Rollovers: When to Do Them; Doing Them Right?

Under the radar of most of the media and other observers is one of the fastest-growing and most important transactions in personal finance. It and the follow-on transactions are critical to the financial lives of most Americans. Yet, people receive little guidance on the transactions and frequently have thousands of dollars siphoned as a result.

The transaction is the rollover of money from a qualified retirement plan to an Individual Retirement Arrangement. The most common rollover is from a 401(k) plan to an IRA. There are other types of rollovers. Money can be moved from one 401(k) to another, from one IRA to another, and from a defined benefit pension plan to an IRA, to give three common examples. But the 401(k)-to-IRA rollover is the most common and will occur many times as the Baby Boomers retire.

There often are several options for handling a 401(k) balance when leaving an employer. Often the balance can be left in the account for distributions to begin later, an annuity option might be available, and the account can be taken as a lump sum that is not rolled over to an IRA.

Though there are times when each of these is the best choice, for most people the best move is to have the account rolled over to an IRA. The rollover puts the account at the broker or mutual fund company of your choice. This allows you to find the best combination of fees, investment choices, and other services. Also, many 401(k)s do not offer retired employees the range of distribution options available from IRAs. A concern about leaving the account in the 401(k) is an employer can change 401(k) options and fees at any time, and you might have difficulty keeping up with plan changes when you no longer are at the company.

There are right ways and wrong ways to make a rollover successful.

The first step is to plan well in advance. Too many people plan where they will travel to in the first six months of retirement but do not consider what they will do with the 401(k) balance. In the last week of work the employer might present the options and ask what the employee wants to do. The depth and quality of the options vary among employers.

You want to research the IRA fees, services, and investment options at mutual fund firms and brokers and decide where you want to transfer the account balance. You should have an idea of how the account will be invested initially and which types of investments are most important to you. I favor the discount brokers, such as Charles Schwab and TD Ameritrade or the large fund firms with brokerage subsidiaries, such as Fidelity and Vanguard. These charge reasonable fees and offer a wide range of investment options and other services.

Also, decide how you will transact business: telephone and mail, in person, or on the web. The firms listed above score well in each of these choices.

After that, a successful transfer should be easy. Most financial firms now have departments to handle rollover transactions.

You want the transfer to be direct from the 401(k) trustee to the IRA custodian, known as a trustee-to-trustee transfer. Otherwise, the trustee will issue you a check and will withhold 20% of the account balance as tax withholding. You recover the 20% when you file your tax return if the entire account balance is rolled over within 60 days of receiving the check. But you must deposit in the IRA not only the entire check received but also the 20% that was withheld for taxes. You must have other sources for this cash, and it won’t be replaced until the tax refund is received. The IRS does not require the withholding if the check is made out to the custodian for your IRA instead of to you. But it is much easier and safer to open an IRA account at the custodian of your choice and complete the paperwork to authorize the trustee-to-custodian rollover. There are many cases and rulings involving taxpayers who missed the 60-day rollover deadline through no fault of their own. The trustee-to-custodian rollover avoids this possibility.

There are no taxes on the rollover when it is completed properly.

To avoid taxes, the rollover must be of a “lump sum.” For a distribution to qualify as a lump sum, it must be of the entire account. In addition, the employee must be either “separated from service” of the employer or over age 59½. This means if you are under age 59½ and reduce your hours, a tax-free rollover might not be available.

Anyone over age 59½, however, can take a lump sum distribution and continue working for the employer and accumulating a new 401(k) balance, as long as the entire account balance accrued to date is rolled over. There are times when someone over age 59½ who is not retired might want to roll over the 401(k) to an IRA. The quality of the 401(k) might be poor, with limited investment options, high costs, or other problems. Or the employee might want to transfer the balance to be handled by an investment manager. But check with your plan administrator. Not all 401(k) plans allow these in service transfers for those who continue working with the firm.

There used to be a tax reason to roll over the 401(k) into a new, separate IRA, but there no longer is. But there is an asset protection reason to make the rollover to a separate IRA. When a 401(k) balance is rolled over to a separate IRA, it receives greater protection under federal bankruptcy law than an IRA that also contains individual contributions.

A time when you probably do not want to transfer the 401(k) balance to an IRA is when the account contains employer stock. There is a special tax advantage for employer stock that is distributed to a taxable account or left in the 401(k). This advantage is lost and taxes actually are increased when the employer stock is rolled over to the IRA.

Fortunately, when a 401(k) contains employer stock and other assets, the account can be split at distribution time. The employer stock can be distributed to a taxable account and the rest of the account rolled over to an IRA. Each receives tax-advantaged treatment. Details of how to handle employer stock were in our November 2007 issue, which is on the Archive and Back Issues sections of the web site.

There are some non-tax factors to consider. If you will need a lot of cash in the next few years, it might be better to take the lump sum distribution in cash and report it using the 10-year averaging method or even leave it in the 401(k) until you need the money.

If you will consider purchasing an annuity with part of your retirement assets and the 401(k) plan offers an annuity option, examine that annuity option closely. Compare the payouts with what would be available by purchasing a commercial annuity. You might want to select the annuity option for all or part of the account balance. There is a tax advantage when the annuity is purchased by the 401(k) account and distributed to the employee while the rest of the account is rolled over to an IRA. If the employer offers a good deal on the annuity, it can make sense to convert part of the account to an annuity and roll over the rest to an IRA.

A nontax factor is who would manage the money over time if you rollover the account to an IRA. Perhaps you would be comfortable doing this but your spouse wouldn’t be. That might be a reason to elect a 401(k)’s annuity option. It also might be a reason to elect an IRA rollover and find an investment manager to manage the account.

How to handle the 401(k) account is one of the most important decisions most Americans will make. You need to know and research the options and sort through them to find the best choice for you and minimize the taxes on it. The difference can be thousands of dollars over your life time. Ideally, you should begin the process a year or more before retirement.

RW September 2009.