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I f you participate in a 401(k) or another type of employer-sponsored retirement plan, when you leave the company, you'll have to decide what to do with your account. Many people roll the balance into an IRA.
Benefits: If handled properly, not only do you maintain tax deferral, you control how your money will be invested.
However, an IRA rollover is not your only choice. Other options...
Take the cash. If you do this, you'll owe income tax on the full amount right away.
Keep the money in your former employer's plan. Many companies permit you to do this.
Transfer money to a new employer's plan. Even if you're not immediately eligible to participate, you can hold cash in the new plan until you can make other investments.
Crack your nest egg. You can withdraw some of your retirement funds, pay tax on the withdrawal, and roll the balance into a tax-deferred IRA.
Why would you choose one of these alternatives rather than a rollover? Possible reasons...
You're in a cash crunch. If you need to spend some or all of the money in your plan, you might as well withdraw it from the plan right away. That's especially true if you were born before 1936.
Loophole: People in that age group qualify for a special tax break. They can use tax-favored 10-year averaging if they take all of their money out of the plan. This could cut their taxes to a relatively low rate.
Trap: You don't get this tax break if you do an IRA rollover.
Key: Even if you can't use 10-year averaging, the 2003 tax law created lower income tax rates that may make withdrawals appealing.
You need a helping hand. If you don't want to manage your own retirement fund, you may prefer to leave the money with your former employer or transfer it to a new one. Inside an employer's plan, professionals decide who manages the investment options.
You want to extend tax-free growth. Under the Tax Code, you can defer taking required withdrawals from a company plan, even after you reach age 70 1/2, as long as you're still working. (With an IRA, you must start taking distributions after you reach age 70 1/2.)
Caveat: You can't own more than 5% of the company you work for.
You need to keep creditors at bay. Money in an employer-sponsored retirement plan is generally protected from creditors, judgments, divorce settlements, etc., under federal law.
Trap: State law may not provide your IRA with the same protection. If you live in a state where IRAs aren't fully sheltered, you may prefer the safe harbor of an employer's plan.
You need to borrow. Many employer-sponsored plans, including 401(k)s, permit you to borrow half your account balance, up to $50,000.
Advantages: Plan loans may be easier to get than bank loans, with less paperwork. Also, repayments (plus interest) go to your retirement account rather than to a bank.
Trap: You can't borrow from an IRA. And, any outstanding 401(k) loans must be repaid before a rollover, reducing the amount you'll have in your IRA.
Therefore, if you have outstanding loans, or think you might want to borrow in the future, keeping money in an employer's plan may be the best choice.
You hold appreciated employer stock in your plan. An IRA rollover can cost you a substantial tax break.
Example: Your retirement plan account includes $50,000 worth of your employer's stock, which was worth $10,000 when contributed to your account. If you roll over your entire account, that $50,000 eventually will be taxed at ordinary income rates, now as high as 35%, upon withdrawal.
Strategy: Withdraw the employer shares while rolling the rest of your plan balance into an IRA. You'll owe tax immediately, but only on the value of the shares when contributed to the plan, not on their current value.
In this example, you'll immediately be taxed on $10,000 but the $40,000 in net unrealized appreciation (NUA) remains untaxed until the shares are sold. When you sell those shares, you'll owe tax at a 15% capital gains rate, assuming current law remains in effect.
THE PENALTY BOX
In between ages 55 and 59 1/2, therefore, you're better off keeping your money in a company plan, if you expect to take distributions.
If you need to tap your retirement plan, withdrawing money from an IRA before age 59 1/2 may expose you to a 10% penalty.
Loophole: You can take money from an employer-sponsored plan, penalty free, if you were at least age 55 in the year you left your job.
LIFE INSURANCE
If your account in an employer-sponsored plan includes life insurance, you might want to keep your money in that plan in order to keep the policy in force.
Key: You may find it costly to continue your life insurance after you leave the company plan. If you're in poor health, you might not be able to buy needed coverage at a reasonable price.
WHEN IRAS ARE IDEAL
If none of the above reasons apply to you, you're probably better off with a rollover IRA. In some situations, IRAs are especially appealing.
Example: You're interested in a Roth IRA conversion. After five years and age 59 1/2, all withdrawals may be tax free.
Required: Only traditional IRAs may be converted to a Roth IRA. Therefore, you must first roll over a company plan distribution to an IRA, in order to subsequently convert to a Roth IRA.
Keep in mind that Roth IRA conversions are permitted only if your adjusted gross income before the conversion that year is not over $100,000. You'll owe tax on all the deferred income when you convert an IRA to a Roth IRA.
Key: No matter what your reason, always ask for a "trustee-to-trustee transfer" when you execute an IRA rollover. Keep your hands off the money being rolled over.
Trap: If you handle the funds, you'll face mandatory 20% withholding on the rollover. You'll have to make up the difference from your own pocket to avoid owing income taxes.
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