To some, engineering an IRA rollover is like walking several miles in a blizzard wearing a pair of flip-flops. It's easy to get cold feet due to the myriad rules, regulations and complicated financial lingo.
But, with a little planning, it can be a fairly straightforward process.
When you leave a job, you have to decide what to do about your company retirement plan -- and you have four options. You can roll it into your new employer's plan (if the new plan permits), roll it over into an IRA or take a lump-sum distribution. Or you can do nothing and just leave it in your former employer's plan.
Before you make any moves, consider your situation.
Leave it behind, maybe
Sometimes (not often) letting your money stay put in the old plan is the best option.
First the ground rules: As long as your nest egg is worth more than $5,000, you can leave it where it is. But if it's worth less than $1,000, your employer may elect to cash it out and send you a check. If it's worth somewhere in between, most employers automatically roll your assets into an IRA.
Leaving your money behind with your former employer may make sense if:
* You're approaching age 55, at which time you wish to begin taking distributions. If you separate from service (you're fired, you quit, you retire, etc.), you can begin taking regular withdrawals or the entire balance from a company plan without paying a 10 percent penalty at 55. But if the money is in an IRA, you generally have to wait until age 59½ to avoid the penalty.
* You like the investments in your former employer's plan, they have low expense ratios and the plan provider is famous for offering low-cost plans.
* You've listed nonspouse beneficiaries (such as children, grandchildren), and you want them to have the ability to convert the assets into a Roth IRA. Or, you want them to have the flexibility to stretch payments over their lifetimes. (Note: Surviving spouses have fewer restrictions with both 401(k) and IRA assets.)
"If you roll the money into an IRA and then you die, your nonspouse beneficiary cannot make a Roth IRA conversion from that money," says James Lange, CPA, attorney and author of "Retire Secure! Pay Taxes Later."
Mini-lesson: If you convert tax-deferred assets to a Roth IRA, you have to pay income taxes upfront, but then your money grows tax free and you pay no taxes when you begin taking distributions. Conversely, with a traditional IRA, you get a tax break upfront, your money grows tax free and you pay taxes at ordinary rates upon withdrawal.
Lange says Roth IRAs are typically better for heirs because they receive income-tax-free distributions over their entire lives and, unlike traditional IRAs, Roths are not subject to the minimum distribution rules that require withdrawals beginning at age 70½.
If you subscribe to the "pay taxes later, rather than sooner" philosophy, it also makes sense to leave money in a former employer's 401(k) plan when naming nonspouse beneficiaries so that your beneficiaries can elect to stretch payments over their lifetimes. To get this benefit, the beneficiary must roll the proceeds over into a properly titled inherited IRA -- but this only works if your 401(k) administrator permits this transaction.
Lange cites another advantage to leaving money in a former employer's 401(k) plan: Some older company plans offer a fixed-income fund called a guaranteed income contract, or GIC, with a better-than-average yield.
"The GIC will often pay more than a comparable security with equal safety than what you can get on the market," Lange says. "If for no other reason, it's because sometimes the GIC has been around for a long time and they still have bond and other fixed income instruments that are paying a lot more than the ones are today."
Another consideration: Individuals in especially litigious fields, such as physicians and attorneys, sometimes prefer to shelter part of their investments in 401(k) plans because they have more federal protections than IRAs. For example, IRA assets are shielded from creditors in cases of bankruptcy, but may not be for other types of judgments such as civil lawsuits.
"This is really for people who are ultra-high risk, where every tiny bit of asset protection helps," says Michael Kitces, Certified Financial Planner and director of financial planning at Pinnacle Advisory Group in Columbia, Md.
Don't take a cash distribution
Experts say it's generally not a good idea to take a distribution from your retirement plan. You'll have to pay taxes and usually a penalty besides, and you won't have that money earning compound returns for your retirement.
"For the vast majority of people who take a cash distribution, it never makes it into the qualified account," says Nora Peterson, author of "Retire Rich with Your Self-Directed IRA."
"They end up diverting the money to some other use."
Fran Kinniry, a principal at Vanguard Investment Strategy Group, says sometimes people who get the cash are tempted to go out and buy luxury items such as motorcycles and boats -- purchases that most financial experts never condone if you're financing them with retirement funds. (Note the risks of tapping into your 401(k) account in the video below.)
"Once you get the check in hand, we see that some people are tempted to do the wrong thing," Kinniry says. "Sometimes if you can't see it, can't feel it, can't touch it, there's some benefits from that standpoint."
You can't see it, feel it or touch it if you do a direct rollover to an IRA.
Consider cashing out in these cases
Sometimes it doesn't make any sense to do an IRA rollover. In such cases you'd be better off putting assets in a taxable account.
For instance, some 401(k) plans allow employees to make after-tax contributions, so only earnings will have to be taxed at the time withdrawals are made. We're talking about plans that precede the newfangled Roth 401(k) plans.
401(k) vs. IRA?
If you roll over these assets in an IRA, the after-tax money and earnings become commingled, and you'll forever have to take withdrawals on a pro-rata basis and keep track of the different monies on Form 8606. It's tedious and time-consuming.
Another exception to the rollover: If you have lots of company stock in your retirement plan, you may be eligible for a big tax break called net unrealized appreciation, or NUA. Net unrealized appreciation refers to the difference between your stock's value when it was originally contributed by your employer, and its market value at the time of distribution.
While it's wise to invest no more than 10 percent of retirement assets in company stock, sometimes employees wind up with a lot more. Stock bonus plans and profit sharing plans may hold significantly higher amounts of company stock.
"In that case you would not do the rollover, you would take the lump sum distribution," says Ed Slott, CPA, a noted expert on IRAs.
Here's how it works: You move the stock-in-kind to a taxable account and pay tax on the value the stock had at the point when it was contributed to the plan, rather than on all the growth it may have enjoyed since. You don't pay tax on the appreciated portion until after you sell the shares. At that point, you pay NUA tax at the lower capital gains rate rather than at ordinary income tax rates, even if you sell the shares a day after you set up the account. There are other stringent IRS rules you have to follow at the same time, though, so be sure you get guidance from someone who knows exactly what to do.
Do a direct rollover
Most of the time cashing out the assets is a bad idea. Likewise leaving your assets with a former employer rarely makes sense. It's hard to know how much you're paying in fees. On top of that, investment options are usually limited.
"There are very few advantages to leaving it in a company plan," Slott says. "That's probably the worst place because you're just so restricted and subject to all kinds of arcane plan rules and you may not be able to get to your money when you want it."
A rollover lets you have more control, flexibility and tons of investment options. (See what Suze Orman says about 401(k) vs. IRA rollovers in the video below.)
If you decide a rollover is right for you, make sure to do a trustee-to-trustee transfer, where the money goes directly from your retirement plan to an IRA without your touching the money in between, says Slott.
There are many benefits to this type of transfer. To name two, you avoid the 60-day rule and 20 percent withholding tax rule.
If you get your hands on the money, the IRS allows you 60 days to move it into an IRA without losing its tax-favorable status. However, IRS rules stipulate that your former plan administrator is obligated to withhold 20 percent in taxes. That means that you must come up with the difference with your own funds before the 60 days are up.
"If you miss the 60-day window, or don't make up the withheld amount, you will be taxed on the entire amount or the shortfall, and if you're under 59½, you will pay a 10 percent early distribution penalty," says author Nora Peterson. "It's important to remember that the early withdrawal is taxable as regular income in the year it is withdrawn. And the 10 percent penalty is in addition to those taxes."
A trustee-to-trustee transfer prevents all this from happening, since 100 percent of your funds will move directly from your former plan to your new IRA rollover account.
This method also enables you to avoid the one-rollover-every-12-months rule. The IRS does not limit the number of times you do a "trustee-to-trustee" or direct transfer. But if you choose to receive the proceeds in your hot little hands, the IRS limits you to one rollover every 12 months.
Warning: Just because you instruct your plan to do the direct transfer, that doesn't mean things can't go wrong. Good follow-up skills are critical.
"Many times (the money) goes to some other account that's not an IRA and people don't realize it until the next year when they're doing taxes and their accountant says that they took a taxable distribution," says Slott.
Have a plan for your investments
Before you do the rollover, you need to decide which firm you plan to do future business with and become acquainted with its investment options.
Cost is the probably the biggest factor in deciding where to invest your money. Carefully consider all of the administrative, custodial and ongoing management fees associated with the firm and its products and services before you roll over. Look for funds with low annual expense ratios.
Kitces says some accounts have a $20 to $30 annual fee for maintaining the account. However, most companies will waive that fee once you reach a certain asset level.
Also, be aware of closing fees, Kitces says. "If there was a 403(b) that might have held an annuity, clarify whether there are any surrender charges associated with closing the annuity."
Vanguard's Kinniry says picking a good fund family is probably the most important consideration.
"We think a fund family that ranks in the top third or top quarter on 10-year performance rankings along all product lines is probably a good place to start," he says.
No matter what decision you make, Peterson advises that you do your homework. "You have to know what you are investing in. Otherwise your money will be eaten up by fees, market turndowns and bad choices," she says.
Also, be sure to have an investment plan. "If you're going to be moving money into a new IRA, ideally you should have some plan of what you're going to invest in once the money gets there," says Kitces.
Letting the money just sit around in a money market fund is a mistake people make when they don't have an investment plan.
Ideally you should follow an asset allocation plan that's appropriate to your age, risk tolerance and time horizon. A diversified portfolio will expose you to less risk in the long run. Make sure you take into account the asset classes represented in other investment vehicles you currently own and avoid duplicate product offerings.
"One of the biggest mistakes I see is that people have money at different financial institutions. But if you actually look at what they own, you might see a huge overlap," says Lange.
Always name a beneficiary
Many people are under the false impression that if they name beneficiaries in a will, they can rest assured that their IRA will be passed on according to their wishes.
"This mistake is deadly and all too common," Lange notes in his book, "Retire Secure."
The reason, he says, is that the will or trust does not control the destiny of retirement plan assets. Beneficiary designations do. But if none is named, there is a default destination for the assets.
"I just had a case where a person who worked for a big company died in his 40s, had $400,000 in his retirement account and no beneficiary," Slott says. "All of it went to the estate."
From there the assets go through probate. Investment contracts with beneficiary designations automatically bypass the probate process.
Pinnacle Advisory Group's Kitces adds that you should have a contingent beneficiary as well. A contingent beneficiary could be a trust, a child or your grandchildren. He says if you are uncertain about who to name, get help.
"If you have any estate planning documents already in place like wills or trusts, call your attorney and ask him to tell you how you should word your beneficiary designation," Kitces says, so that it conforms with your estate plan.
As indicated earlier in this story, your beneficiaries can take advantage of the ability to spread out payments over their lifetimes. But unless you tell them about it, they may never find out on their own. Advise your nonspouse beneficiaries that upon your death, they will need to roll over your IRA into a properly titled "inherited IRA" with your name on it. And let your estate planning attorney know that you'd like this done for your beneficiaries.
Otherwise, if your children cash out your IRA, the proceeds of the lump sum will be subject to tax, which will instantly diminish their wealth as well as your past efforts to build a fortune.