For many people whose nest eggs are socked away in 401(k) plans or individual retirement accounts, the time comes when they wonder if they should roll over their money to a different type of tax-advantaged option.
Many considerations come into play, depending on the specific situation. But one of the most common scenarios involves workers who have left jobs where they had 401(k) plans.
According to data from the Investment Company Institute, 51 percent of households owning traditional IRAs have rolled over funds from employer-sponsored retirement plans.
"The first thing they need to do is stop and take stock of their situation," said Laurie Siebert, a certified financial planner with Valley National Group. "What I often see is people in a panic situation if they were laid off or they moved and they react too quickly." Instead, she said, "they should stop and think about their options."
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One of the available alternatives lends itself to that advice: An ex-employee can leave the money in the legacy 401(k) if the balance totals at least $5,000.
Those plans "have certain benefits and rules that people need to pay attention to before they move their money," Siebert said. "Don't just roll it over [to an IRA] right away."
While advisors typically recommend never taking early withdrawals from a 401(k), a couple of life situations illustrate the importance of evaluating the rules.
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Federal law allows an ex-employee to tap a portion of the money penalty-free in a divorce situation or if he or she leaves a job exactly at age 55. If the money is rolled over to an IRA, that benefit is lost.
Early distributions before age 59½ usually result in a 10 percent penalty.
Once you've made the choice to roll over your 401(k) funds, your options are to move the money to your new employer's 401(k)—if it accepts rollovers—or put the money in a traditional or Roth IRA.
Contributions to a traditional IRA are tax-deductible within certain income limits, and withdrawals are taxable. The benefit of a Roth IRA is that withdrawals are tax-free; however, contributions are not.
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"If you convert your money to a Roth IRA, you pay taxes on the contribution today," Siebert said. "You want to make the conversion when you are in the lowest tax bracket you expect to be in."
Another option is to roll over the 401(k) into a traditional IRA as a kind of resting point. You can then choose later to roll portions of that IRA into a Roth, once a year, thereby spreading out your tax burden.
"Nibble at it," said Charles Sachs, a certified financial planner with Private Wealth Counsel. "Move it, as you need to, into a Roth IRA."
This applies whether the money in the traditional IRA ended up there as a 401(k) rollover or as original contributions.
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Some 401(k) plans now also offer 401(k) Roths, allowing what's known as in-plan Roth conversion. The same tax considerations apply to these as they do Roth IRAs.
Another benefit of rolling over your 401(k) to an IRA is access to potential lower-cost investment options.
"Most 401(k) plans are going to limit your choice of investments," said Daniel Lash, a certified financial planner with VLP Financial Advisors. "In an IRA, depending on where you open it—say, at a discount brokerage—you can invest in almost anything."
Additionally, rolling your 401(k) dollars into an IRA helps you keep track of where all your retirement money is.
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According to data from the U.S. Labor Department, the median time spent at one job is fewer than five years. Moreover, the number of workers at least 25 years old who have been with the same company 10 years or more stands at just 29.2 percent.
So if you leave your 401(k) every time you leave a company, you might, after a couple of decades, have a half-dozen 401(k) accounts floating around. If you've changed addresses in that time and have failed to notify your 401(k) provider, you might stop receiving statements from the plans.
"Before you know it, you won't even be quite sure where your money is," Lash said.
Rolling savings over into a new employer's plan also provides this benefit but may not deliver the same lower-cost investment choices.
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"Most of the time, it makes sense to not stick it in a 401(k) plan that is restrictive," said Sachs at Private Wealth Counsel.
Financial advisors generally agree that no matter how meager your nest egg might seem, if you are under age 59½, relocating it to another retirement account is far wiser than pocketing the money and facing a tax hit.
"It's fairly common for people to just take the cash," Lash said. "But that's the last thing anyone should do."
If they choose to take a cash withdrawal, they are taxed twice: 100 percent of the money is taxed as regular income, and they also must pay a 10 percent penalty.
Also keep in mind that companies are permitted to kick you out of their plan if less than $1,000 is in your account. If they cut you a check, they will automatically withhold 20 percent of it for taxes.
If you have between $1,000 and $5,000, companies can give you the boot, but must roll the money into an IRA for you.
The bottom line is that with the options available and the differences among individual life situations, pausing to think for a moment before rolling over your money is worth it.
"If you're going to do this on your own, it can be okay," Sachs said. "But at least make sure you understand exactly what makes sense for you."