401(k) rollovers: How to avoid very costly mistakes

  • Unprepared early retirees who liquidate 401(k) plans before age 59½ may get hit with an early withdrawal penalty — plus taxes.
  • Financial dangers can be sidestepped with tactics such as the net unrealized appreciation rule.
  • Avoid rolling 401(k) funds into an IRA if there's a remote chance you might reenter the workforce after initial retirement.
Man with a headache.
sturti | Getty Images
Man with a headache.

A client met with me to discuss his dream of taking an early retirement. As a 58-year-old electrical engineer, Paul made it clear he was tired of enduring constant stress and increased responsibilities at work.

His pension and 401(k) plan were finally at levels where he felt confident he could retire early, and on his own terms. And since most of his co-workers were in the midst of making their own exits, Paul was ready to follow suit and roll his 401(k) plan into an individual retirement account so he could begin living off the distributions.

It sounded like a good plan to Paul. Well, not so fast.

Because Paul hadn't yet reached the magical age of 59½, taking early distributions would result in a very unattractive 10 percent early withdrawal penalty if we didn't plan this carefully.

As his financial advisor, I mapped out a plan. To help Paul retire early without paying unnecessary penalties, I rolled his pension into his IRA while leaving his 401(k) plan with his employer. This allowed him to take advantage of the "55 and separated rule," which allows certain workers to take early withdrawals without penalty.

This is how it works: If you are 55 or older in the year you leave your job and need to take a distribution of your retirement-plan funds immediately, you should leave the money in your company plan and take your withdrawals from there. That's because distributions from your company plan — again, if you are 55 or older in the year you left your job — are not subject to the 10 percent early distribution penalty if you no longer work for that company (or what the tax code refers to as "separation from service"). Remember, however, that the distribution would still be subject to federal income taxes.

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This client story illustrates an important danger of rolling your 401(k) plan over to another plan too soon. If you don't have a comprehensive plan in place and you liquidate your 401(k) plan before you hit the age of 59½, you may wind up paying an early withdrawal penalty — and that's on top of taxes.

But there are other dangers to be aware of that come with rolling over your 401(k) plan, most of which can be avoided with some thoughtful planning and preparation.

Let's imagine you have a favorable stock position with your employer and plan to take advantage of a little-known rule that can help you avoid penalties and minimize taxes. Under the "net unrealized appreciation rule," only the cost basis of the shares you sell is subject to tax (and perhaps an early withdrawal penalty) at the time of distribution. The cost basis is what someone actually pays for the stock, whereas the difference between the cost basis and the stock's current price is called the NUA.

In short, the NUA isn't subject to tax until the stock is sold and will never be subject to an early withdrawal penalty. That's good, right?

Unfortunately, taking advantage of the NUA rule isn't for everyone. If you roll the stock into a taxable account, for example, you'll need to pay taxes on the cost basis and potentially a 10 percent early withdrawal penalty if you're younger than 59½.

For a young person, rolling to an IRA and deferring taxes for 30 or more years may be a better choice. The benefit of the tax deferral may outweigh the benefit of the lower tax rate on the NUA.

Another thing that many people who want to do an early roll over of their 401(k) fail to consider is pure choice. To that point, an overlooked consequence of rolling over a 401(k) to an IRA is the loss of investment options that may only be available through your employer-sponsored 401(k) plan.

"If you continue to work past 70, you may be able to keep making contributions to your 401(k) plan and not be subject to what is called a required minimum distribution."

Additionally, advisors urge investors to make sure they understand the costs involved with a rollover. Since there are many very low-cost 401(k) plans provided by employers, don't just rush into rolling your 401(k) to a new custodian, because the fees may actually be higher.

Since high earners don't have the ability to contribute directly to a Roth IRA, many do what is called a "backdoor" Roth IRA. When you make a backdoor Roth IRA contribution, you are making a nondeductible contribution (already taxed) to a traditional IRA before making a Roth conversion. However, rolling over your 401(k) too early can rule out this option.

Why? The problem arises when making the nondeductible IRA to Roth conversion. The Internal Revenue Service will look at all your IRA investments as an aggregate to decide if your conversion will be taxable. The IRS won't look at your 401(k) plan dollars, however. The goal with the "back-door" strategy is to have as few traditional IRA dollars as possible. Leave pretax funds in that 401(k) plan.

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Finally, let's imagine you plan to work forever — or, at least well past the ripe old age of 70½. Maybe you leave the work force early, but eventually work your way back because you're bored or fear you are running out of money. In that case, you might want to avoid rolling over that 401(k) into an IRA.

If you continue to work past 70, you may be able to keep making contributions to your 401(k) plan and not be subject to what is called a required minimum distribution.

By avoiding an RMD, you can also avoid unnecessary taxes on those distributions until you leave your employer and separate from service.

However, if you moved your 401(k) plan into an IRA, you will need to start taking that RMD by April of the year after you turn 70½. Additionally, you will be paying taxes on that income, whether you're still working or not.

— By Jeff Rose, CEO of Alliance Wealth Management and founder of GoodFinancialCents.com

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