Rollovers of Retirement Plan and IRA Distributions

Rollovers of Retirement Plan and IRA Distributions

1. More Investment Choices

Your 401(k) is limited to a few planets in the investment universe. In all likelihood, you have a choice of mutual funds from one particular provider. However, with an IRA, you can invest just about anywhere. In addition, you’re likely to have more types of investments to choose from—not just mutual funds but also individual stocks, bonds, and exchange traded funds (ETFs), to name a few.

“IRAs open a larger universe of investment choices,” says Russ Blahetka, CFP, founder, and managing director of Vestnomics Wealth Management LLC in Campbell, Calif. “Most 401(k) plans do not allow the use of risk management, such as options, but IRAs do. It is even possible to hold income-producing real estate in your IRA.”

You can also buy and sell holdings any time you want. Most 401(k) plans limit the number of times per year that you can rebalance your portfolio, as the pros put it, or restrict you to certain times of the year.

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Tax Consequences of a 401(k)-to-IRA Rollover

As mentioned above, you generally won’t have to pay any taxes on your 401(k)-to-IRA rollover. The only time you’ll have to deal with taxes is if you have a traditional IRA and want to roll over to a Roth IRA.

One other tax consideration: You can choose to do a direct or indirect rollover. For a direct rollover, your old plan sends the money directly into your new IRA. In an indirect rollover, your old plan sends you a check with the cash and withholds 20% of your funds. These withheld funds are a taxable distribution unless you make up the difference out of pocket. You’ll likely have to pay a 10% fine for the early withdrawal. This rule only applies if the check is sent directly to you, though. It doesn’t matter if your old plan sends you a check to forward to your new IRA.

When should I roll over?

You have 60 days from the date you receive an IRA or retirement plan distribution to roll it over to another plan or IRA. The IRS may waive the 60-day rollover requirement in certain situations if you missed the deadline because of circumstances beyond your control.

1. Choose a good brokerage to hold your account

(if you aren’t already invested with one): Factors to consider include cost (look for a brokerage offering $0 trading commissions and few or no other fees, such as IRA custodian fees); availability of investments; customer service; usability; and research tools. 

What Are the Advantages of Leaving My 401(k) With My Ex-Employer

You might consider leaving your 401(k) with your ex-employer if you believe the plan is well run, its expenses are reasonable, and you don't want the responsibility of managing the money yourself. However, make sure you don't lose track of the account over the years and that the plan administrator always has your current address.

Note, also, that this doesn't have to be an all-or-nothing decision. You may be able to keep some of your balance in your old 401(k) and roll the rest into an IRA. After that, you can contribute to both your new company's 401(k) and your IRA as long as you don't go over the annual contribution limits.

Indirect Rollovers

You can handle a rollover yourself by withdrawing money from your account and depositing it in your new employer’s plan or an IRA. You may opt for an indirect rollover to take advantage of a short-term loan if you’re temporarily between jobs or you’re waiting to close on your old home to make the down payment on a new one.

Caution: Opting for an indirect rollover as a short-term loan should be a financial last resort, since you’ll face early withdrawal penalties unless you repay the loan within 60 days. The IRS has a self-certification procedure if you inadvertently miss the 60-day time limit.

When you indirectly roll over a 401(k), your employer gives you a check for the value of your account, minus 20 percent withholding. The IRS requires your employer to take out that 20 percent in case you decide to keep the money rather than roll it into another account. Even though that amount isn’t included in the check you receive, you must provide it from another source if you want the full amount of your rollover to remain tax deferred. If you complete the full rollover within the time limit, the withholding will be returned to you when you file your tax return for the year. However, if you do decide to keep the money, the withholding will go towards the taxes you’ll owe on the early distribution.

Any pretax contributions and all earnings that you don’t deposit within this 60 day window are considered withdrawals and are taxable. You may also be vulnerable to an additional 10% tax penalty if you are younger than 59½.

When You Don’t Roll Over

Cashing out your account is a simple but costly option. You can ask your plan administrator for a check—but your employer will withhold 20 percent of your account balance to prepay the tax you’ll owe. Plus, the IRS will consider your payout an early distribution, meaning you could owe the 10 percent early withdrawal penalty on top of combined federal, state and local taxes. That could total more than 50 percent of your account value.

Think Twice The repercussions of taking money out now could be enormous: If you took $10,000 out of your 401(k) instead of rolling it over into an account earning 8 percent tax-deferred earnings, your retirement fund could end up more than $100,000 short after 30 years.

If your former employer’s plan has provided strong returns with reasonable fees, you might consider leaving your account behind. You don’t give up the right to move your account to your new 401(k) or an IRA at any time. While your money remains in your former employer’s 401(k) plan, you won’t be able to make additional contributions to the account, and you may not be able to take a loan from the plan. In addition, some employers might charge higher fees if you’re not an active employee.

Further, you might not qualify to stay in your old 401(k) account: Your employer has the option of cashing out your account if the balance is less than $1,000 (minus 20 percent withholding) though it must provide for the automatic rolling over of your assets out of the plan and into an IRA if your plan balance is more than$1,000.

What happens if I don’t make any election regarding my retirement plan distribution?

The plan administrator must give you a written explanation of your rollover options for the distribution, including your right to have the distribution transferred directly to another retirement plan or to an IRA.

If you’re no longer employed by the employer maintaining your retirement plan and your plan account is between $1,000 and $5,000, the plan administrator may deposit the money into an IRA in your name if you don’t elect to receive the money or roll it over. If your plan account is $1,000 or less, the plan administrator may pay it to you, less, in most cases, 20% income tax withholding, without your consent. You can still roll over the distribution within 60 days.

Best Practices and Strategies for Rolling Existing Retirement Funds Into an Annuity

Determining how much of your retirement savings should be in an annuity should start with an analysis of your routine expenses. Ideally, you should make sure you have a guaranteed income stream to fund at least 80% of your budget. This income stream can come from Social Security, a pension or annuities.

When you consider rolling your retirement savings into an annuity, you should be familiar with the types of annuities and the benefits and drawbacks of each. Some investment advisors say that variable annuities are not a good option because they can be expensive, complicated and unpredictable. Fixed annuities, however, are less costly to the purchaser and more reliable as far as an income stream.

You should consult a financial advisor to chart out your budget moving forward and determine how much of your retirement savings should be used to purchase an annuity. You should determine what type of annuity works best for you and whether you should purchase specific riders to modify the contract to meet your needs.

You could also use various strategies, such as annuity laddering, which takes advantage of different types of annuities to construct the income stream you need, or a split-funded annuity, which enables you to get the best of different types of annuities.

Another possible strategy is to delay receiving the annuity income stream as long as possible. That’s because your expected lifespan is part of the calculation an annuity provider uses to determine how big your payments will be. The shorter your life is projected to last, the higher the individual payments. Consequently, the older you are when you begin receiving payments, the higher the income payments will be.

5. Invest your newly deposited funds

You’ll have to choose investments in your new IRA so your money can grow. Make sure to maintain an appropriate asset allocation given your age, and consider your risk tolerance. 

Finally, when your new IRA has been opened, be sure to read up on common IRA mistakes to avoid, such as forgetting required minimum distributions, not designating beneficiaries, and trading too often in the account. 

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Common questions

What is the difference between a rollover and transfer of assets?

A rollover is when you move funds from one eligible retirement plan to another, such as from a 401(k) to a Rollover IRA. Rollover distributions are reported to the IRS and may be subject to federal income tax withholding. See the question below around direct and indirect rollovers to understand both options and their tax consequences. 

A transfer of assets is when you instruct your retirement account provider to move funds directly between two accounts of the same type, such as from one Traditional IRA to another Traditional IRA. Transfers can take place as often as you like. They are not reported to the IRS because you never take possession of your money.

Are there fees associated with a Schwab Rollover IRA?

There are no fees to open or maintain a Rollover IRA at Schwab. You only pay fees for transactions you make in the account, such as trading stocks, or for investments you hold in the account, such as operating expenses on mutual funds. See the Charles Schwab Pricing Guide for Individual Investors and its amendments for comprehensive details on fees.

What types of retirement plans can I roll over?

Eligible employer-sponsored retirement plans are those that you receive qualifying distributions from, and include 401(k) plans, 403(b) plans, profit-sharing plans, money purchase plans, and Keoghs/Qualified Retirement Plans (QRPs). 

Plans that may not be eligible include employee stock ownership plans (ESOPs) and defined benefit plans. 

You may be allowed to roll over after-tax dollars and governmental 457(b) qualifying distributions. Contact your plan administrator(s) to find out if your particular plan is eligible for rollover.

What is the difference between a direct rollover and an indirect rollover?

With a direct rollover from an employer-sponsored plan to an IRA, the administrator of your plan delivers your distribution directly to the financial provider where your Rollover IRA is held. Since you never actually take possession of your assets, there is no mandatory 20% federal tax withholding. 

With an indirect rollover, you do receive the assets from your employer-sponsored plan, and roll over either all or a portion of the assets into another eligible plan within 60 days of receiving the distribution. Your employer may be required to withhold 20% for federal income tax. However, you can recover the deduction if you roll over the amount you received from your prior employer plus the 20% that was deducted. You will receive the refund in the form of a tax credit when you file your tax return.

What if my employer made my rollover distribution check payable to me, rather than to Schwab?

If your employer sends you a rollover distribution check made payable to you, you can deposit it directly into your Rollover IRA. Be sure to write your Schwab Rollover IRA account number on the check and deposit it within 60 days to avoid taxes and penalties.

Your plan administrator may have withheld 20% for federal income tax. You can recover the deduction if you roll over the amount you received from your prior employer plus the 20% that was deducted. 

Please see IRS Publication 590 or talk with your tax advisor for more details.

I am not sure how to request a rollover from my prior employer. What should I do?

Call a Schwab Rollover Consultant at 866-855-5635 and we will work with your former plan administrator to make sure your retirement savings are rolled over properly. Please talk with your tax advisor for details about your specific situation.

Am I responsible for tracking my pre- and post-tax rollover contribution amounts?

Yes, you are responsible for tracking your tax basis. All rollovers are tax-reportable events on IRS Form 1099-R for the distributed amount and Form 5498 for the contributed (rollover) amount.

Can I make contributions to my Rollover IRA once it is open?

Yes, but if you do, you may not be able to roll the IRA into a new employer-sponsored retirement plan. Different plans determine which assets, if any, will be accepted. If you think you might start a new job in the future, you should check with your new employer regarding their plan’s rules.

How Many IRA Rollovers per Year?

You can only rollover IRAs once per year, for all your aggregate IRAs. The once-per-year rule applies to the 60-day IRA rollover, where funds are withdrawn from one IRA account, and the account holder has 60 days to deposit the funds into another IRA account. The 60-day rollovers are considered a distribution since the account holder personally receives the check from their IRA; the check must be deposited to another IRA to avoid creating a tax liability.

However, direct IRA rollovers are excluded from the once-per-year rule. This type of rollover is also known as trustee-to-trustee rollover, where the IRA transfers the retirement money directly to another IRA. Trustee-to-trustee rollovers are not subjected to the 60-day deadline. These transfers are not considered distributions, hence are excluded from the once-per-year IRS rule.

Will you pay taxes when you rollover from 401(k)?

If you rollover a 401(k) to another 401(k) or IRA, there are situations when you may owe taxes on the transaction. Usually, you must pay taxes when you rollover funds from a traditional 401(k) to a Roth 401(k) or Roth IRA, since funds are moved from a pre-tax account to an after-tax account.

For example, if you rollover from a traditional 401(k) to a Roth 401(k) or Roth IRA, you must pay taxes on the rollover, since a Roth 401(k) and Roth IRA are funded with after-tax dollars. In contrast, if you rollover from a traditional 401(k) to a traditional 401(k), you won’t pay tax on the rollover since both retirement accounts are pretax.

Taxes may also arise if you don’t complete the rollover within the 60-day period. Generally, when you opt for an indirect rollover, the 401(k) plan will send you a check with your 401(k) money, and you must deposit the check to a qualified retirement plan. If you don’t rollover the funds within 60 days, the money will be considered a taxable distribution subject to income taxes and a potential 10% early distribution penalty.

How does a rollover IRA work?

When you change jobs or retire and have savings left in your former employer’s retirement plan, you typically have four options (PDF) when deciding what to do with your money.

If you opt to move your money into an IRA, you’ll determine if a traditional IRA or Roth IRA is right for you. This generally depends on the type of money in your original account and your tax situation. It’s common to roll pre-tax money into a traditional IRA and post-tax money into a Roth IRA.

You can usually open your IRA online, over the phone, in person, or by mail and then fund it by requesting to transfer money from your former employer’s retirement plan to your new account.

Tips for Retirement Investing

  • Consider finding a financial advisor to steer you in the right direction in terms of savings and investments. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • When you’re starting to plan for retirement, you should consider the tax laws of the state you live in. Some have retirement tax laws that are very friendly for retirees, but others don’t. Knowing what the laws apply to your state, or to a state you hope to move to, is key to getting ahead on retirement planning.

Photo credits: ©iStock.com/designer491, ©iStock.com/jxfzsy, ©iStock.com/UberImages

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