Few options may seem to exist when determining what to do with the funds a client has accumulated in an employer-sponsored 401(k) upon changing employers—and the most likely course of action is to roll those funds into an IRA. While this strategy may be advisable in some cases, and can certainly serve to consolidate the client’s accounts to simplify management, there are important scenarios in which an IRA rollover is not the best move. In fact, in some instances rolling 401(k) funds into an IRA can actually present serious tax and non-tax disadvantages.
To make the right decision and maximize the value of the client’s retirement nest egg, it’s necessary to evaluate all pieces of the puzzle before jumping for an IRA rollover.
Potential Tax Disadvantages
For a client who has reached age 55, but has not yet reached age 59 ½, the tax advantages of allowing the funds to remain in the 401(k) are clear. If the client were to roll the funds into his or her IRA, a 10% penalty tax would apply to any withdrawals made before the client reaches age 59 ½ (in addition to the otherwise applicable ordinary income tax rate).
A client who leaves employment once he or she has reached age 55 can withdraw funds from the 401(k) without incurring the 10% penalty for early withdrawals.
If a client plans to work past the age when distributions become mandatory (age 70 ½), he or she can avoid the required distributions by leaving the funds in the employer-sponsored 401(k). As long as the client continues to work and does not own 5% or more of the company, he or she can avoid taking distributions from a 401(k), thereby avoiding the associated income tax liability that those distributions generate.
Distributions from an IRA are required to begin when the client turns 70 ½, regardless of whether he or she has actually retired.
Further, if a client holds stock in his employer within the 401(k) plan, he or she may qualify for favorable tax treatment if the stock is left in the 401(k). Upon distribution from the 401(k), the sale may qualify for taxation at the client’s long-term capital gains tax rate, rather than the ordinary income tax rate that would apply to the appreciation on the stock if it was rolled into the IRA and later sold.
Clients may wish to keep funds in an employer-sponsored 401(k) after leaving employment because it’s possible to borrow against those funds, though these loans are limited and must be repaid relatively quickly. Despite this, a loan against an IRA balance is not an option (penalties and taxes would apply to the IRA as though it were a distribution).
If the 401(k) offers attractive investment options, the client may wish to keep the funds invested in the 401(k). Further, if the 401(k) has lower than average fees, the client may be better off leaving the funds in the 401(k).