By J.D. White
In my experience of nearly a decade in the industry, it is not uncommon for people to get advice to roll over a 401(k) to an IRA any time it is possible without incurring a penalty. Granted, new regulations require that only education be provided when discussing the options for a 401(k). It still seems that most people understand that there are some benefits to having their retirement funds with someone that they personally know and trust.
Here lies the problem – it is not always the right move. I'll use a story of one of my clients to illustrate how this could create a major hurdle in your retirement plan if you plan to leave your largest income to provide prior to turning 59 ½ years old.
A couple of years ago I met a woman that we will call Natasha Romanoff (a.k.a. “Black Widow”). She was looking for someone that could help her build a solid retirement plan and help her manage her investments and we were able to provide her the service. She was 57 years old and had recently left her long-time corporate job in technology to “slow down” and perhaps follow some passion projects. The major hurdle that she faced was a lack of income – she wouldn’t receive Social Security until at least the age of 62, at a reduced benefit. Her full benefit would not be received until she turned 66 ¾ years old. She was married at one point but is now single and on her own with one adult child living in another part of the state.
This presented our second hurdle – health insurance. Not only did she not have the income to cover her regular bills, but she also needed to come up with the money to fund a health insurance policy in the open market. For simplicity, let us say that she needed $60,000 per year in income ($5,000 per month) and that insurance would run about $12,000 annually ($1,000 per month). Her previous employer provided her with a 401(k) with matching contributions, but no pension money. Her 401(k) has done well over the last 20 years and has just hovered over the $1,000,000 mark. The problem is that IRA rules will not let you pull money from the account until you hit age 59 ½ without incurring a hefty 10% penalty PLUS income tax on the withdrawals (there are a few exceptions, but that’s another article).
Here is the kicker: she might be able to pull money from the 401(k) from the old employer without incurring a penalty. She will still need to pay income tax on the withdrawals, but this could prove useful until she reaches 59 ½ and then whatever age is determined to start Social Security, and then Medicare benefits at age 65. The rules for being able to make the penalty-free withdrawals are as follows:
- Must be at least age 55 for a public company (50 for some public companies).
- Must have reached age 55 prior to leaving the company.
- The money must stay in the 401(k) – it will not work in an IRA.
- The 401(k) has to be from your most recent employer.
- You can go back to work at another company and continue withdrawing from the same account, but not a different one.
Our solution was not as straightforward as just leaving all the money in the 401(k) until she reached age 59 ½. She wanted to use our investment strategies for as much of her funds as possible which meant we needed to do some calculations. Assuming she turned 57 the month that we started working together, we would need 2 ½ years of income (plus tax) and another 2 ½ years of health insurance coverage. The math: 2.5 X ($60,000 income + $12,000 insurance premiums) = $180,000. Let’s assume she is in the 22% tax bracket; we won't get into the weeds about “marginal tax rates” here. $180,000 / (1 – 22%) = $204,545.45. We are not in the business of taking on unnecessary risk, so we decide to leave $250,000 in the 401(k) and roll over the remaining $750,000 into a traditional IRA for her benefit. She was able to establish withholding of taxes with the 401(k) provider and can request money easily as she needs it or establish a monthly withdrawal. Problem solved.
The moral of the story? You should be educated on making these kinds of decisions when you only get one shot at it. Once you roll over a 401(k), it is nearly impossible to reverse that decision. People with my same job position will often overlook a detail like this because we get excited about the idea of managing more money. The industry is changing, however, and more and more of us are required to act in a fiduciary capacity and put your interests first. Make sure that you are having these conversations prior to rolling your 401(k) into an IRA.
In summary, a plan participant leaving an employer typically has four options (and may engage in a combination of these options), each choice offering advantages and disadvantages. The options include:
- Leave the money in his/her former employer’s plan, if permitted.
- Roll over the assets to his/her new employer’s plan, if one is available and rollovers are permitted.
- Roll over to an IRA.
- Cash-out the account value.
Lastly, Natasha Romanov is not an actual client, and the name and facts were changed to protect the identity of my client.
About the Author: J.D. White, CFP®
J.D. White, CFP®, CRPC®, AWMA®, AAMS® is president and wealth manager of White Hawk Wealth Management in Broomfield, Colorado. They pride themselves on their dedication to serving others through financial planning and investment advice. Their mission is to revolutionize the way that people view wealth management and the way that the service is offered.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. No strategy assures success or protects against loss. Investing involves risk including loss of principal.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Western Wealth Management, a registered investment advisor. LPL Financial is not affiliated with any other named entity.
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