Is it wise to rollover a 401K to an IRA if terminating employment?

[Guest Mountain Man]

What options exist for an employee's 401k account if they are terminating employment before retirement age. It seems may people role their 401k into an IRA. However, I understand but am unclear on the specifics, that the tax rate for 401k assets held over 5 years may be as low as 10%. Is this true. If it makes more sense, is there any way of maintaining a 401k account if your employer throws you out on termination.

[Guest Karen Geiger]

Generally, if you have more than $5,000 in your 401(k) account, the employer cannot automatically cash you out upon your termination of employment. If you are automatically cashed out (because you have less than $5,000)or decide to take the money out of your 401(k) plan, you may (1) receive a cash payment, in which case 20% of the payment is withheld as taxes and if you are under age 59 1/2, you will owe an additional 10% penalty; (2) roll the money over into an IRA, in which case no taxes are withheld until you withdraw the money from the IRA; or (3) roll the money over into your new employer's plan if it accepts rollovers, again no taxes are withheld until you receive the money.

For more information on this, you should request a copy of the Special Tax Notice, which is provided to plan participants when they request a distribution from a retirement plan.

There is no way of preventing your employer's automatic cash out if you have less than $5,000 in your Plan account.

[Guest Mountain Man]

Thanks Karen, you cleared up a few questions I had. Since my 401k is over $5000 it should be my election to roll it out (probably an IRA will be my only option). Is this an on going election or do I have a one time election on termination and prior to 59 1/2. It appears that a significant advantage of keeping it in a 401k, as apposed to rolling it to an IRA, is that when a distribution is taken it is taxed at the long term capital gains rate. I don't think that is an option in an IRA. If my 401k is vertually all before tax dollars, most all qualifying for LT tax treatment and includes both my and my employer's contibutions, what parts qualify for LT taxes.

[Guest]

other factors to consider:

this first one is based on experience - if you move, sometimes the prior employer has trouble tracking you down. while I wouldn't expect you to 'forget' you have $ sitting somewhere, I would just mention the fact that I have a number of participant that can't be located because they have moved. please keep that in mind if you leave your $ in the plan - tell them if you move!

another thing to consider. though I don't recommend it - you can not take a loan out of an IRA. if you roll the $ into a plan of your new employer (if a plan exists, etc) you might have the option of taking a loan. again, I don't think taking a loan is a good idea, but then I also the full amount on my charge cards each time because I think they are a bad deal as well.

[Guest Karen Geiger]

Generally, all withdrawals from an employer's retirement plan and an IRA are taxed at ordinary income rates, not at capital gain rates. The only reason you would be eligible for capital gain rates upon your distribution would be if you were born before January 1, 1936 and you were a participant in your employer's 401(k) plan before 1974. Therefore, if you do not qualify for this special tax treatment, your distribution from your 401(k) plan or IRA will be taxed based upon your tax bracket when you withdraw the money. The 20% withholding that I mentioned in my previous message is a mandatory withholding by the federal government. Whether that is the amount you ultimately pay in taxes on the distribution depends on your tax bracket when you file you taxes after the end of the year in which you receive your distribution.

As to your election to receive your 401(k) plan assets, you are eligible to request a distribution at any time. By law, however, you must begin taking a distribution by April 1 of the calender year following the calendar year in which you attain age 70-1/2. Also, once you attain the later of "normal retirement age" as it is defined in your 401(k) plan or age 62, the plan may automatically cash you out.

[Guest Jeff Kropp]

Be aware that once you elect to leave your money in your former employer's plan, you may be prevented from taking the money until your normal retirement age. Although most plans probably don't impose this restriction (for legal reasons) some still do. You may want to review your plan summary to see if this restriction applies.

[Guest Mountain Man]

The thing that makes me think that the capital gains rates apply is IRS Notice 98-24 paragraph 52,152. In this notice it seems to indicate that the capital gains rates applies to Net Unrealized Appreciation. It states, along with other things I am having a hard time understanding, that "the amount of net unrealized appreciation which is not included in the basis of the securities in the hands of the distributee at the time of distribution is considered a gain from the sale or exchange of a capital asset held for more than 18 months to the extent that such appreciation is realized in a subsequent tasxable transaction".

Can anyone knowlegable with the regs help interpret Notice 98-24. It seems that if you take a distribution in a year your income is low that your tax on at least a portion of that distribution could be as low as 10%. Any idea if these regs also apply to an IRA?

[Mary Kay Foss]

If you will receive employer securities as part of your 401k distribution, you will pay tax on the plan's cost of the securities. A 10% penalty will also apply if you're under 59.5. If the securities are sold immediately the unrealized appreciation will be subject to tax at capital gains rates. The capital gains rate could be as low as 10% depending on your other income.

To make the decision you need to know what the plan's cost of the securities is and the current value of the employer stock. I advise many people who have been in the plan a long time to take some or all of the stock directly and roll the balance of the distribution to an IRA. Once you roll employer stock to an IRA you are no longer eligible for the special treatment described in Notice 98-24.

Also the 20% federal withholding only applies to cash distributed. If someone takes shares only, there is no withholding required.

[Mary Kay Foss]

The regs do not apply to an IRA. Capital gains rates apply when a plan distributes employer securities with a current market value in excess of the plan's cost.

If that is your situation, the plan's cost of the shares is taxable to you at ordinary income tax rates. A 10% penalty will apply if you're under 59.5 and don't meet one of the exceptions in Sec. 72t. If the shares are immediately sold the difference between the market value when distributed and the plan cost is taxed at capital gains rates. Those rates could be as low as 10% depending on your other income.

If you retain the employer stock and have the plan roll the balance of the distribution to an IRA, there should be no federal withholding. If there are no employer securities in your plan, rolling it to an IRA is the best choice as mentioned in the previous replies.

[Guest Mountain Man]

Thanks Mary, that's what I wanted to hear. I am thinking that taking and selling a part of my employer securities and rolling the rest to an IRA is the way to go in my case. I understand that to decide exactly how much to take requires knowing the plan's basis in the employer stock. A few additional detail are necessary to decide what is best.

You state that the stocks must be immediately sold. Is there a window of time for this sale. Also, if I take only part of the employer securities can I take the first ones purchased, i.e., those with the lowest basis. Some of the most recent purchases in the plan will have a high basis and contain short term gains and I want to avoid taking that stock out. Similarly, does it matter whether I take the stock I purchased with my before tax dollars or my employer's matching purchases. Lastly, is this a one time thing, i.e., do I have to take a lump sum distribution or can I take a partial distribution of employer stock now and a full distribution later using 98-24 tax treatment both times.

[Greg Judd]

Re: the treatment of employer securities as part of your lump-sum distribution, see IRS Publication 575, p. 21 or thereabouts.

[Guest Mountain Man]

Greg, I appreciate the referral to Pub 575 page 21. This confirms the point Karen made earlier. I still can't reconcile this with Notice 98-24 which does not bring up any age limitations on capital gains treatment and the statement on page 14 of Pub. 575 which also specificly addresses distributions of employer securities and is consistant with Notice 98-24. It states that "when you sell or exchange employer securities with tax-deferred NUA, any gain is long-term capital gain up to the amount of the NUA". There is no age limitation. This seems to contradict the age restricted capital gains treatment Karen mentioned. Any thoughts?

[Mary Kay Foss]

Mountain Man

I didn't mean to imply that you have to sell the employer stock immediately, I just wanted to make the point that if you did sell it immediately there's no 10% penalty.

The employer reports to IRS an average basis for all the shares in the plan so I don't think you can do much planning about which shares have been sold. However, all of the shares are treated as long term. You only worry about short-term gains if shares are sold in the year after receipt for an amount higher than the value when distributed. In such a case only the excess over the value when distributed is a short-term gain.

You can't rollover the shares bought with the after-tax contributions but any such shares always qualify for the special capital gain treatment. Shares bought with pre-tax contributions only benefit if they're part of a lump-sum distribution. Leaving the 401k plan by rolling over the excess over the shares you want distributed will be a lump sum. If you just take a partial distribution and leave some shares behind, you can't use the special capital gain provision on pre-tax contrib (& employer matching) shares.

It's not a one-time thing, you can sell the shares at any time after you receive them and you can sell as many or as few as you want. The only downside is the short-term gain for appreciation in the first year after receipt.

[John G]

"You can't rollover the shares bought with the after-tax contributions but any such shares always qualify for the special capital gain treatment."

Are you talking about rollover to an IRA or do you also include rollover to another company plan? Are there more options if Mountainman starts a company and creates a plan into which he deposits his 401K.

[Mary Kay Foss]

I'm sorry I was not specific in my last reply. The shares bought with after-tax contributions can't be rolled over to an IRA or to another 401k.

Also the special treatment for the net unrealized appreciation only applies when you leave a plan with that employer's securities and take the shares directly. If you transfer those shares to a new employer's plan or your own created qualified plan, the benefit is lost.

[Guest Bill Schulze]

I think there may be one other consideration in rolling a 401(k) distribution to an IRA. This concerns whether the assets are protected in bankruptcy. 401(k) assets are, but IRA assets may not be. I believe it depends on the state staututes regarding bankruptcy.