Unless you want to take the tax and penalty hit, never take a check from your 401(k) made out directly to you. You must do what is called a direct transfer from trustee to trustee. The money can never see the inside of your bank account or taxable brokerage account. The money must be transferred directly into an established traditional IRA or new employer 401(k) plan.
If your account balance is more than $5,000, you can leave it in your previous employer's 401(k). However, I usually recommend that you not leave your retirement money behind.
This trail of 401(k) balances at various employers is never monitored or rebalanced. Over time these balances can be lost, especially if your mailing address changes and you don't inform your previous employer's 401(k) plan administrator that you've moved. It also creates a mess for your heirs who have no idea that you have multiple 401(k) balances at different companies.
Your best bet is to either roll over your balance directly into your new employer's 401(k) plan or an IRA you've established at a brokerage firm. Most companies allow you to roll your 401(k) balance from a previous employer into their plan, but you will need to check with your employer.
If you are considering rolling funds into an IRA, make sure it is a traditional IRA (not a SEP or Simple) and does not hold funds that were contributed after tax. Mixing after-tax contributions with pretax contributions usually results in either you or your heirs paying taxes again on the after-tax funds.
Rolling your retirement funds into an IRA affords more flexibility than you usually have with a 401(k) plan. Many 401(k) plans offer only a few investment options, which might be poorly managed or charge high fees.
The administrative costs and the money management fees of the employer's 401(k) plan are not reported to you. You see your account's performance only after the fees have been subtracted. These fees can easily constitute a 2 percent per year withdrawal from your account, which is significant and can compromise the long-term performance of your portfolio. If your account balance is $100,000, you could be paying fees of $2,000 a year without realizing it.
Moving your funds to an IRA solves both of these problems. In an IRA you are able to customize a portfolio to meet your specific investment goals and risk profile. There are many brokerage firms that have huge mutual fund supermarkets and charge reasonable commission and custodial fees. Luckily, IRA fees must be disclosed, but it's important you understand them.
Make sure your brokerage firm offers a good selection of mutual funds that are well managed and charge a reasonable fee. You can also invest in stocks and bonds directly in your IRA, an option that is not available in most 401(k) plans. Just make sure the brokerage firm you choose charges reasonable trading commissions.
IRAs still offer greater flexibility in estate planning than 401(k)s do. For instance, if you have multiple beneficiaries with substantially different ages, you may want to establish a separate IRA for each beneficiary. This would allow you to create different portfolios to meet the investment objectives of each beneficiary.
Although it is usually a good idea to move your 401(k) plan to an IRA, there are a few special conditions that might cause you to move the funds to your new employer's 401(k) plan instead:
• You may decide to transfer your old 401(k) to your new 401(k) plan in order to have the flexibility to retire earlier. If you plan to retire from ages 55 to 591/2, you may want to leave your retirement funds in a 401(k) plan so you can access the money without incurring the 10 percent penalty. This is available only if your company's plan allows for distributions before normal retirement age (591/2) and you separated from service after age 55.
If you retire before age 55, you do not get this special penalty-free withdrawal period from ages 55 to 591/2. In contrast, funds withdrawn from an IRA before age 591/2 are subject to a 10 percent penalty unless you take advantage of a provision that allows for "substantially equal payments."
• Here is another 401(k) perk. The government usually requires taxpayers older than 701/2 to start taking annual minimum distributions based on IRS life expectancy tables. If you are older than 701/2 and are still working, you can avoid taking "required minimum distributions" (RMD) from your employer's 401(k).
Funds held in an IRA must meet the RMD rules and cannot be delayed. Please note that you are allowed to delay your distributions from your 401(k) only if you do not own more that 5 percent of the company. If you plan to keep working past 701/2, you may want to transfer your balances in previous employers' 401(k) plans to your new employer's plan to be able to delay taking distributions until you stop working.
Most people can't afford to retire at age 55 and few people intend to keep working past age 701/2, but these two options are good to know.
IRAs do offer some relief in special circumstances that are not available to funds in 401(k)s. You can take IRA distributions before age 591/2 to pay for qualified higher education expenses for yourself, your spouse, your children or grandchildren, and incur no penalty. There is no dollar limit on IRA early withdrawals for qualified higher education expenses. However, these expenses must be incurred and paid for during the same taxable year, and distribution amounts that exceed annual qualified higher education expenses are subject to the 10 percent penalty tax. Remember, you'll still have to pay the regular income tax on the distribution.
The IRS is also very specific regarding which expenses are qualified and how expenses should be properly documented. Proceed cautiously if you pursue this perk, and make sure you get professional help from your financial planner or tax professional.
Another special circumstance that allows you to avoid the 10 percent penalty for early distributions from an IRA is available to first-time home buyers. You can withdraw as much as $10,000 from your IRA toward the purchase of your first home.
There is one last landmine to highlight before you roll over your 401(k) plan. If you own highly appreciated employer stock within your 401(k) plan, don't touch it! You may qualify for one of the best tax breaks out there. It is called "Net Unrealized Appreciation" (NUA).
This strategy allows a lump-sum distribution of company stock from your 401(k) plan to be taxed as ordinary income and is assessed only on the stock's basis (purchase price).
If you have highly appreciated employer stock in your 401(k) and are interested in this strategy, make sure you carefully research it and get help from your financial planner or tax professional.
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