401k Rollovers - A Missed Oppportunity to Save Tax

Considering that you are about to retire or are close to it, what do you plan to do with your contributions made by you and your employer to your 401k? Should you complete a 401k rollover?

You have two alternatives at hand. One is that you can keep the 401k with your previous employers and the other one is to opt for 401k rollovers. But before you choose anything, it's important to consider the tax and investment results of 401k rollovers to an IRA.

With an IRA, you have the option of investing your funds in different ways. This allows you to have excellent control over your investments. But the money that you take out of your IRA is taxable at regular income tax rates, which can be as high as 35% and the lesser capital gains tax are not applicable. Moreover, you need to pay an additional penalty tax of 10% for getting the distribution before the age of 59 ½, unless you qualify for an early IRA withdrawal or any other exclusion. One exclusion is if you have separated from the employer and then may take funds as early as age 55 without penalty.

You can even choose to ignore the options of 401k rollovers, and allow your money to stay in the companies 401k plan.

If you do decide to rollover your assets, it is critical to be aware of this following scenario.1 This method involves doing a 401k rollover for part of your assets and capturing an associated tax benefit if you have shares of your organization included in your 401k. In such circumstance, you can use the benefit of paying lesser capital gains rates on the net unrealized appreciation (NUA) of those shares.

You can do this by dividing the 401k into two parts, i.e. the company's stock and the other part. Now take the other part and carry out a 401k rollover and get your company to transfer your money directly to your IRA and not to you at first.

When starting a process for 401k rollovers, you do not want to have the company give the funds directly to you because it creates a tax problem. On this amount given directly to you, 20% will be held back for taxes. And you will have to physically carry out the 401k rollover in 60 days time and include the held back amount of 20% with it, if you want to protect your no-tax transfer. But this 20% has to be paid from your own money. You can recover this held back amount of 20% later when you file your tax return. Undoubtedly, this is the difficult way to carry out 401k rollovers so be sure that the part of your fund rolled over to an IRA is a direct rollover, sent directly from your employer to your IRA custodian.

The part of 401k that is in company shares can be taken out as a lump sum. The money that was initially put in those securities is subject to regular income tax currently but later on you only have to pay tax on the appreciation that is yet to be realized but it will be at the rate of capital gains (presently 15% federal).

[1] All information taken from IRS Publication 575 regarding 401k rollovers and net unrealized appreciation.