You might think 401(k) rollovers are less common than they actually are. Like dusty boxes in an attic, many people have an employer-sponsored plan from a former job, such as a 401(k), lying around. It’s not uncommon anymore to speak with someone who has worked for several different companies over the last 10 years—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 has ended (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.
- Before deciding that a rollover is right for you, examine all of your options.
- Make sure you understand how the plan fees will change if you roll over your funds.
- Consider the possibility of a Roth conversion, changing pre-tax to after-tax dollars.
Before You Roll Over a 401(k), Understand Your Plan
A 401(k) plan is a tax-advantaged defined-contribution savings account (not a defined-benefit pension plan), as set forth in section 401(k) of the Internal Revenue Code. The maximum employee contribution in 2021 is $19,500 (or $26,000 for those 50 or older, when catch-up contributions are added in).
These plans can have a pre-tax component or an after-tax component. Normally, many investments are available as options for growing your retirement assets, in keeping with your risk tolerance.
5 Questions to Ask
Knowing what to do with your plan from a former employer depends largely on the circumstances in which you find yourself. You should always consult a professional tax or financial advisor before making any decision. Here are five questions you should ask to let some light into your 401(k) attic.
1. What Are My Options?
This is the most important question. The answer, depending on your desires and circumstances, could be one of the following four, only two of which involve rollovers.
- Keep the money where it is, if permitted. You will no longer be able to make contributions to the account, but you may change how you are allocating your funds for investment. This option also may allow you to make penalty-free withdrawals based on certain criteria. Check with the administrator, as every plan is different.
- Roll the money into your current 401(k) plan, if permitted. This will terminate your former account. This action gives you control over contributions and investment options for the funds once again, although you are, of course, subject to the provisions of your new plan.
- Cash-out. This option can be a very expensive way to use your money, as the funds will be subject to any taxes and penalties that may apply. For example, let’s say a 45-year-old Michigan resident is cashing out her account of $10,000. It will be subject to ordinary income tax. We’ll assume she’s in the 24% bracket (as of 2020, that means $85,526 to $163,300 in taxable income). There’s also a 10% penalty because she’s under 59½, and let’s not forget another 4.25% for the Michigan state tax, totaling 38.25%. To use her $10,000 will cost her $3,825.
- Roll the money into an individual retirement account (IRA). This could mean a traditional or Roth IRA, depending on how your contributions were made. Doing this, an investor opens the door to flexible investment strategies, in contrast to the one-size-fits-all options in a 401(k). However, there can be 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.
Due to the coronavirus pandemic, the IRS has extended the 2020 federal tax filing date for individuals until May 17, 2021, and along with it the contribution deadline for IRAs (traditional and Roth)—versus the previous deadline of April 15, 2021.
As well, given the winter storms that hit Texas, Oklahoma, and Louisiana in February 2021, the IRS has delayed the 2020 federal individual and business tax filing deadline for those states to June 15, 2021. The IRA contribution deadline for those affected by these storms is extended to June 15, 2021.
2. What Are the Current Fees in My Plan?
Investment plans are not free. 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, and other miscellaneous fees—to each participant.
3. If I Perform a Rollover, How Will the Fees Change?
Every investment professional is required by the Financial Industry Regulatory Authority (FINRA) to disclose the expense associated with each investment in enough detail that the investor clearly understands the obligation.
4. Is a Roth Conversion Something I Should Consider?
The IRS allows you to convert any amount of your pre-tax retirement assets to after-tax Roth contributions. Prior to 2010, only those with an adjusted gross income below $100,000 were eligible for conversion. Now there is no income cap, but there are many rules and tax implications of which to be aware.
5. If I Perform a Rollover, What Advantages Could I Realize?
This should get a conversation going regarding the “why” of the rollover. Investors should match themselves up with a professional who understands what they’re trying 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, don’t do anything you’re not sure of or uncomfortable with. 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.