a tax or financial expert if you're unsure of how rollovers affect your personal situation.
Understand Your 401(k) Before You Roll It Over
A 401(k) plan is a tax-advantaged defined-contribution savings account as set forth in section 401(k) of the Internal Revenue Code (IRC). The benefits you receive from a 401(k) are based on the returns generated by your investment portfolio.
The Internal Revenue Service (IRS) limits how much you can contribute to your 401(k) each year. As an employee, your annual contribution can't exceed $20,500 in 2022 and $22,500 in 2023. For 2022, you can put aside an additional $6,500 if you are 50 or older for a total of $27,000 For 2023, if you are 50 or older you can contribute an additional $7,500, for a total of $30,000. The IRS adjusts these amounts annually for inflation.
These plans can have a pre-tax or after-tax component. Normally, many investments are available as options for growing your retirement assets, in keeping with your risk tolerance.
Knowing what to do with your plan when you leave your employer depends largely on the circumstances in which you find yourself. You should always consult a tax professional or financial advisor before making any decision. Here are five questions you should ask to let some light into your 401(k) attic.
A 401(k) is different from a defined-benefit pension plan. The benefits from a defined-benefit pension plan are calculated ahead of time so you know what you'll get when you retire.
1. What Are My Options?
This is the most important question. Depending on your desires and circumstances, the answer could be one of the following four—only two of which involve rollovers.
Don't Move Your Money
This is a great option if you're allowed to do so. You may not be able to continue contributing if you keep your 401(k) account with your former employer but you may change how your money is allocated.
This option also may allow you to make penalty-free withdrawals based on certain criteria. Check with your plan administrator, as every plan is different.
Roll it Over Into an Existing 401(k)
Choosing this option allows you to continue contributing to your plan. It also gives you control over how your investments and other options are handled. Keep in mind that you are subject to the provisions of your new plan.
When you roll the 401(k) account from your previous employer, it terminates your former account.
Cash It Out
This can be a very expensive option. Withdrawals will be subject to any applicable taxes and penalties, including state taxes and a 10% early withdrawal fee if you're under 59½.
Let’s say a 45-year-old Michigan resident is in the 24% bracket ($95,376 to $182,099 in taxable income as of 2023) before she cashes out her $10,000 account. She's liable for the 10% penalty and another 4.25% for the Michigan state tax for a total of 38.25%. As such, withdrawing her $10,000 will cost her a total of $3,825.
Keep in mind that cashing out your account may boost your taxable income by putting you into a higher tax bracket.
Roll it Over Into an Individual Retirement Account (IRA)
Rolling your account into an individual retirement account (IRA) could mean a traditional or Roth IRA, depending on how your contributions were made. An investor who chooses this route opens the door to flexible investment strategies, in contrast to the one-size-fits-all options in a 401(k).
But there are drawbacks. Keep in mind that you can make contributions to an IRA until tax day (April 15), while 401(k) contributions must be made by the end of the calendar year.
2. What Are the Fees in My Plan?
Investment plans are not free. This means that you're charged a fee for the administration of your plan. The U.S. Department of Labor regulation 408(b)(2) makes it mandatory for employers to disclose fees, which include:
- Investment expense ratios
- Plan provider fees
- Administration fees
- Other miscellaneous fees to each participant
3. How Will the Fees Change If I Do a Rollover?
Every investment professional is required by the Financial Industry Regulatory Authority (FINRA) to disclose the expense associated with each investment. They must also provide enough detail that the investor clearly understands their financial obligation.
4. Should I Consider a Roth Conversion?
The IRS allows you to convert any amount of your pre-tax retirement assets to after-tax Roth contributions. Only those with an adjusted gross income (AGI) below $100,000 were eligible for conversion up to 2010. Keep in mind that there is no income cap, but there are many rules and tax implications of which you need to be aware.
5. What Are the Advantages of a Rollover?
This should get a conversation going about why you want to do the rollover. Investors should match themselves up with a professional who understands what they want to accomplish. An advisor should discuss the pros and cons regarding rollovers based on the investor’s specific and current situation.
The Bottom Line
Your retirement money is important. Know your options completely. Meet with your accountant if your financial advisor isn’t up on the tax stuff, and, as always, stay away from anything you're unsure of or uncomfortable with doing. The advantages and disadvantages of both rollovers and a Roth conversion are many, so your best course of action is to do your homework, know the rules, and seek out professional advice.