Seven 401k Rollover Traps

In these days of increasing unemployment and layoffs, it is important not to lose money by falling into a 401k trap.  Direct rollovers from a 401k into an Individual Retirement Account (IRA) are not subject to income taxes or penalties.  However, a recent study by the Employee Benefits Research Institute found that those with $50,000 or more in their 401k rolled over on average 72.4% of the balances after leaving their employer.  The numbers got worse as the size of the 401k assets went down.

The consequences of failing to roll over 401k distributions can be severe. The distributed funds are subject to ordinary income tax, plus a 10% penalty for early withdrawal.  Let’s look at the seven 401k traps you should avoid if you change employment.

1.      The first mistake to avoid is failing to do a direct rollover to an IRA.  In a direct rollover, your 401k funds are transferred from custodian to custodian such that you never receive constructive receipt of the funds, so no tax is due on the transfer.

2.      If you have already received your 401k funds, you have 60 days in which to roll the funds into an IRA.  The problem here is that the funds you received from your 401k will be reduced by 20% withholding rules.  So, you will need to make up the 20% difference from other assets within the 60 day time limit.  Failing to do so will result in the 20% being taxable at ordinary income rates, plus a 10% penalty.

3.      Loans outstanding from your 401k present another potential trap. Typically, your employer will transfer the funds in your 401k, less the loan amount.  You will have up to sixty days to deposit the loan amount into your rollover IRA.  Failure to do so will cause the loan amount to be subject to income tax and the 10% penalty.

4.      Another mistake people make is leaving money on the table.  Most 401k plans have an employer’s match.   The employers’ contributions are not always timed with the employees’ contributions.  So, you should check with your employer about their contributions and your vesting rights under the 401k plan rules.  Make sure you get all you are entitled to.

5.      If you own company stock in your 401k, you may wish to treat the IRA rollover differently.  The key is the current price of the stock compared to what you paid for it.  If the current value is greater, you have net unrealized appreciation (NUA).  In such a case, rolling over all assets except company stock may make sense.  You will be subject to income tax and the 10% penalty on the cost basis of the stock.  The difference between the current price and your cost basis is your capital gain, which is subject to capital gains tax when sold.  If the after-tax gains are positive, then it is the smart move.

6.      Look at the Roth conversion.  Ok, this is not a trap, it’s more of an opportunity, but humor me.  Roth IRAs earn interest, dividends and capital gains free from tax.  Roth’s provide income to the owner that is tax free.  Many 401k participants may wish to consider rolling their 401k assets to a Roth IRA.  There are drawbacks.  To do this, you must pay tax on the entire amount converted to the Roth IRA.  Additionally, there are currently restrictions on Roth IRA eligibility based on a person’s income level (these disappear in 2010).  But, for those that meet these restrictions, it provides an opportunity to pay all the taxes now while asset values are low, and in return, you never have to pay tax on those assets or the respective income again.

7.      For those people who are looking to retire now or just need some additional income while seeking employment that may pay less, there is the opportunity to take income from your IRA rollover prior to age 59½ without having to pay early withdrawal penalties.  Rule 72(t) allows for equal periodic payments from an IRA without the penalty.

Leaving a job is a difficult experience.  The many complexities of the 401k make it a perilous time for those already facing difficult decisions.  Your Money Concepts’ financial advisor is there for you.  He or she will help you through the maze of issues you currently face, and will be with you in the future.

P.S.  Please feel free to forward this to anyone you know who may be going through a change in employment.