4 Important Considerations Before Doing a 401(k) Rollover
What exactly is a 401(k) rollover? It is when you have money in a 401(k) (or another type of retirement plan) with a former employer, and you then transfer that money into an Individual Retirement Account (IRA) or another retirement plan with your new employer. Many retirement plans will also allow you to do this when you reach age 59.5, even while still working for that company. There are a tremendous number of advertisements out there telling you that you should roll over your old retirement plan, but many of these do not adequately disclose or cover what you should consider before doing a rollover. In this post, I will cover the four most important things to consider before completing a rollover.
1. Do you own stock in your 401(k) for the company you previously worked for?
If you own stock in your 401(k) from a previous employer, you can potentially save taxes on this money by taking advantage of an IRS distribution option known as net unrealized appreciation or NUA. It allows the company stock portion of your 401(k) to be taxed as a long-term capital gain, rather than as ordinary income, which for many people would be a tax savings. Unfortunately, many people have never heard of NUA and just sell the company stock when doing a rollover voiding the ability for this tax savings.
How it works can be somewhat confusing, so let’s start with an example. Let's just assume you worked for CVS, and you have worked there for many years. You purchased shares of Aetna stock long before the merger with CVS and you paid $10,000 over time to buy this stock (your cost basis). The stock is currently worth $100,000. Doing some quick math, you currently have a $90,000 gain on your CVS stock. In addition to the CVS stock and you also have mutual funds inside of the 401(k) plan worth $200,000. This gives you a total 401(k) balance of $300,000. If done correctly you could pay long-term capital gains rates on this $90,000 gain at potentially 0%. The cost basis of $10,000 would be taxed as ordinary income in the year that you process the NUA distribution. The mutual funds would be taxed as ordinary income (just like all other 401(k) distributions based on your tax rate in the year they were distributed.
To take advantage of this, you would need to distribute the entire 401(k) in the same tax year. Meaning the entire balance would need to be withdrawn by the end of the tax year you elect to use NUA. You would probably want to start this process at least a month before the end of the year to ensure your transaction was processed in time. The company stock portion would be sent to a brokerage account of your choice and the remaining funds, in this case, mutual funds would be liquidated and a rollover check would be sent to the IRA of your choosing. If you do not already have a taxable brokerage account and Traditional IRA, you would want to open them prior to the NUA transaction being completed.
You might be thinking that paying 0% taxes on this CVS stock sounds great. What is the catch? Well, there are a few. First, in order to take advantage of this, you must have a triggering event, and there are four triggering events. They are death, disability as defined by the IRS, separation of service from the company, and lastly attainment of age 59.5. Death? Yes, death is a triggering event and though it will not benefit you, it could benefit your spouse if they inherited your 401(k) after your passing or you if you inherit your spouse’s 401(k) and they also have company stock in their 401(k). Disability generally also means you don’t work for the company any longer and reaching age 59.5 is also important because if you attempt this prior to that age you will be subject to a 10% IRS penalty.
The next catch is that you can’t have rolled any money out of this 401(k) prior to this request. If you did, you can no longer take advantage of NUA. So, if you plan to take advantage of this then do not do any rollover until you’ve retired or left the company. The final catch is that because you must distribute or roll over the entire account balance out of the 401(k) by the end of that year, you don’t want to keep contributing to the 401(k). So even if you are now 59.5 and qualify to use NUA, you wouldn’t want to do so until you’ve left that company.
I mentioned earlier that you might be able to pay 0% tax on the capital gain on this stock. Currently for single/married filing separately filers with taxable income of less than $40,400 and joint filers with taxable income of $80,800 there is 0% tax on long-term capital gains and qualified dividends. Keep in mind that taxable income is after deductions such as the standard deduction and over age 65 deduction. So, if you’re retired or currently out of work, this would be a good time to take advantage of this 0% capital gain. You also don’t have to sell all of the stock in the same tax year, and you could sell it over a few years to keep yourself in the 0% capital gains bracket. However future tax rates are subject to change.
If your taxable income were higher than previously mentioned, NUA could still be a good deal as long-term capital gains rates then go up to 15%. If you just sold the stock when you did the rollover and took distributions beginning at age 72 you probably would end up paying more tax. Most people in retirement with sizable 401(k) balances will end up paying at least 22% in federal tax. At a minimum, this could be a 7% federal tax savings between 22% and 15%. Higher earners with larger 401(k) balances and pensions could pay even more than that. Taxes are something that never goes away and unfortunately can become even more complex in retirement.
One other thing with this, you must think about is, if you do this when you're on Medicare, there is an additional amount you might have to pay for Medicare. It's called an income related monthly adjustment amount (IRMAA). If your income is over $88,000 for those filing singly and over $176,000 for those filing jointly then this applies.
To know if this makes sense you would need to know the cost basis of the company stock that you own. Some 401(k) providers make it easier than others to get this information. You may be able to find it online or on your 401(k) statement. If you can’t locate it then contact your 401(k) provider. Also, remember that it is never good to have a large portion of your money invested into one company stock. Even great companies can see their stock prices decline significantly. We don’t have to look too far back for examples of this. A stock price decline could wipe out a lot of the tax savings that you're receiving by taking advantage NUA. So, you’ll have to balance out the amount of risk you’re taking by pursuing this.
2. Do you have a loan against the 401(k)?
If have an existing loan with a 401(k)plan, then you want to get that loan paid off before you do a rollover. If you don’t pay off that loan before you do a rollover then the remaining loan balance is potentially taxable to you. Let’s say you had $100,000 401(k) with a $20,000 loan balance and you process a rollover request. You would receive $80,000 that could be rolled over and the $20,000 would be taxable to you at your ordinary income tax rate for that year.
Normally you have 60 days to repay a loan if you separate from your 401(k) plan, whether the separation was voluntary or involuntary. Due to the Tax, Reconciliation, and Jobs Act that was passed in 2017, you now have until your taxes are due for the year that you took the rollover. This includes extensions. For most people, the latest you can file your taxes with an extension is October 15. Whatever the loan balance was, you want to get that paid back into your new retirement account so that it won’t be taxable to you. If you don’t pay it back, then it is subject to income tax and if you’re under 59.5 it is also subject to a 10% penalty.
With our prior example above of the $100,000 401(k) with a $20,000 loan balance, the $20,000 loan balance would need to be deposited into an IRA prior to the tax filing deadline to avoid taxes and penalties. Let’s assume the participant was 55 years old and in the 22% Federal Tax Bracket and 6% State Income Tax Bracket. Then this $20,000 loan balance would be subject to $4,400 Federal Tax, $1,200 State Tax, and $2,000 Federal Tax penalty for a total tax of $7,600.
If you were affected by COVID-19 and meet the definition of a “qualified individual” under the CARES Act, you can treat a 2020 loan offset (non-repayment due to separation) as a coronavirus-related distribution (CRD). This allows you 3 years to repay the $20,000 loan and roll it over into your new IRA. This $20,000 loan would also not be subject to the 10% early distribution penalty, and you could report this taxable income over 3 tax years rather than just one.
3. Are you under age 59.5?
If you are under age 59.5 then you should think hard about doing a rollover. Current IRS 401(k) provisions waive distributions from 401(k)s if you are separated from service between age 55 and 59.5. If you roll this money to an IRA or new 401(k) you lose the ability to avoid the 10% early distribution penalty. This would be a big mistake and could cost you a lot in taxes should you need access to your money before 59.5. At 59.5 the 10% early distribution penalty no longer applies. If clients are considering a rollover between 55 and 59.5 and not using NUA, I recommend leaving some money behind in the 401(k) just in case they need access to the money before age 59.5.
If you have a 457 retirement plan, then there is never a 10% penalty for early distributions before age 59.5. If you leave a job where you have a 457 retirement plan, then you want to avoid rolling over all the money until you’re 59.5 so you can access the money without the 10% penalty.
4. Are you satisfied with the investment options in the plan?
401(k) investment options come in all shapes in sizes. It is up to the company offering the plan to decide which investment options to offer and you have little control over this. These plans are designed to meet multiple employees’ needs so the funds being offered might not be a fit for you. Even the best 401(k) plans offer less than 50 investment options to select from and many 401(k) plans offer fewer than that. By opening an IRA account with a discount broker such as TD Ameritrade, Fidelity, or Charles Schwab you now have access to thousands of funds and stocks to choose from. This greater selection many times will allow you to design a more diversified portfolio.
You also should know what fees you’re paying in your 401(k) plan. 401(k) plans charge fund fees, administrative fees, and sometimes asset management fees. These fees can quickly add up. Every 401(k) is required to disclose those fees to you in what is known as a Participant Fee Disclosure 404(a)(5). I suggest all 401(k) participants review this to first know what they are paying each year.
Next, I suggest that you focus on using as many low-cost investment options as you can. Hopefully, your plan has these options and if not, this is a definite reason to consider a rollover. Low-cost investment funds would have an annual expense ratio of .25% or less. The expense ratio is the annual internal costs that mutual funds charge their investors. These fees often go hidden from investors because you never receive a bill for this fee. Instead, they are disclosed in a mutual funds prospectus and are collected daily from each mutual fund.
You will find that many of the lowest cost investment funds are index-based funds. The goal of these funds is not to beat the stock, bond, or real estate market, but rather track that market. Study after study has shown that over long periods of time these index funds often outperform their counterparts (expensive actively managed funds). If you can build a portfolio of low costs funds, then you stand a good chance of meeting your retirement goals.
Keep these 4 steps in mind if you are considering a rollover of an old retirement plan. Don’t be afraid to reach out to a fee-only financial planner such as myself to help you with this complicated decision. Unfortunately, once you have requested a rollover you have little time to correct any bad decisions you might have made.
