If you're like most people, you likely have old retirement accounts (401(k) (403(b), 457, etc.) from former employers. When we change jobs, whatever the reason, we often neglect to think about what to do with our former employer's retirement accounts. There are too many other things on our minds.
Financial advisors will often tell you the best option is to rollover (transfer) those retirement plans into an IRA. But is that the best option? What other choices are there? What are the pros and cons of each option?
Though you often won’t hear of them, there may be up to six options available for these plans. Not all options may apply to you. That will depend on your current and former employers' rules for their specific plans. Others may not make sense in your situation. I will review the six options in this article.
A detailed review of each option is beyond the scope of this article. You should always consider talking to a professional advisor who has a good understanding of each option. Getting the right advice is essential when considering what to do with these accounts.
By the end of the post, you will have the information you need to understand these options and decide which one works best for you.
Options for former employer retirement accounts
#1 Leave the money with your current plan
Often, this becomes the default option simply because of not knowing what else to do. Most plans won’t make you take a distribution. The exception is for smaller accounts (typically $5,000 or less). Leaving your plan assets in your current plan may or may not be the best choice.
Typically, when you take a distribution from any retirement account under age 59 ½, you pay a 10% penalty. That’s in addition to income tax. If you separate from your employer in the year in which you turn age 55 or later, the 10% penalty is waived.
The Employee Retirement Income Securities Act (ERISA) regulates company retirement plans. ERISA covered plans may offer much stronger creditor protection. Non-ERISA plans (IRAs, Roth IRAs, etc.) are protected under state law. Though states often have strong creditor protection, it is essential to check your state’s rules before deciding.
ERISA plans may offer lower fees on investments than outside accounts. Plan sponsors often negotiate fee reductions with their investment and other service providers. Weigh services against the fees charged. Outside advisors may offer services that your plan does not. Look at these on a case by case basis.
#2 Roll the money into your new employer’s plan
Check to see if the plan allows rollovers from other company’s plans. If so, many of the same advantages may apply to move the money to your new company’s plan. The age 55 exception and creditor protection would still apply. Fees may be lower, and services may be better.
The new plan may offer loans to participants. Though not usually a good idea, this may be an option for you in the case of an emergency need. Borrowing from an IRA is considered a prohibited transaction. So, if that’s important to you, take that into account.
The same disadvantages would apply as leaving the money in your current plan. Consider what options are most important to you and let that be the deciding factor on whether to stay with your current plan or move assets to your new company.
#3 Roll the assets to your own IRA
You can roll over the money to an existing IRA or open a new IRA. The rollover can be direct or indirect.
You would likely have access to a much broader list of investment options. Most company retirement plans have a pre-selected list to make your selection.
IRAs have a much broader list of allowable investments. Two things are prohibited – life insurance, collectibles. Because of the corporation rules, IRAs cannot own S- Corporation stock. So, if you own a small business that is an S-Corp, your IRA could not hold your company’s stock.
Many people have changed jobs multiple times during their careers. Often, that means having multiple former employer retirement plans. You can roll these various plans over into one IRA. This may be an option for your new company plans as well. Check on that before deciding.
The indirect rollover is also known as the 60-day rollover.
In this transaction, the existing custodian sends the distribution from your retirement account directly to you. You then have 60 days to deposit the money into another qualified retirement account (IRA, 401(k), etc.). The 60-day rollover clock starts the day you receive the check.
If the proceeds are from a former employer’s plan, there is a mandatory 20% withholding for taxes. You must complete the rollover by the end of the 60-days. It’s not good enough to have sent the check before the end of the period.
The IRS considers the rollover complete when the new custodian deposits your funds into the new account. When you miss the deadline, the entire account value is subject to taxes. For those under age 59 ½, the 10% early withdrawal penalty would apply.
When using the 60-day rollover to move funds from a traditional or Roth IRA, there is a limit of one IRA rollover per twelve-month period. That twelve-months is not based on a calendar year. It is a 365-day period that starts the day of your first distribution. For this rule, traditional and Roth IRAs are combined. A rollover from either account type counts as the one rollover per year.
John takes a distribution from an IRA and decides to do an indirect rollover on November 15, 2018. He completes the rollover by December 20, 2018. If John has another IRA, he cannot roll it over until after November 16, 2019. If he does, he violates the 60-day rollover rule of one IRA in a twelve-month period. Also, John cannot roll over any other distributions in 2019 from the account he rolled over in 2018. He would have to wait 365 days from the date he deposited the funds into the new IRA.
An Indirect rollover is inefficient and complicated. There are severe penalties for noncompliance.
The direct rollover
The direct rollover is a trustee to trustee transfer. It does not have the complications and limitations of the 60-day rollover. In a trustee to trustee transfer, the funds from the existing retirement account go directly to the new custodian.
When the transfer is from one employer plan to a new employer plan, the funds go directly to the trustees/custodians of the new employer plan.
If a rollover to an IRA, money is sent directly to the IRA custodian. If sent via check, the check is made payable to XYZ Company, custodian for the IRA of John Q. Public. In this way, the money would not go to the IRA or retirement account holder. Instead, it goes from one custodian directly to the other.
As such, the 60-day rule does not apply.
No mandatory tax withholding
The direct rollover rule applies to rollovers from employer plans to IRAs, from IRAs to plan rollovers, and to Roth IRA conversions.
If the funds are from a company retirement plan, there is no mandatory 20% tax withholding since the money does not go directly to the account holder. There is no once a year limit applied to direct rollovers. You can make as many direct transfers as you want within a twelve-month period.
Even though a Roth conversion is considered a rollover, and even if considered a 60-day indirect rollover, it does not count for the once per year rule. That rule applies only to like-to-like accounts (IRA to IRA, Roth to Roth, etc.). Since a Roth IRA is not like a traditional IRA, the rule does not apply.
Required minimum distributions (RMDs)
With ERISA plans, you must take required RMDs from each account separately. You cannot consolidate and take them from one account. In traditional IRAs, you can take RMDs for multiple IRAs from one account. This simplifies the process.
Trustees in ERISA plans are fiduciaries. As fiduciaries, the decisions they make for plan participants must always be in the participants' best interest. Proposed legislation partially enacted in June 2017 requires anyone advising on IRAs to act as fiduciaries. There is heavy lobbying from the brokerage and insurance industry to undo this legislation. A bill has already come out of Congressional committee that dismantles this law.
Though the regulation is now mostly gone, many companies changed their practices during the legislative battle. Some always did the right thing and acted as fiduciaries. Before rolling into an IRA with an advisor, find out if they are committed to acting as a fiduciary on the account.
Creditor protection may be weaker (depending on state law). The age 55 RMD distribution exception is not available for IRAs. More appropriate investments may be available in company plans.
IRAs offer more exceptions to the 10% early withdrawal penalty (medical, education, first time home buying, etc.). You may have access to more and better investment options outside the current plan
Access to more services may be available in outside accounts. Look at what your plan includes that may be similar to the services outside advisors provide (financial planning, tax advice, estate planning, etc.) for the fees they charge.
#4 Take a lump sum distribution
For a variety of reasons, the lump sum distribution is the least favorable option of the six. Taking a lump sum distribution removes the tax deferral available in a retirement account. Distributions received are generally fully taxable in the year in which they are received. If the recipient is under age 59 ½, an additional 10% penalty would also apply.
If your plan assets include your company’s stock, you may benefit from the net unrealized appreciation (NUA) tax benefit. In many situations, the NUA benefit allows participants to transfer the company stock from a retirement account into a taxable personal investment account. This must be what’s called an “in-kind” transfer. An in-kind transfer means the shares of the stock are transferred, not the cash from the sale of the stock.
The IRS rules allow this stock to be sold at favorable long-term capital gains tax rates, either 15% or 20%, depending on your income. You would pay ordinary income tax on the amount you paid for the stock in the year in which it was distributed.
An NUA example
Let’s say you have $200,000 worth of company stock in your retirement account that you paid $50,000 to buy. If you followed the NUA rules and distributed shares of the stock into a personal investment account, you would owe ordinary income taxes on the $50,000 you paid for the stock. The tax bill is for the year you took the distribution.
When you sell the stock, whether in the year you transfer the account or in succeeding years, you would owe capital gains taxes at on the $150,000 in gain. Assuming a 24% tax rate, that represents a tax savings of $13,500 over just taking the cash.
Here's the calculation:
$50,000 x 24% (marginal rate)=$12,000
$150,000 x .15 (capital gains rate) = $22,500
Total tax = $34,500
$200,000 x 24% (marginal rate) = $48,000
A savings of $13,500
If you have highly appreciated company stock in your 401(k) plans, consider using the NUA option. The lump sum distribution and NUA options are only available after a triggering event (separation from service, retirement, reaching age 59 ½, etc.)
NOTE: These tax calculations are simplified for illustration purposes. The percentages used may not be an accurate portrayal of actual taxes owed. When considering the tax consequences of any investment decision, you should check with a CPA or other professional tax expert.
#5 Convert the plan assets to a Roth IRA
Like traditional IRAs, earnings while in Roth IRAs are not taxed. Unlike traditional IRAs, withdrawals from Roth IRAs are not taxable if done correctly. To be tax-free, withdrawals taken from a Roth IRA must be from an account that is at least five years old and where you are at least age 59 ½. There are no required minimum distributions with Roth IRAs. You can withdraw contributions made to a Roth IRA at any time without tax or penalty.
Amounts converted to a Roth IRA are taxable as ordinary income in the year in which you convert. In the first five years after the conversion, all converted dollars can be withdrawn tax and penalty free. After five years, all distributions will be tax-free. If over 59 ½, they will also be penalty free.
Roth IRA conversions allow you to pay taxes at today’s tax rates. Future tax rates can never be known for sure. However, if you believe that tax rates will go up in the future, a Roth conversion may make sense.
In previous years, those who converted traditional to Roth IRAs could undo those conversions. Called recharacterization, the option allowed you to recharacterize your converted dollars back into a traditional IRA. It's as if you never converted the IRA in the first place.
One of the main reasons to do this was a significant drop in the value of the account. Undoing the conversion when the market drops removed the tax bill on the conversion. Shortly thereafter, the account could be converted back to a Roth at the lower value reducing the tax bill.
The Tax Cuts and Jobs Act eliminated this option. IRAs converted in 2017 could have still been recharacterized up until October 2018. Any IRA converted in 2018 and beyond cannot be recharacterized.
Like the other options, there are many rules to follow and many other things to understand. Working with a competent financial advisor or tax specialist is important.
#6 Make an in-plan Roth conversion of plan assets
If you have a 401(k) or similar company retirement plan, you may be able to convert the assets to a designated Roth account (DRA) inside your company’s plan. You may also hear these described as Roth 401(k) plans. Not all plans offer DRAs (Roth 401(k)s). Check with your employer to see if you have the option. The second question is do they allow in-plan conversions to the DRA.
Here are some things to consider. Like traditional IRA conversions, you cannot recharacterize 401(k) money converted to a DRA. Make sure you can pay the tax bill on amounts converted. Consider doing smaller Roth conversions over several years to make the annual tax bill smaller.
If the plan allows partial distributions, consider converting those distributions to a Roth IRA rather than an in-plan conversion.
You've heard me say it numerous times when talking about IRS rules governing retirement accounts. They are complicated and often unclear. Getting them wrong is costly. Missing an RMD or not taking enough will cost you 50% of what you should have taken. Withdrawing from a retirement account before reaching age 59 1/2 costs you 10% in addition to your normal income tax. Not understanding the tax implications of a Roth conversion can wreck your plans.
Visit this IRS page, Retirement Plans Frequently Asked Questions, to get the facts. It's always best to consult the source of these rules.
The important thing to remember is this. There are more options for your old retirement accounts than rolling them into an IRA. Conventional wisdom and most financial advisors tell you rolling old plans into an IRA is the best option. That may be the case. Rather than assuming that's the case, get educated on the options you may not have known existed. That knowledge can help you make the best decision when considering what to do with your former employer's retirement accounts.
Now it's your turn. Were you aware of these options? Have you been advised to roll over an old plan to an IRA? What factors help you decide?Follow us
Fred is the Founder and President of Leamnson Capital. He helps people preparing for and in retirement with financial, retirement, Social Security, and estate planning.
At Money with a Purpose, he focuses on three primary areas: Personal Finance, Overcoming Adversity, and Lifestyle. He has been quoted in Forbes, USA Today and appeared in Money Magazine, MarketWatch, The Good Men Project, Thrive Global and many other publications.