If you’re about to receive a distribution from your 401(k) plan and you’re considering a rollover to a traditional IRA, you’ll be happy to learn that these transactions are usually straightforward and trouble-free. However, there are some pitfalls you’ll want to avoid. Before acting, keep the following in mind:
Consider the pros and cons of a rollover. The first mistake some people make is failing to weigh the advantages and disadvantages of a rollover to an IRA in the first place. You can leave your money in the 401(k) plan if your balance is over $5,000. And if you’re changing jobs, you may also be able to roll over your distribution to your new employer’s 401(k) plan.
Although IRAs typically offer significantly more investment opportunities and withdrawal flexibility, your 401(k) plan may offer investments that can’t be duplicated in an IRA (or can’t be duplicated at an equivalent cost).
Also, consider that 401(k) plans offer virtually unlimited protection from your creditors under federal law (assuming the plan is covered by ERISA; solo 401(k)s are not), whereas federal law protects your IRAs from creditors only if you declare bankruptcy. Any IRA creditor protection outside of bankruptcy depends on your particular state’s laws.
Also keep in mind that many 401(k) plans allow employee loans and most don’t provide an annuity payout option, while some IRAs do.
Not every distribution can be rolled over to an IRA. For example, required minimum distributions can’t be rolled over, nor can hardship withdrawals or certain periodic payments; do so and you may have an excess contribution to deal with.
Use direct rollovers and avoid 60-day rollovers. While it may be tempting to give yourself a free 60-day loan, it’s generally a mistake to use 60-day rollovers rather than direct (trustee to trustee) rollovers. If the plan sends the money to you, it’s required to withhold 20 percent of the taxable amount. If you later want to roll over the entire amount of the original distribution into an IRA, you’ll need to use other sources to make up the 20 percent the plan withheld. In addition, there’s no need to taunt the rollover gods by risking an inadvertent violation of the 60-day limit.
Remember the 10-percent penalty tax. Taxable distributions you receive from a 401(k) plan before age 59½ are normally subject to a 10-percent early distribution penalty, but a special rule lets you avoid the tax if you receive your distribution as a result of leaving your job during or after the year you turn age 55 (age 50 for qualified public safety employees). But this special rule doesn’t carry over to IRAs. If you roll over your distribution to an IRA, you’ll need to wait until age 59½ before you can withdraw those dollars without the 10-percent penalty (unless another exception applies). So if you think you may need to use the funds before age 59½, a rollover to an IRA could be a costly mistake.
Learn about net unrealized appreciation (NUA). If your 401(k) plan distribution includes employer stock that’s appreciated over the years, rolling over that stock into an IRA could be a serious mistake. Normally, distributions from 401(k) plans are subject to ordinary income taxes, but a special rule applies when you receive a distribution of employer stock from your plan: You pay ordinary income tax only on the cost of the stock at the time it was purchased for you by the plan. Any appreciation in the stock generally receives more favorable long-term capital gains treatment, regardless of how long you’ve owned the stock. (Any additional appreciation after the stock is distributed to you is either long-term or short-term capital gains, depending on your holding period.) These special NUA rules don’t apply if you roll over the stock to an IRA.
Finally, if you’re rolling over Roth 401(k) dollars to a Roth IRA, be aware that if your Roth 401(k) distribution isn’t qualified (tax-free) because you haven’t yet satisfied the five-year holding period, those dollars will be subject to the Roth IRA’s five-year holding period, no matter how long they were in the 401(k) plan. So, for example, if you establish your first Roth IRA to accept your rollover, you’ll have to wait five more years until your distribution from the Roth IRA will be qualified and tax-free.
BARBARA KENERSON is first vice president/Investments at Janney Montgomery Scott LLC and can be reached at BarbaraKenerson.com.