Which rollover option best for retirees?

08/25/2013 12:00 AM

08/24/2013 6:16 PM

Should I leave my money at my old job or take it with me? This is one of the biggest questions among recent retirees and those displaced from their jobs. While there is no “one size fits all” answer, here are a few considerations to help you decide which option is best for you.

Rollovers come in two options: direct and indirect. From a tax standpoint, direct rollovers are preferred because even though the check may be mailed to your address, technically you never take possession of the money. Instead, it is made payable to a custodian for your benefit and they deposit the money into your IRA. Using this option allows you to avoid taxation and penalty because the money is essentially moving from your current custodian – the 401(k) provider – to your new custodian where your IRA is located.

However, indirect rollovers work differently. First, the check is made payable directly to you. Since the 401(k) provider has no assurance that you will deposit the funds into an IRA, they are required to withhold 20 percent for federal taxes. That does not mean that you will be taxed only 20 percent on this distribution.

Everyone’s situation is different, so your federal tax liability from this distribution may be greater or less than the required withholding. Also, if you are younger than 55, you likely will incur a 10 percent penalty in addition to whatever tax you owe.

Even though taxes and a potential penalty are associated with the indirect rollover option, the IRS does grant you 60 days to deposit the entire amount of the rollover into an IRA without consequence. For example, suppose you had a $100,000 balance in your former employer’s 401(k). If you opted to do a direct rollover, the full $100,000 will move from your current employer to your IRA. If you decided instead to do an indirect rollover, then you would receive a check made payable to you for $80,000, and the other $20,000 is sent to the U.S. Treasury. In the latter scenario, you have the option to deposit the $80,000 plus $20,000 from another source so that you can avoid the taxation and penalty.

Age also should be a factor when deciding whether to roll over the money or leave it with your former employer. Most people know that when it comes to retirement plans, 59.5 is a magical age. That is when you can begin taking withdrawals without it being considered an early distribution. This is significant because it allows you to avoid the 10 percent penalty.

What few realize, however, is that age 55 can be magical, as well. If you retire or are displaced from your job between the ages of 55 and 59.5, then you should weigh the costs and benefits of rolling over your money before making a final decision. The reason for this is because those age 55 and above are allowed to take withdrawals from their retirement plans like 401(k)s and profit sharing plans without incurring the 10 percent penalty. This rule does not exist for IRAs. Instead, 59.5 is generally the age for IRAs. While there is an option for 55-year-olds to avoid this penalty with IRAs, it is very rigid and does not have the simplicity of the 401(k) option.

Another factor to consider involves investment options. Within your retirement plan at work, you are limited to the investment options available within the plan, which usually consists of mutual funds and possibly company stock. Some people prefer to have additional options that enable them to invest in CDs, individual stocks and everything in between. For those who prefer more flexible investment options, IRAs generally provide this.

Making the decision to rollover money from your former employer can be a big decision, but with the right counsel and considerations, you can make a decision that is best for you.

Life is a journey. Plan for it.

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