What You Need to Know
- Choosing the right 401(k) exit strategy for clients leaving a job is an important part of their retirement planning.
- Factors such as their age and taxes must be considered.
- Each client’s situation is different, and your planning for their old 401(k) should reflect their needs.
Your clients may leave a job for a variety of reasons. The job market conditions of the past couple of years have caused many employees to switch employers in search of higher pay and other perks. It could be due to retirement or an involuntary situation.
Whatever the reason, when your clients leave a job, it’s important that they have a 401(k) exit strategy laid out. Here are some things to consider in order to help guide them to the best strategy for them.
Rolling Over to an IRA
Rolling the client’s 401(k) balance over to an IRA is often the best option. This allows them to consolidate not only the money from this 401(k) but also from other 401(k)s from former employers all in one spot.
If the client has some of their 401(k) money in a designated Roth account, this portion can be rolled over to a Roth IRA. This offers the advantage of not having to take required minimum distributions on this money when they reach age 72.
Rolling their 401(k) to an IRA offers a number of advantages:
- An IRA will offer a wider range of investment choices than a 401(k) plan. Assuming you are managing the client’s investments, this strategy allows you to incorporate this money into the strategy you have in place for the client’s other investment assets.
- Investing via an IRA is often a lower-cost alternative for your client, especially if their former employer’s plan was a high-cost plan.
- People will work for a number of employers over the course of their career. Consolidating old 401(k)s and other retirement plan accounts in one place helps to ensure that retirement assets in old employer plans will not fall off the radar.
1 One disadvantage of rolling the money over to an IRA is that IRAs do not offer creditor protection as does a 401(k) plan. This is something to consider if this is a factor based on your client’s situation.
Net Unrealized Appreciation (NUA)
If your client decides to roll their 401(k) balance to an IRA upon leaving their job, they can take advantage of the net unrealized appreciation rules if their 401(k) account contains shares of their former employer’s stock.
Under the NUA election offered by the IRS, if your client owns company stock inside their old employer’s 401(k), they can elect to take a distribution of the shares. These shares would go into a taxable account. They must then pay ordinary income taxes on the cost basis of the shares.
The advantage is that if the shares are held for at least a year after the distribution, they will be subject to preferential long-term capital gains rates if sold at a gain from the original cost basis. In the case of shares that are highly appreciated, the tax savings can be significant. There is, of course, the risk that the share price could drop over time as well.
If the client had other assets in their 401(k) such as mutual funds, this money would be rolled over to an IRA as normal.
Leaving the Money in the Employer’s Plan
This might be a viable option in some cases for certain clients. It can make sense if the plan options offered in the plan are rock-solid and low-cost, especially if you would have trouble putting the client in investments that are as good or better than the ones in the plan by rolling the money over.
Another consideration is whether your client needs the added level of creditor protection offered by a 401(k) plan. It’s important, however, to note that some employers may treat the accounts of former employees differently from those of current employees. Be sure your client does their homework on this before deciding to go this route.