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To Rollover or Not Rollover Your 401k Plan – It Depends

Jun 11, 2023 | Budget

Four seniors walk bicycles along a beach. Text reads "To Rollover or Not Rollover Your 401k Plan – It Depends," alongside the Stewardship Trust Advisors logo.

One of the biggest decisions many clients face is what to do with their 401k plan when they leave their employer. There is no clear cut answer as to whether you should roll over your 401k plan to an self-directed IRA (which will be later called a “rollover IRA”), another employer’s 401k plan, or simply to leave it where it is, because it involves several different factors, including long-term investment costs and the availability of investment options within the plans. However, the most critical factor that can have a big impact, both short and long term, are the tax implications of a rollover. Understanding these implications is essential before making any decision regarding your 401k plan.

To Roll To Rollover or Not Rollover Your 401k Plan? – It Depends

Here are some of the more common tax complications that arise from a rollover:

Taxation of Indirect Rollovers

An indirect rollover occurs when you take a distribution from your 401k plan with the intent of rolling it into an IRA or a new 401k plan. With some exceptions, any distribution from a 401k plan is subject to ordinary income taxes; and, if a distribution is made before age 59 ½, a 10 percent penalty may apply. If your intent is to roll your distribution from a 401k plan into an IRA, it must be done within a 60 day period to avoid the tax and penalty. It’s not uncommon for someone to take a distribution from a 401k plan with the intent of rolling it over into another plan and miss the deadline. If your advisor recommends rolling out of your existing plan, then one should roll it over to the new employers plan or directly to a self-directed IRA. Choosing the indirect rollover where the check is made payable to participant is normally the least favorable.

The big tax complication comes when the plan sponsor, as they are required to do, withholds 20 percent of your distributions for tax purposes regardless of your intent to roll it over into an IRA. As a result, you would then be rolling just 80 percent of your funds into the new plan. Even though you would eventually get it back through an IRS refund, the other 20 percent that is withheld must be made up by you within the 60 day time limit in order to avoid the tax and penalty on the entire distribution.

To avoid this possibility, the better course might be to ask your new custodian/ advisor (for an IRA) or plan sponsor (for a new 401k plan), to initiate a direct rollover of the funds from the old plan into the new account.

Roth Rollover

Depending on your income level and tax circumstances, you may decide to roll your 401k plan into a Roth IRA. With a Roth IRA your funds grow tax free and they can be withdrawn tax free. That’s because a Roth IRA takes only before-tax dollars as contributions. So, when you transfer 401k funds into a Roth IRA, you must first pay the taxes on the distribution to the extent of the amount being rolled over less any after-tax contributions included in the amount being rolled over. But once your funds are inside the Roth IRA you will enjoy both tax free accumulation and tax-free withdrawals. Note that if you choose this option, 100% of the funds rolled over are taxable in the year the rollover into a Roth takes place and we would recommend consulting with your tax advisor first.

Early Retirement Withdrawal

If you foresee yourself retiring early, you may not want to roll over your entire 401k plan to an IRA. With a 401k plan, you can begin taking withdrawals as early as age 55 without penalty. If you roll your funds into an IRA, you will lose that option unless you choose rule 72 (t) allowing for the Substantially Equal Periodic Payment rule, a somewhat complicated formula for withdrawing funds prior to age 59 ½. Deciding what to do with your 401k plan after leaving an employer must take into consideration many factors – your current circumstances, your personal financial outlook for the future and the tax consequences of any of the options you may choose. You should always consult with an investment advisor and tax consultant to determine both the tax consequences and the benefits of an IRA Rollover.

Have Questions About Planning for Retirement?

At Stewardship Trust Advisors, we have nearly 100 collective years of experience when it comes to helping our clients plan for their future financially. To roll over or not rollover your 401K is just one part of the puzzle.

We’d love to meet with you to help you create a comprehensive plan for retirement. Schedule a consultation today.

These weekly articles which are produced and distributed by Pilgrims Capital Advisors, Inc. contain information on topics about investing, tax planning, estate planning, asset allocation, insurance and many other financial subjects. Please note that they are very general in nature and must be applied to your own individual circumstances through the services of a trained or licensed professional that specializes in these areas. If you have questions or needs related to the subject matter of this article please contact us by clicking on the link below and we will point you in the right direction.

Pilgrims Capital Advisors, Inc. is a Registered Investment Advisory Firm located in the state of Michigan.

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