Changing jobs or retiring are two of the biggest life transitions. And, along with those transitions comes the dilemma of what to do with the money in the retirement plan of your previous employer. If you’re like most people, your employer retirement plan – be it a 401(k), 403(b), or 457 Plan – makes up a sizeable portion of your retirement nest egg. You need to weigh your options carefully, as mistakes and missteps in handling these plans can be costly and could jeopardize your retirement.

Understanding your four main options for handling your old 401(k) or 403(b) is critical to your retirement success. So, let’s take a look at your four main options:

Option 1: Remain in Your Old Company Retirement Plan

The fact that you’re leaving an employer does not necessarily mean you must take your 401(k) or 403(b) with you. While there are many reasons why it may be a bad idea to leave money in your previous employer’s retirement plan. For some people, leaving the money in the plan could be a good option.

Reasons to stay in your old company retirement plan:

The age 55 exception to early withdrawal penalties. Probably the biggest incentive to leave your money in your old company retirement plan. This rule provides that, if you are 55 or older in the year you leave your employer, any distributions taken prior to attaining age 59½ will not be subject to the 10% early withdrawal penalty. If you’re changing jobs and your finances are such that you could envision a scenario where you may need to tap into some of your 401(k) money to tide you through to 59½, this could be your best option.

This exception only applies to your funds while they remain in the company retirement plan. If you roll over your account into an IRA, this exception is lost and all distributions before age 59½ will be subject to the early withdrawal penalty unless other exceptions apply.

Age 50 exception for public safety workers. Similar to the age 55 exception, this rule is applicable only for state and local public safety workers. It allows for plan funds to be withdrawn penalty-free if the worker separates service in the year they turn age 50 or older. If you happen to be a public safety worker, this exception may be an important part of your plan to bridge your income needs between separation of service and age 59½.

Federal creditor protection. Your old 401(k) or 403(b) plan (but not a 457 plan) covered under the Employee Retirement Income Security Act (ERISA). This provides protection from bankruptcy as well as from lawsuit judgments. For some former plan participants, like physicians who may face a malpractice lawsuit, this could be an important consideration, as these protections may be reduced or lost once an old plan is rolled over.

Ability to hold life insurance. Life insurance cannot be held inside of an IRA, but it can be held inside of a 401(k). This may factor into your decision if you happen to own life insurance in your 401(k) since if when you leave the plan you may have to either treat the life insurance as a taxable distribution, purchase the policy from your 401(k), or surrender the policy for its cash value. In addition, if you still need the death benefit to protect your loved ones, replacing the coverage could be more expensive and may be difficult or impossible in the event your health has changed.

Option 2: Rollover to Traditional IRA

An additional option for your old 401(k) and 403(b) plans is to roll the account assets into a Traditional or Rollover IRA. There are advantages to holding retirement assets in an IRA that are not available to you while the money remains in your old retirement plan.

Reasons to rollover your old company retirement plan:

Greater range of investment options. As an IRA owner, you have an almost limitless choice of investments options from which to utilize in constructing your IRA portfolio. You are no longer required to select from the relatively limited options available inside your former employer’s retirement plan. This means that you are able to build a customized mix of investments appropriate for your unique circumstances and retirement needs.

Expanded beneficiary options. Retirement plans are often designed with more restrictive beneficiary options than those available to you in an IRA. For instance, many plans don’t want to deal with the recordkeeping required to enable stretch payments to an eligible designated beneficiary (EDB). Many plans also preclude you from naming a trust as a beneficiary. And, finally, ERISA-covered plans require the consent of your spouse if you want to name someone other than your spouse as the beneficiary of your retirement plan.

Simplicity of satisfying required minimum distributions (RMDs). IRS rules permit you to aggregate the value of all your IRAs when calculating your RMDs. In addition, you can take your RMD from anyone or a combination of your IRAs. On the other hand company retirement plans each require their own separate RMD.¹

Greater tax withholding options. In general, company retirement plans are required to withhold 20% if you decide to have your eligible rollover distribution paid to yourself. With an IRA, there is no mandatory 20% withholding.

Ability to utilize higher education and first-time home buyer penalty exceptions. Distributions from IRAs are not subject to the 10% early withdrawal penalty when used for either higher education expenses or first-time home purchase. These exceptions are not available in 401(k) and 403(b) plans. So, if you intend to utilize either of these exceptions, a rollover to an IRA is a requirement to avoid the penalty on these early withdrawals.

No restriction on withdrawals. Many company retirement plans have restrictions or limitations on withdrawals from the plan. However, as an IRA owner, you have immediate access to your account – regardless of age. While you may incur the 10% early withdrawal penalty prior to age 59½, you still have access to your IRA funds … access your 401(k) may not provide.

Flexibility and increased control. A Rollover IRA gives you the flexibility to make changes more quickly since administrative delays and hurdles are eliminated.

Option 3: Convert to a Roth IRA

For some, option to convert to a Roth IRA can be very attractive. If your plan permits, the conversion can be done inside your plan. If your old company retirement plan does not offer a Roth option inside the plan, rolling your funds out of your old plan may be the only way to gain the tax-free Roth IRA treatment. Here’s why:

Ability to segregate after-tax money. For those with sizeable 401(k)s and 403(b)s, you should be aware that Roth conversion is not an all-or-nothing scenario. You have the option to only roll over part of your plan into a Traditional IRA and part to a Roth IRA. The IRS treats your rollover to a Roth is considered the same as a conversion.

If you have ever made after-tax employee contributions to your plan, this can be especially advantageous. Although those contributions are not Roth dollars, the earnings on after-tax contributions are taxable when distributed from your plan. If your plan separately accounts for after-tax contributions and their earnings, that after-tax money can be segregated from your pre-tax money.

When you roll over the plan, the plan administrator normally issues two checks: one for your pre-tax money and one for your after-tax money. The after-tax money should be placed into a Roth IRA since this qualifies as a valid Roth conversion. Since these are after-tax funds, your Roth conversion is tax-free.

Not only does this strategy provide the greater benefits afforded by a Roth IRA, it also eliminates the requirement to track cost basis had you rolled your after-tax money into a Traditional IRA.

Option 4: Lump-Sum Distribution

The final option is to take a full or partial distribution and pay taxes on that amount now. Despite incurring an immediate tax bill, it can potentially save you money in the long run.

The IRS makes special allowances, called net unrealized appreciation (NUA) rules, for how employer stock held inside of a company retirement plan is treated. Leveraging these NUA rules on company stock held inside a 401(k), allows you to pay long-term capital gain tax rates on the appreciation of the company stock – rather than being taxed as ordinary income.

As a plan participant, you need a triggering event in order to qualify to utilize the NUA rules. Those triggers are:

• Attaining age 59½

• Separation from service²

• Disability³

• Death

To complete an NUA distribution, your company stock is transferred in-kind to a non-qualified brokerage account. The other plan assets are normally rolled over to a Traditional IRA. When the NUA stock transaction is begun, the entire 401(k) balance must be removed by the end of that calendar year. The timing and execution of an NUA distribution is crucial.  A misstep or wrong turn could cause you to lose this valuable opportunity.

Although it could represent significant tax savings, the NUA tax break is not available to everyone. In addition, it is not always a perfect fit for those with company stock held in their 401(k). But, it’s certainly an option that should be taken into consideration.

In Conclusion

Plans and people are all unique. Your situation and needs may differ from the above examples. There’s no one-size-fits-all solution for what to do with your old retirement plan. Sometimes, a combination of these different options may make the most sense. So, to maximize your retirement resources, be sure to weigh all your options before you make any final decisions.

1.        The IRS provides an exception for 403(b) plans, which can also be aggregated.

2.        Not available to self-employed participants.

3.        Only available for self-employed participants.

 

The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but is intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax, or personalized financial advice. Please consult a legal, tax, or financial professional for information specific to your individual situation.