Key Takeaways
- The IRS has strict rules regarding 401(k) rollovers.
- If not properly executed, your 401(k) rollover could result in significant taxes and penalties.
- A qualified wealth manager can help ensure a smooth rollover while helping you to avoid potential pitfalls.
If you’ve recently left a job where you maintained a balance in an employer-sponsored retirement plan, it’s important to make a plan for your retirement savings. A 401(k) rollover can be a smart way to avoid triggering a taxable event; however, if not completed properly, 401(k) rollover mistakes could cost you.
Following are three important considerations to keep in mind before initiating a rollover of your 401(k) or 403(b).
A Direct Rollover Is a Great Way to Avoid Taxes and Penalties
If not carefully executed, a distribution from your employer-sponsored retirement plan can result in significant taxes and penalties. Any assets issued directly to you will be taxed as ordinary income. Under 401(k) rollover rules, if you haven’t yet reached age 59 ½, you may be subject to an additional 10% early withdrawal penalty. The IRS requires that plan administrators withhold 20% from any distribution issued directly to an individual, which counts toward your income tax liability when you file your taxes.
The 60-Day Rule and Withholding Requirements
If you receive a distribution paid directly to you, the IRS allows you to complete an indirect rollover within 60 days to avoid taxes. Within the 60 days, you will need to deposit the full distribution into an IRA. You will need to use outside funds to make up the 20% that was withheld in order to roll over the full amount of the distribution. If you miss the 60-day window, the entire distribution will be subject to taxes and penalties.
A great way to avoid these taxes and penalties is to complete a direct rollover from your 401(k) to your IRA. There are two main ways to complete a direct rollover. You can:
- Have your 401(k) plan administrator issue a check directly to your new employer-sponsored retirement plan or IRA. As long as the check isn’t issued in your name, no taxes will be withheld.
- Request a trustee-to-trustee transfer from your 401(k) financial institution to the new institution.
How to Handle Company Stock During a Rollover
If you hold a significant amount of company stock in your 401(k) plan, rolling it over to an IRA could be a costly mistake. That’s because IRA assets are ineligible for a valuable tax planning strategy called net unrealized appreciation (NUA).
Using Net Unrealized Appreciation (NUA) to Help Reduce Taxes
NUA is the difference between the cost basis of employer stock and the stock’s current market value. If you hold company stock in a qualified employer-sponsored retirement plan, you may be subject to more favorable capital gains tax treatment on the investment gains when you sell that stock. However, this favorable tax treatment doesn’t apply if you roll over the stock to an IRA, because once the assets are held in an IRA, they’re subject to ordinary income tax when withdrawn in retirement.
Instead of rolling over the company stock to an IRA with the rest of your assets, consider requesting an in-kind distribution of a portion of, or all, your company stock to a taxable brokerage account. Doing so allows the stock’s appreciation to be taxed as capital gains when it’s eventually sold (rather than as ordinary income). You will pay ordinary taxes on the stock’s original cost basis in the year it’s distributed.
It’s important to note that, in order to qualify for NUA, you must distribute the entire vested balance of your 401(k). The non-stock assets can be rolled over to an IRA, while the stock is transferred in-kind to a taxable brokerage account. Requesting a divided rollover such as this can be a complex process, so be sure to work with your wealth manager to avoid any unintended tax consequences.
Monitoring Your Rollover and Avoiding Errors
If your rollover is improperly executed, you could face significant tax liabilities and penalties. That’s why it’s important to track your rollover’s status and quickly follow up if any aspect of your rollover is delayed.
Why You Should Consider Working With a Fiduciary Wealth Manager
A great way to help ensure you remain in compliance with 401(k) rollover rules is by working with a qualified wealth manager. Not only will your wealth manager help facilitate an efficient rollover process but he or she will also help ensure your retirement investments remain in line with your financial plan, overall portfolio and long-term goals.
