Like many Americans, you are probably working hard to build wealth in the form of retirement savings. Undoubtedly, you also appreciate the importance of strategies to help preserve those assets when you change jobs or retire. One of the best ways to do so is through an Individual Retirement Account (IRA) rollover, which can help maintain your retirement funds' tax-advantaged status and may provide you with better control over your asset allocation strategy and the distributions you will ultimately take from the account.
Unfortunately, many individuals fail to take advantage of the rollover option. In July, Hewitt Associates, a consulting firm in Lincolnshire, Ill., surveyed nearly 200,000 U.S. workers and found that 45 percent took their 401(k) plan distributions in cash. The costs of that decision are substantial because the IRS imposes income taxes and a 10 percent penalty on most pre-retirement distributions. The distributed funds also lose the long-term advantage of tax-deferred growth potential inside a retirement account.
Benefits of IRA Rollovers
An IRA rollover offers other benefits in addition to preserving tax deferral. These include:
• Increased investment flexibility. Most employer-sponsored retirement plans offer participants a limited number of investment options. In contrast, a rollover to a self-directed IRA gives you a much broader selection of investments, including stocks, bonds, exchange traded funds, certificates of deposit and real estate investment trusts, among others. This flexibility allows you to customize your retirement portfolio to help meet your financial goals and risk tolerance levels.
• Increased control of estate distributions. Employer-sponsored plans typically limit beneficiary designations. With an IRA, you retain much more control over the account's distributions from your estate, which allows you to integrate the IRA with your overall plans. For example, you can name younger family members as beneficiaries to stretch out the required distributions. If you wish to contribute to your favorite charities, an IRA allows you to designate those organizations as beneficiaries. You can also leave your IRA to a trust to help reduce potential estate taxes while distributing the funds among multiple recipients.
Rollover Techniques
Your circumstances will determine which IRA rollover technique to use. In a full rollover, your employer transfers 100 hundred percent of your retirement plan balance directly to the IRA's custodian. Some employer plans do not permit rollovers, though, so you'll need to ask your human resources department about the plan's details. For example, defined benefit plans - also known as pension plans - frequently allow only periodic payments to you and your beneficiary. Other plans, however, such as 401(k)s, 403(b)s, 457s, and profit-sharing plans, allow rollovers.
A partial rollover combines a lump-sum distribution with a rollover and works well in several instances. If you own company stock in your retirement plan and that stock has appreciated in value, the net unrealized appreciation (NUA) distribution strategy may reduce your tax liability when you sell the shares. You instruct the plan to distribute the company stock to a traditional; i.e., non-IRA brokerage account. At the time of distribution, you'll pay income tax on the average cost of the shares, not their full market value. The difference between your average cost and the market price at the time of distribution is the NUA; when you sell the shares, you'll pay capital gains taxes on the NUA and any subsequent appreciation. The top long-term capital gains rate is 15 percent versus 35 percent for ordinary income, so the tax savings can be substantial.
If you are age 55 or older and are separating from your employer's service, a partial rollover from a 401(k) plan can give you access to additional income. Most distributions before age 591Ú2 are subject to a 10 percent penalty, but distributions from a 401(k) are penalty-free if you meet the age and separation from service conditions. If there is a chance you'll take withdrawals before 591Ú2, leave some funds in the 401(k) to cover those withdrawals and roll the balance to an IRA.
Avoiding RolloverMistakes
Because rollover amounts can be substantial, it's important to avoid mistakes when setting up the transfer from your employer's plan. One common mistake is instructing the plan administrator to distribute the funds to you instead of a direct transfer to the IRA custodian. If you do that, the administrator will send 20 percent of the distribution to the IRS, even if you subsequently roll the remaining 80 percent into an IRA. A second mistake is naming your estate as the IRA's beneficiary. That designation will expose your IRA to probate and limit your heirs' control over the timing of distributions. Naming specific beneficiaries - individuals, trusts, or charities - avoids those problems. Happy holidays! For more information, e-mail William.a.creekbaum@smithbarney.com or call 689-8704.
• William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of SmithBarney, a financial services firm serving Northern Nevada at 6005 Plumas Street, Ste. 200 Reno, NV 89509.