1. You plan to retire between ages 55 and 59.5
As you’ve probably read before, taking money out of a traditional IRA prior to age 59-and-a-half results in a 10% penalty, unless you meet one of several exceptions.
What many investors don’t know is that with a 401(k), the 10% penalty on distributions does not apply if you are at least age 55 (rather than 59.5) at the end of the calendar year in which you left your employer.
So, if you’re planning to retire prior to age 59.5, keeping money in your old 401(k) is an easy way to get penalty-free access to some cash for the years between ages 55 and 59.5. Then, after you reach age 59.5, you can roll what’s left of the 401(k) into an IRA if it makes sense to do so.
2. You’re planning a Roth conversion
If you have a traditional IRA that includes nondeductible contributions and you are planning to do a Roth conversion in the near future (a “back-door Roth,” for example), holding off on a 401(k) rollover is likely to be beneficial.
When you do a Roth IRA conversion, the percentage of the conversion that is not taxable is calculated as your net nondeductible contributions, divided by the sum of:
— All of your traditional IRA balances (and SEP and SIMPLE IRA balances) as of the end of the year of conversion,
— Any Roth IRA conversions you made throughout the year, and
— Any other distributions you took from your IRA throughout the year.
Rolling a pre-tax 401(k) into an IRA increases the first item on that list, thereby reducing the portion of a conversion that would be nontaxable. In other words, rolling over a pretax 401(k) into an IRA in the same year that you do a Roth conversion will increase the portion of the conversion that is taxable as income.
3. Your old 401(k) has better investment options
In some cases — particularly if your previous employer was a large organization — you may actually have better investment options in your old retirement plan than you would in an IRA.
For example, if your ex-employer’s retirement plan includes the “Institutional” share class of Vanguard mutual funds, the expense ratios on those funds are typically about 1/3 lower than the cost of the ETF or “Admiral” share classes that you would have access to in an IRA.
Or, if you worked for the federal government and had access to its Thrift Savings Plan (TSP), no fund available to retail investors is going to be less expensive than the 0.025% expense ratio you’re paying on the TSP funds.
4. You have employer stock in your 401(k)
If you have appreciated employer stock in your old 401(k), you might want to roll that stock into a taxable brokerage account rather than into an IRA in order to take advantage of the “net unrealized appreciation” rules.
Here’s why: If you roll the stock into an IRA, all of it will be taxable as ordinary income when you eventually withdraw from the IRA.
But if you roll the stock into a taxable account, only your cost basis (the amount you paid for the shares) will count as a taxable distribution. Any net unrealized appreciation (the amount by which the stock has increased in value while in your 401(k) account) will be taxed as a long-term capital gain rather than ordinary income.
It’s important to understand, however, that if you’re under age 55 when you roll the employer stock into a taxable account, the 10% penalty will apply to your basis in the stock, because it will count as an early distribution.
If you’re considering taking advantage of this particular tax break, I would suggest consulting with a tax professional to make sure you follow the necessary rules.
Whenever you are deciding what to do with your 401(k) at an old employer seek the advice of a independent fiduciary. Many brokers will recommend rollover, not because it is in your best interest. Brokers will recommend a rollover to earn a commission.
Please comment or call to discuss how this affects you and your financial future.