By Lee Sherbakoff, CPA/PFS, CFP®, RICP®
We all dream of a fulfilling retirement, but that dream doesn’t become a reality without years of diligent planning and saving. And there’s no better retirement savings vehicle than a 401(k), into which I’m sure you’ve been socking away your hard-earned dollars year after year. But what happens to this money if you switch to a new job? The days of sticking with one company for an entire career are long gone—the average working adult changes jobs 12 times during their career (1)—so the odds are pretty good you’ll need to make a decision when your current employer becomes your former employer.
It’s crucial to know what a 401(k) rollover is, and how to do one with your investment accounts. After all, everyone wants to streamline their financial portfolio as much as possible (and pay less in fees and have more investment options) while also still tailoring it to their specific situation. So let’s go over the basics of a 401(k) rollover.
What is a 401(k) Rollover?
A 401(k) rollover is an option you have when you leave a company and want to transfer your investments into an individual retirement account (IRA). Normally people do this if they are leaving a company, switching to a new company, or retiring, but you can also do a 401(k) rollover into another 401(k) with a new employer. (2)
Pros and Cons of A Rollover
The main benefits of a rollover from a 401(k) to an IRA are the following:
- More options. Most 401(k) plans have a limited selection of mutual funds and bonds to invest in. IRAs offer those plus other options, such as stocks, exchange-traded funds, and income-producing real estate. (3)
- Lower expenses and management fees. This will vary depending on your 401(k), but usually having an IRA decreases management fees, administrative fees, and expenses related to each fund you have.
- Convert from a tax-deferred account to a Roth account. Contributions to a 401(k) plan or traditional IRA are made using pre-tax dollars, which means distributions are taxed at the time of withdrawal. Rolling money from a traditional 401(k) into a Roth IRA gives you the option of paying taxes now so that you will not have any taxes due at the time of withdrawal in the future. If this is an option you are considering, you should discuss with your advisor and your tax professional to consider current and future forecasted tax rates to see which pathway makes the most sense.
Required Minimum Distributions (RMDs)
Tax-deferred retirement plans are subject to required minimum distributions (RMDs). Taxes are due at the time of withdrawal. The SECURE Act changed the timeline for taking RMDs for both IRAs and 401(k) plans. For IRAs, anyone who reached age 70½ on or after January 1, 2020, will not be required to begin taking RMDs until April 1st of the year after they reach age 72. (4) Failure to take RMDs at the appropriate time will result in a hefty 50% penalty on any distributions you fail to take on time. (5)
Some 401(k) plans (but not all) allow you to leave money in the plan until you retire, effectively delaying RMDs, as long as you are still working for the employer who sponsored your 401(k) plan. If you leave any 401(k) funds in your prior employer’s account, the exception will not apply to those funds. (6) The exception also does not apply to IRAs; if you have funds in an IRA, you must start taking RMDs when you reach the age limits regardless of when you retire.
Both IRAs and 401(k)s include a 10% penalty if you withdraw money before the age of 59½. The 10% penalty is in addition to taxes that you will owe on the money no matter what. There is one exception for 401(k) plans, known as the Rule of 55; if you retire at 55 or later, you can take penalty-free withdrawals from your current 401(k) sponsored retirement plan. The Rule of 55 does not apply to IRAs, nor does it apply to 401(k) plans still housed in a prior employer’s account.
How to Execute a Rollover
Thankfully, rollovers are pretty simple. Once you have chosen a bank, financial institution, or online investing platform, you contact your 401(k) plan administrator to let them know where you want your funds transferred. (7) You can choose to do either a direct or indirect rollover. A direct transfer is generally recommended because it is the simplest form of getting money from one point to the next, and you do not have to worry about how or when to deposit funds.
You also have the option of doing an “indirect rollover,” where your employer cuts you a check and you are responsible for depositing the funds into a new tax-deferred investment account within 60 days. Your employer will be required to withhold 20% of the funds to pay taxes due (this 20% comes back to you in the form of a tax credit when you file your return). That means you will only receive a check for 80% of the value of your 401(k), and you will need to replace the 20% withheld amount from your personal funds or another source. (8) If you fail to deposit the funds to a tax-deferred account within 60 days, the transfer will be treated as an early withdrawal and the entire amount will be subject to an additional 10% penalty.
Is a Rollover a Good Option For You?
Although there’s a lot of flexibility with 401(k) rollover options, it can be confusing to know which path to take. You want to make the most of your 401(k), and as with any retirement-related decision, cookie-cutter advice just won’t do. Your situation is unique, so it’s best to discuss your options with a financial professional before pulling the trigger.
We at The Nalls Sherbakoff Group would love to answer your questions and help you evaluate your options. Once we get to know you and your unique situation, we can then create a retirement road map to help you reach your financial goals. We invite you to set up a complimentary appointment so we can see if our services are the right fit for you. Reach out today by calling (865) 691-0898 or contacting us online.
Lee Sherbakoff is principal and financial advisor with The Nalls Sherbakoff Group, LLC, an independent, fee-only financial planning and investment management firm. He specializes in serving pre-retirees and retirees, helping them create and execute financial plans and retirement income plans that lead to sustainable long-term, real-life returns that meet their deepest and most important financial goals and objectives. Lee has a Bachelor of Science in Finance from The University of Tennessee and a Master of Strategic Studies from the U.S. Army War College as well as the Certified Public Accountant (CPA), Personal Financial Specialist (PFS), Certified Financial Planner™ (CFP®), and Retirement Income Certified Professional (RICP®) credentials. Lee spent over 31 years in the U.S. Army Reserves, including serving at the Army’s highest levels on the Department of Army staff at the Pentagon and being deployed in support of Operation Desert Storm (1991) and Operation Iraqi Freedom (2008-2009). When he’s not loyally serving his clients, Lee enjoys giving back to the community and to his profession, acting as a council member of the Tennessee Society of CPAs and a member of the American Institute of CPAs. In addition, he is past President of the Knoxville Chapter of Tennessee Society of CPAs and past President of the East Tennessee chapter of the Financial Planning Association. To learn more about Lee, connect with him on LinkedIn.
DISCLOSURES: The information provided is for general informational purposes only and should not be considered an individualized recommendation of any particular security, strategy or investment product, and should not be construed as investment, legal, or tax advice. The Nalls Sherbakoff Group, LLC makes no warranties with regard to the information or results obtained by third parties and its use and disclaim any liability arising out of, or reliance on the information. These indexes reflect investments for a limited period of time and do not reflect performance in different economic or market cycles and are not intended to reflect the actual outcomes of any client of The Nalls Sherbakoff Group, LLC. Past performance does not guarantee future results.