Episode 18: Concerning Those 401(k) Rollovers

In this episode, our financial professionals Roger and Jake break down the essentials of 401(k) rollovers to help you make informed decisions about your retirement savings.

Whether you're planning for the future or making critical financial moves, this episode provides practical insights for your retirement savings.

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In this episode, Roger and Jake will be talking about the important things to know concerning 401(k) rollovers, which is a common topic in meetings.

At some point in time, everyone has probably left a job or maybe some people are just retiring.

A lot of times, people who are retiring or have left their employer will ask, “What do I do with this retirement plan from my previous employer? What are my options?” Well, you can do a 401(k) rollover. And there are two main options that you can take advantage of with a 401(k) rollover.

One is our preferred option, the one that we're going to want to do whenever we can. It's called a “direct rollover.” The direct rollover will send the money from the current custodian to the new custodian.

So, whomever is managing the custodian of your 401(k) plan will send the money either via check or electronically to the custodian of the IRA or Roth IRA that we've set up to receive those funds. Your money moves over, it’s a tax-free event and the simplest way to do it. The more complex and less ideal way is what's called an “indirect rollover,” and that's something that we try to avoid when we can.

An indirect rollover is going to cut a check out to you in your name, and that starts a ticking time clock of 60 days. That check that you receive is going to be 20% less than your account value because they're going to automatically withhold 20% for taxes. You're going to get that check, and you've got 60 days to get that money from the check that you've received into an IRA or a Roth IRA to complete the indirect rollover.

If you do it on the 61st day, the entire account value is going to be deemed taxable. And you can only do an indirect rollover once every 12 months or you might face some penalties.

The wording between the two is so similar, but the implications of a direct rollover versus an indirect rollover are vastly different. So that's why completing a direct rollover is ideal and what we would always recommend that clients do.

So, be mindful of those two options when you're looking at a rollover.

 There could also be a little bit of a misconception on whether it’s a direct or indirect rollover if the current custodian you’re moving your money from makes the check out to the new custodian, but you personally receive the check in the mail. It’s still a direct transfer. You might receive the check at your home, but it's made out to the new custodian, the new holder of your money. If they're making it out to you, that's the difference. That is the case where it becomes an indirect rollover; when you've taken kind of possession of that money, and you're going to have to write another check to the new custodian.

Don't get too worried if you're doing a rollover and get a check saying, “well, hey, they made it out to the custodian, they sent this check to my house. What now?” That’s okay. As long as it's made out to the new custodian who's holding the money, it's a direct transfer. It's all right.

Another thing to consider are “in-service withdrawals,” that usually happen when you're 59 and a half. In-service withdrawals are an opportunity you can take advantage of in your plan to diversify on the investment side; to take money out of your account sooner than your retirement age, if you'd like, or to take a distribution from your account while you’re still taking part in your employer’s plan. So, you're still able to contribute to your 401(k). You're still able to get your matching contribution.

Oftentimes, and for the topic of this podcast, people go, "hey, I want to roll some of this money out and diversify so that I can invest a little bit differently than what's available." Sometimes it's just 10 to 12 funds, most of which are set for target retirement date funds in my retirement plan at work. For most plans, the average age is 59 and a half.

So once you reach 59 and a half, you can implement this in-service rollover, in-service distribution, but it is plan specific. Some will allow you to do it as soon as age 55 or any age in between, so you actually have to look at your plan documents or talk to someone in your HR department to figure out at what age can I process an in-service rollover or withdrawal from your 401(k) plan.

Jake and Roger will look at the cost - What benefit are you getting from potentially taking an in-service withdrawal or not? There are benefits in most cases from a diversification or a strategic standpoint of managing the money. But whether you’re working with a financial professional or doing it yourself, make sure you understand what the cost factor is on in-service withdrawals as well.

One thing that gets missed when rolling over a 401(k) is what type of money do you have in your 401(k)? So many clients, when they come in say, "Rog, I don't remember what I did 20 years ago. I don't remember what I did 10 or 15 years ago. Heck, I don't remember what I did two to three years ago to fund my 401(k)." And with the number of times that people change jobs, so many of our clients that work with us have plans all over the place from different employers that they've had over the years.

Because of that, they might not remember how they funded some of these plans. Some might be what we call traditional funding: they made a contribution, they got a tax deduction, their earnings grow tax deferred, but those earnings will be taxed once they start withdrawing from the plan.

The more recent kind that started in the last 10 to 15 years is the Roth 401(k). You can do a traditional 401(k) and a Roth 401(k) contribution all within the same plan. With a Roth, you don't get a tax deduction on the contribution. It grows tax deferred, it grows tax free because it withdraws when you start taking them out, tax free.

Lastly, there’s the least common kind of funding today. In the early years of 401(k)s, people would make contributions in their 401(k) that the contributions were not deductible. However, their earnings still grow tax deferred. But when you withdraw them, you have to pay taxes.

Having the different types of 401(k) fundings complicates things, because you have to track what type of money you initially contributed to your plan. So, before you do a rollover, from previous employer’s 401(k) to an IRA of your own, you're going to want to make sure you know what's in there. Because you're going to set up different accounts and the type of money has to go to its corresponding IRA account type; Roth 401(k) money has to go to a Roth IRA account for instance.

If you have never made a Roth contribution in your working career, you may be making them now, going forward, if you earn too much money. Because the Secure Act 2.0 stipulated that if you're making catch-up contributions in your 401(k) plan, and you earn over a certain dollar amount of income, the IRS is going to require your catch-up contributions Roth contributions.

That's not a bad thing, by any means. But it may be something that you didn't anticipate. You're going to start to see a line item in your pay stub or on your statements showing Roth money building up in your account that you may have never actually elected yourself. Well, that's something that may be coming down the line.

So, you must be aware of the types of money in your account. But even a step further, you also need to be cognizant of if you have company stock inside of your 401(k) plan.

And this is where some mistakes can be made. If you work for a company that has publicly traded stock, and let's say you got half a million dollars in stock, along with the mutual funds or other investments that you funded in your 401(k), well, you may be eligible to participate in what we call Net Unrealized Appreciation (NUA). So, what does that mean?

Let’s say you have stock in your 401(k) plan. At the time that you're getting ready to retire, you ask the custodian of your 401(k), you ask, "what do I actually have in this plan and what is its value today? And at what price was this stock given to me at?” And suddenly, you look at this realize this stock is worth half a million today because the share price went up. But when you received it - your basis or what you “purchased” it at - was $50,000. So now what are your options?

Well, you think to yourself, “I’m going to take this company stock and put it in an account in my own name. Not in an IRA, but just an account in my own name. And you know what I'm going to do? I'm going to pay the tax on the value of the stock when it was given to me.” So in this scenario, it’s half a million dollars’ worth of company stock, but the basis - the value it was at when gifted to you - was at $50,000.

You’ll have to pay taxes on the $50,000. But then with half a million dollars in your account, you're going to have the money in your pocket to pay the taxes. So, if you do this, you don't really want to do anything with IRA. You want to say, look, I'm going to take the money from the 401(k), transfer the stock to my IRA, right? And I'm going to pay the taxes out of my pocket on the basis, on the $50,000 value that basically I bought the stock at. That's what you do.

And why do you want to do that? Because if you leave the half a million in there and you just roll it to an IRA, now that half a million is fully income taxable when you start taking withdrawals out of that IRA.

If you say, “look, I'm going to roll this stock to an individual account, non-IRA, pay the taxes on the $50,000, the value that it was granted to me, and now I'm going to start taking withdrawals and selling some of this stock.” Well, that's a big gain - $50,000 basis and $450,000 gain. But by not rolling that stock straight from the 401(k) to an IRA, the tax rate is usually going to be lower.

It could be zero, could be 15%, could be 20%. And those rates are usually lower than the income tax rates that you'd pay just blindly rolling it all over to an IRA. So this Net Unrealized Appreciation, if you've got company stock that you've owned for a long time, it is absolutely worth your while to say, "what did I pay for that?" Or what was the value that it was given to me over all these years? You need to figure that out.

If you're talking about our example, we were saying, look, I only pay income tax on $50,000 versus half a million in the stock value, it might be very well worth your while, right? You're going to want to look at that and seriously consider that.

When you're looking at 401(K)s and knowing what do you do or when do you do it, you need to know this Rule of 55. So the Rule of 55, what does that deal with?

A lot of people leave and switch jobs multiple times throughout their career, ultimately leading up to retirement one day. So let's say you've consolidated these accounts, you've got one 401(K) plan and you're retiring at age 55 or 56. If you were to roll that money to an IRA and start immediately taking withdrawals, unless you set up a 72T - which is a whole other topic that we can get into in a later podcast - if you take those withdrawals at age 55 or 56, you're going to pay a 10% early withdrawal penalty.

This is because you're rolling to the IRA. The IRS’s guidelines states you must be at least 59 and a half to begin taking withdrawals from an IRA. If, instead, you keep the money in your 401(K) plan and you’re age 55 or 56, you can take a withdrawal from the 401(K) without that 10% early withdrawal penalty. That's the Rule of 55.

You’re still paying the federal and, possibly, state income taxes, but this allows you to avoid that 10% early withdrawal penalty. So that's something that just your age can determine what the better scenario is and allows you to avoid those early withdrawal penalties even if you're under that 59 and a half mark, but you're between 55 and 59 and a half. It behooves you to keep the money in the 401(K) plan and take the withdrawals instead of rolling it out to an IRA.

There are a lot different intricacies and complexities to something that seems so simple. There is a lot that goes into 401(k) rollovers. And we’ve only touched on a few of them.too.

When you’re looking at rolling over your 401(k)m you're going to want to make sure that you're looking at what's the cost. What am I getting into? What are the benefits of going to an IRA instead of staying in my 401(K)? Thinking about the Rule of 55, that's a pretty big deal. Especially if you want to retire before you’re 60, 62, or 65.

Whatever that scenario is, you want to pre-plan this out. You want to have this in your financial plan to understand what the game plan is going to be.

How am I going to get access to this money? And how can I do it while minimizing the taxes, right? So when you're talking about 401(K)s, ask yourself, “am I going to do a rollover? Am I going to take advantage of the NUA?” It’s all about coordinating all these different things that we've discussed to bring life and finances together.

Thanks so much for reading and for learning about 401(k) rollovers with us today. For questions about our financial services or finances in general, send us an email, give us a call, and of course, please like and subscribe to our podcast and stay tuned for our next episode.