Retirement Watch Lighthouse Logo

How to make the best of a rollover of a retirement plan?

Last update on: Oct 17 2017
retirement-plan-rollover

One of the biggest obstacles to effective retirement planning is the number of complicated decisions that are made only once or twice in a lifetime. A lot of research is required to make the right decisions, and the wrong decision can cost thousands of dollars in taxes or more in reduced benefits during retirement.

Yet, few people do enough research. A 2003 survey by American Century Investments found that of those who left their retirement accounts with an employer after switching jobs, 44% did so because they found the rollover process confusing, too much trouble, or too time-consuming.

A very complicated decision is what to do with an employer retirement account, including a 401(k), when there is a transition such as changing jobs or retiring. The choice generally cannot be reversed, and the consequences last for life.

Here are the actions one can take with an employer retirement account when leaving a job, whether leaving for retirement or another job, and the consequences of each action.

Leave the money alone. Often, the departing employee has the option of leaving an account with the employer. Many employers do not allow this option when the account is small, because of the cost of maintaining the account. But often the account can be left with the employer plan.

Leaving the account might be smart if the plan has attractive features, including investment options, and reasonable costs. Leaving the money in the account also ensures that taxes will be deferred.

There can be disadvantages to keeping the employer account. You will not be able to make additional contributions to the account. Any future investments you make will have to be in another account, and multiple accounts can complicate your life. In addition, over time the employer can add costs or restrictions to the plan or change the features you found attractive.

Another disadvantage is that the employer account might have distribution restrictions at retirement time. An IRA allows distributions at any time, and a “stretch” distribution schedule can be established that ensures the IRA lasts as long as legally possible. Employer plans are not required to permit such long distribution schedules, though they may choose to do so.

Take it to a new employer. When switching jobs, check the terms of the new employer’s retirement plan. Many larger employers allow funds from a prior employer’s plan to be rolled over into the new plan. If the new employer has attractive investment options and reasonable costs, it can make sense to consolidate your retirement accounts in one place.

Of course, you will lose access to the old employer’s investment options. There also is likely to be a period of time during the transition when you will not be able to manage the investments. The account will be out of the markets for a while, because the investments in the old plan have to be converted to cash for the transition. The shares in the funds are not transferred.

IRA rollover. An employer plan account can be rolled over into an IRA when leaving a job, whether for retirement or a job change. The rollover can be tax free. It also provides the opportunity to consolidate investment options in one account or with one financial institution. (If you put the rollover in a separate IRA, this preserves the option of transferring it to a new employer’s plan in the future.) An IRA also should provide more investment options than an employer plan.

A rollover requires converting the old account to cash and transferring the cash. That means there will be a time when it is out of the markets and you cannot manage the investments.

With a rollover, it is possible you lose access to attractive funds in your old employer’s plan. This is especially likely when the employer plan offers closed funds or institutional investor-only funds with low fees.

Fees should be lower with the IRA, but that isn’t always the case. Consider fees when choosing an IRA sponsor and compare those with fees at the employer plan.

Another potential disadvantage of the IRA is that loans are not available. Most employer plans generally allow loans from account balances. This might be a moot point. Many employer plans allow loans only to current employees, so repayments can be withheld from paychecks.

If a rollover is selected, there are two options. It is important to choose one and follow all of its rules.

The best method often is referred to as the direct rollover or trustee-to-trustee transfer. Your employer plan administrator transfers the money directly to the IRA custodian you designate. Your only role is to open the IRA and complete the paperwork ordering the transfer. There are no taxes on this transfer.

The other method is a regular rollover. The employer gives you a check for the account balance. But 20% must be withheld for taxes. You have up to 60 days to deposit the equivalent amount (plus the 20% withheld) in an IRA or other qualified retirement plan.

If you complete the rollover on time, the 20% withholding will be refunded after your income tax return is filed. If you fail to complete the rollover within 60 days, the amount that was not rolled over is included in gross income and taxed. If you are under age 59 ½, there also is a 10% early distribution penalty.

The taxes for failure to meet the 60-day deadline can be waived by the IRS, but you have to apply for the waiver and have an excuse the IRS will accept.

The best bet usually is the trustee-to-trustee transfer. It avoids withholding taxes, and there is no 60-day rule.

Cash out. You can take the retirement account in cash (actually a check). If you do, the entire amount (except for any after-tax contributions) will be included in gross income for the year. There also will be a 10% early distribution penalty if you are under age 59 ½. This rarely is a good option unless you really need the money and have no other source for it. You will get to spend only 25% to 50%, and perhaps even less, after all taxes and penalties.

Buy an annuity. The employer balance also can be used to purchase an annuity or take an annuity the employer offers. Taxes will be due only as payments are received. There also is no 10% penalty. The payment schedule can be guaranteed to last your lifetime or whatever other schedule suits your needs.

An annuity provides a fixed income that you cannot outlive. The disadvantages are that there is no inflation protection, and you give up the potential for higher returns.

If you choose an annuity, shop around for the best deal from a safe insurer. Don’t automatically accept the employer’s choices.

For most people, the best choice is either the direct rollover to an IRA or the annuity. Those choices usually increase the likelihood that the wealth will last a lifetime.

bob-carlson-signature

Retirement-Watch-Sitewide-Promo

Log In

Forgot Password

Search