401k rollover options are many. Upon termination of employment, retirement or your employer closing down the 401k rollover plan, you decide what to do with your 401 plan balance. Here are several rollover options available:
Direct Rollover into an IRA
The easiest option to avoid any withholding taxes (and a10% penalty if under age 59 ½), is to directly rollover your entire plan into an IRA. You have your employer send the 401k balance directly to your IRA. An IRA is a tax-deferred account that can be used to receive retirement benefits distributed from any employer sponsored plan, such as a 401k rollover options. Since all earnings continue to accumulate on a tax-deferred basis in your rollover IRA, your money will compound and accumulate a larger balance than money placed in a taxable account. These options allow you to enjoy a larger nest egg on which to retire.
In many cases, employers will allow you to leave your money in the 401k plan even though you no longer work for the company. However, most people look forward to a rollover into their own IRA because they have additional investment options and greater investment flexibility.
Indirect Rollover into an IRA
An indirect rollover appears when the funds from the 401k plan come to you in a check payable to you.
If for some reason you have already received your distribution in this fashion, minus the 20% mandatory withholding, you have a problem. The employer is required to withhold the 20% IRA tax and submit it to the IRS as a prepayment option on your current year’s income tax (normally due April 15, next year). You have 60 days from the date you received your money to invest these funds into an IRA rollover, along with an additional 20% of your own money to cover the amount withheld. But what if you don’t have the 20% laying around to contribute to your IRA rollover? Tough. The IRS will charge you tax on that 20% as a taxable distribution (plus 10% penalty if under age 59 12/). When you file your income tax return, you will receive credit for the 20% withheld. But that does not help you today as you have only 60 days from receipt of the check to add the 20% to it and complete your IRA rollover to keep it completely tax free. You won’t see the 20% credit until you file your income tax return—next year.
Taxable Distribution Options
Don’t take money from your retirement plan unless you have no other sources of funds. You have 3 reasons to avoid this:
• State and federal income taxes will take a bite out of your distribution. When you were making contributions to your 401(k), you most likely did so with pre-tax dollars. In addition, employer contributions to a qualified plan on your behalf were also tax deferred. Upon distribution, you have to pay current income taxes on all pre-tax contributions and earnings.
• There is a 20% mandatory federal income withholding tax that is applied to eligible rollover distributions options. If you elect to receive a check directly from your employer, you will only receive 80% of your distribution. In essence, if you expect to receive a check for $100,000, your employer will withhold 20%, or $20,000, and send you a check for $80,000.
• A 10% penalty may also apply (also known as a premature distribution penalty). Generally, if you are under age 59 1/2 you will have to pay the IRS an additional 10% penalty when you file your federal income taxes next year. There are certain exceptions to this rule, such as death, disability, or substantially equal payments.
Transfer Funds to Your New Employer’s Plan
If you change jobs and join another company, that company MAY allow you to transfer the balance for your old 401k plan to your new 401k account. However, most people don’t do this because they have greater investment choices in their own self directed IRA.
Keep Funds in Your Old Employer’s Plan
For account values of $5,000 or more, you have options to keep your funds in your former employer’s 401k plan. Your funds will continue to accumulate tax-deferred, and can later be moved to a new employer’s 401 plan or an IRA without penalty. If you are over the plan’s retirement age or age 62, your company may insist that you take a payout in order to decrease the plan’s administrative costs. If this happens, you still have the option to make a rollover to an IRA. Each employer has different rules about leaving funds in their plan once employment has been terminated.
Special Tax Break for Company Stock
Let’s say you work for Chevron and you have Chevron shares in your 401k rollover plan. In these cases where you have company shares in your 401 rollover account, IRS has special options that can help to save you some big tax dollars. Although rolling over your company stock to an IRA may allow you to avoid paying taxes and penalties right now, you may benefit more by using a provision known as NUA (Net Unrealized Appreciation). By having the stock shares sent to you in a taxable form, you only have to pay taxes on the cost basis of the stock. Maybe the stock was purchased years ago at an average price of $10 and today the shares are worth $100. You can receive the shares today, pay ordinary tax on the $10 and pay capital gains tax on the rest (capital gains tax rates are usually less) when you sell the shares later.
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