A recent story in Bloomberg titled “Retirees suffer as $300 billion 401k rollover boom enriches brokers” highlighted the fears of many investors – the potential for conflicts of interest between you and your broker. Are the future pictures on the wall going to be you enjoying a comfortable retirement, living with dignity, and your grandkids graduating from college or vocational school? Or instead, are they going to be those of your broker’s future? Shouldn’t they be both?
What’s in your best interest with your retirement plan when you leave one job for another, or exit the workforce permanently? The issues are numerous, and your situation unique. There’s a big push for the retirement readiness of our nation’s population through financial literacy and saving incentives. Regulators have pushed for greater industry transparency and disclosure. And debates continue over a new fiduciary standard (brokers and advisors to act in the client’s best interests during rollovers).
This is the first of a series of articles intended to help you continue to make smart financial decisions. Future articles will discuss the pros and cons of rollovers (should you do a rollover), and the issue of suitability (how do you invest).
The basic rules on retirement plan distributions are that they’re generally taxable as ordinary income, may trigger early withdrawal penalties, and the potential for tax deferral by rolling the funds over to another eligible retirement account. Here are some of the lesser known rules about rollovers.
Say you leave an employer and have $100,000 in their 401k-style retirement plan. Many automatically think of an IRA rollover. However, some don’t consider the other options with those retirement plan dollars.
• IRA rollover
• Leave it in the company plan
• Roll it to the new company plan
• Take a lump sum distribution
• Make a Roth conversion
Inertia can be a tough thing to overcome. Some plans allow you to stay put. Perhaps you’re comfortable with the current plan reporting, expenses and investment options, and you don’t want to do your homework and explore the broader universe. However, other plans may want you out when you end your employment for a host of reasons including administration, cost and liability issues.
Does your new employer’s plan accept rollovers? If the plan’s investment options are best for you, then rollover to that plan can simplify your life (less accounts to manage). However, some plans don’t accept rollovers, largely due to the same reasons your former plan wants you out.
The lump sum distributions and Roth conversions share a common result – you’re going to write a check or two for income taxes. The lump sum option provides you liquidity and bolsters the “after-tax” side of your balance sheet. A risk is you use the funds for a joy ride (especially when you’re switching jobs) and not preserve the funds for what they were intended (retirement). And the Roth conversion provides the benefits of future tax-free withdrawals, and might avoid future required minimum distributions.
Net Unrealized Appreciation (NUA) Strategy
This might be advantageous if your plan includes company stock that has significant gains, you’re in a high income tax bracket, and expect to be in a high bracket throughout retirement. By taking the distribution of employer stock, you might pay taxes as low as 15% (capital gains) rather than doing a rollover (and even repositioning the shares into other investments), and down the road, taking retirement plan distribution as ordinary income. This strategy is complex and you should consult your CPA for the specifics. Generally, taking distribution of the employer stock to a taxable account triggers ordinary income on the cost basis of the shares, but the NUA (difference between market value at distribution and cost basis) isn’t taxable until you later sell the shares (potentially at long-term capital gains rate if held for a year or more from time of distribution). A risk of this strategy, like many transactions focused primarily on tax savings vs economic merit, is you’ve got a dog of a stock.
Don’t put the IRA rollover decision on autopilot. Good luck!