A 401(k), like any retirement account, is not a simple financial instrument. To transfer funds (“rollover”) from one employer’s account to another involves rules that most of us do not know or have only the vaguest idea of – especially the tax consequences and penalties incurred if you make a mistake or are unaware of better options.
Rolling over a 401(k) without undue costs involves following proper procedures to avoid fees and penalties. And if you’re unemployed, keeping a former employer’s 401(k) plan, which most allow, until you can rollover into a new one is usually better than rolling it into an IRA.
“The biggest mistake made, probably, is simply failing to transfer properly. Trustee-to-trustee is the best way,” says Vernon R. Bartle, CPA and a certified forensics accountant, based in northern California. “If you rollover a 401(k) from, say, an old employer to a new employer or to an IRA, the law is clear: You can’t have access." he says, which means it should not pass through your personal checking or savings account on the way. "This money has a special tax status that supports your retirement," Bartle says. "It’s best to not even touch it. Literally.” Otherwise taxes should be withheld upfront, essentially negating the value of the tax-advantaged account.
So to avoid tax problems with handling money from your retirement account, simply arrange for your 401(k) investment to be transferred directly to another qualified retirement account, “trustee to trustee.” Checks from the existing account to the new one are not made out to you. They are made out to your new investment company, adding FBO (for the benefit of) before your name and the new account number somewhere on the check. You can also have the check, made out that way, mailed to you, and you send it to your new account.
Of course, if your new employer does not offer a 401(k), you can keep it with your previous employer – no future company contributions, of course, or borrowing against it, though. Some employers can close accounts of relatively small amounts, typically less than $5,000, which then you must move to another qualified account or pay some taxes. If you have to do something, an IRA or annuities are your best options.
Otherwise, Bartle advises against going from a low-cost, diversified 401(k) to a high-fee, commissioned IRA. “It’s the worst thing you can do. You want to build the investment as a hedge against the higher cost of living 10 or 20 years from now, not be saddled with high management fees, which sometimes can be as high as three percent with an IRA.” Bartle asserts strongly that a 401(k) is a better investment. Generally, “they have more buying power, have more people in the plan and can get a wider range of better investments.” Generally, this provides greater growth potential.
If you’re laid off at, say 55, withdrawing the money will incur a tax liability both for a 401(k) or an IRA, but an IRA has an additional withdrawal penalty of ten percent unless you wait until you’re 59½. Not so a 401(k).
If you roll into an IRA you are subject to the 60-day rule, unlike a 401(k). Bartle explains: “You are allowed to receive the money temporarily, but you must deposit it into an IRA retirement account within 60 days. And you can do this only once in a one-year period. A trustee-to-trustee transfer doesn’t have a 60-day rule and can be done several times with no waiting period.” If you fail to deposit the funds into a new IRA account, you incur a ten percent penalty until you’re 59½, and also the money becomes taxable as income. (You may want to read Exceptions To The 60-day Rollover Retirement Account Rule.)
If you’re rolling over funds into an IRA, know also that state laws prevail regarding bankruptcy protection. “A 401(k) is protected by Federal law from creditors. Not so with an IRA. You need to know what amounts in an IRA, if any, are protected from creditors by your state’s law,” Bartle says. Many states offer no protection. “Another reason I don’t recommend rolling over a 401(k) to an IRA.”
Rolling into an after-tax Roth IRA requires a tax payment on the amount today in exchange for no tax when withdrawn in retirement. The question here: Is the tax liability going to be greater today than ten to 20 years from now? It's time to watch this clarifying video: Roth IRA Vs, Traditional IRA.
Only a spouse can rollover an inherited 401(k) into their own IRA and, under the Pension Protection Act of 2006, the amount becomes part of that spouse’s IRA and early distributions are not taxable. A non-spouse cannot roll over an inherited 401(k) into an IRA, as a beneficiary or in your own name. “But a non-spouse can through a transfer to a beneficiary IRA, trustee to trustee,” Bartle says. “The money is not paid to you. The trustee moves it from the 401(k) plan to an IRA, which must be titled as a beneficiary IRA to receive the money. Commingling inherited funds with your own IRA is not allowed.” Anyone who inherits a 401(k) rollover has many options to consider. The Internal Revenue Service will provide information and answer questions.
Rollover rules for 401(k)s are not hard to understand. There are just so many that apply to age, employment status, and financial circumstances to consider if you want to make the right rollover decision.
The rules on retirement accounts are not rocket science. Just look them up, follow to the letter, and you will stay out of trouble.