Recently, a client of mine set up an appointment to discuss his early retirement dreams. As a 58-year-old electrical engineer, Paul was tired of enduring constant stress and increased responsibilities at work.
His pension and 401(k) were finally at levels where he felt confident he could retire early, and on his own terms. And since most of his co-workers were in the midst of making their own exits, Paul was ready to follow suit and roll his investments into an IRA so he could begin living off distributions.
But, was this a good idea?
Not so fast.
Because Paul hadn’t yet reached the magical age of 59 ½, taking early distributions would result in a very unattractive 10 percent early withdrawal penalty if we weren’t careful.
To help Paul retire early without paying unnecessary penalties, we rolled his pension into his IRA while leaving his 401(k) with his employer. This allowed him to take advantage of the “55 and separated rule,” which allows certain workers to take early withdrawals without penalty — but with a catch.
“The catch is that you have to be at least 55 years old and separating from service from your current position past the age of 55,” says Seattle Financial Advisor Josh Brein.
Other Dangers of Rolling Your 401(k) Over Too Soon
The story above illustrates an important danger of rolling your 401(k) over to another plan too soon. If you don’t have a comprehensive plan in place and you liquidate your 401(k) before age 59 ½, you may wind up paying an early withdrawal penalty — and that’s on top of taxes.
But, there are other dangers that come with rolling over your 401(k) to be aware of, most of which can be avoiding with some thoughtful planning and preparation.
Navigating the NUA Rule
Let’s imagine you have a favorable stock position with your employer and plan to take advantage of a little-known rule that can help you avoid penalties and minimize taxes. Under the “NUA Rule,” only the cost basis of the shares you sell is subject to tax (and perhaps an early withdrawal penalty) at the time of distribution. The cost basis is what someone actually pays for the stock, whereas the difference between the cost basis and the stock’s current price is called the net unrealized appreciation (NUA).
In short, the NUA isn’t subject to tax until the stock is sold and will never be subject to an early withdrawal penalty. That’s good, right?
Unfortunately, taking advantage of the NUA rule isn’t for everyone, says financial advisor Rick Taborda of LBT Wealth Management.
If you roll the stock into a taxable account, for example, you’ll need to pay taxes on the cost basis and potentially a 10 percent early withdrawal penalty if you’re younger than 59 1/2.
“For a young person, rolling to an IRA and deferring taxes for 30 or more years may be a better choice,” says Taborda. “The benefit of the tax deferral may outweigh the benefit of the lower tax rate on the NUA.”
Don’t Limit Your Options
Another issue many who want to roll their 401(k) over fail to consider is pure choice, says Massachusetts financial advisor Eric C. Jansen of AspenCross Wealth Management.
“One often overlooked consequence of rolling ones 401(k) to an IRA is the loss of investment options that may only be available through your employer-sponsored 401(k) plan, such as access to a Stable Value Fund. This investment option provides returns typically equivalent to short/intermediate term bonds, without the risk to principal that comes with owning a bond fund or ETF in a rising interest rate environment, such as we are in today,” says Jansen.
Dump your 401(k) and you could also wind up paying higher fees, says Colorado financial planner Matthew Jackson of Solid Wealth Advisors.
“There are many very low-cost 401(k) plans provided by employers,” he says. “Don’t rush into rolling your 401(k) to a new custodian if the fees will be higher.”
Jackson recommends reviewing the performance of both plan options to make sure your new option won’t pair lagging performance with higher fees and ongoing costs.
“Paying higher fees and receiving less performance is a sure way to have less in your retirement accounts in the long run,” he says.
Closing the Door to a Backdoor Roth IRA
Since high earners don’t have the ability to contribute directly to a Roth IRA, many do a backdoor Roth IRA instead. In short, they open a nondeductible IRA and convert it to a Roth IRA at a later date. But, rolling your 401(k) over too early can rule out this option.
“Rolling your 401(k) into an IRA too early could close the door to backdoor Roth IRAs for high income earners,” says financial planner and host of retirement podcast Retirement Starts Today Radio, Benjamin Brandt.
The problem arises when making the nondeductible IRA to Roth conversion, says Brandt. The IRS will look at all your IRAs as an aggregate to decide if your conversion will be taxable. The IRS won’t look at your 401(k) dollars, on the other hand.
“If you are a high earner and wish to fund a Roth IRA using advanced strategies like backdoor Roths, you want as few traditional IRA dollars as possible,” says Brandt. “Leave pre-tax funds in your 401(k).”
And End to Borrowing
Another disadvantage that shouldn’t be overlooked is the fact that rolling your 401(k) into an IRA ends the era where you can borrow against that account.
“Most plans allow for loans and you are typically able to borrow up to 50 percent of the vested account balance to a maximum of $50,000,” says financial planner Joseph Carbone Jr. of Focus Planning Group. Not all 401(k) plans offer this option, but most do, he says.
If you roll that old plan directly into your personal IRA, you do not have the loan feature available, says Carbone.
Working Longer Than Expected?
Last but not least, let’s imagine you plan to work forever — or, at least well past the ripe old age of 70 ½. Maybe you leave the work force early, but eventually work your way back because you’re bored or fear running out of money. In that case, you might want to avoid rolling over your 401(k) into an IRA.
“If you continue to work past 70, you may be able to continue to make contributions to your 401(k) and not be subject to RMD’s (Required Minimum Distributions),” says Colorado financial advisor Mitchell Bloom. If you can avoid RMDs, you can also avoid unnecessary taxes on those distributions until you leave your employer and separate from service.
If you moved your 401(k) into an IRA, on the other hand, you will need to start taking RMDs by April of the year after you turn 70 ½ (and paying taxes on that income) whether you’re still working or not.
Should you roll your 401(k) into any other financial product? Only you can decide. If you’re unsure, a qualified financial planner can help you weigh your options and avoid these dangers and others.
This post was originally published on cnbc.com