Six Potential 401(k) Rollover Pitfalls

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You’re about to receive a distribution from your 401(k) plan, and you’re considering a rollover to a traditional IRA. While these transactions are normally straightforward and trouble free, there are some pitfalls you’ll want to avoid.

  1. Consider the pros and cons of a rollover — The first mistake some people make is failing to consider the pros and cons of a rollover to an IRA in the first place. You can leave your money in the 401(k) plan if your balance is over $5,000. And if you’re changing jobs, you may also be able to roll your distribution over to your new employer’s 401(k) plan.
  • Though IRAs typically offer significantly more investment opportunities and withdrawal flexibility, your 401(k) plan may offer investments that can’t be replicated in an IRA (or can’t be replicated at an equivalent cost).
  • 401(k) plans offer virtually unlimited protection from your creditors under federal law, whereas federal law protects your IRAs from creditors only if you declare bankruptcy.
  • 401(k) plans may allow employee loans.
  • Most 401(k) plans don’t provide an annuity payout option, while some IRAs do.
  1. Not every distribution can be rolled over to an IRA — For example, required minimum distributions can’t be rolled over. Neither can hardship withdrawals or certain periodic payments. Do so and you may have an excess contribution to deal with.
  1. Use direct rollovers and avoid 60-day rollovers — While it may be tempting to give yourself a free 60-day loan, it’s generally a mistake to use 60-day rollovers rather than direct (trustee to trustee) rollovers. If the plan sends the money to you, it’s required to withhold 20% of the taxable amount. If you later want to roll the entire amount of the original distribution over to an IRA, you’ll need to use other sources to make up the 20% the plan withheld.
  1. Remember the 10% penalty tax — Taxable distributions you receive from a 401(k) plan before age 591/2 are normally subject to a 10% early distribution penalty, but a special rule lets you avoid the tax if you receive your distribution as a result of leaving your job during or after the year you turn age 55 (age 50 for qualified public safety employees). But this special rule doesn’t carry over to IRAs. If you roll your distribution over to an IRA, you’ll need to wait until age 591/2 before you can withdraw those dollars from the IRA without the 10% penalty (unless another exception applies).
  1. Learn about the net unrealized appreciation (NUA) — Normally, distributions from 401(k) plans are subject to ordinary income taxes. But a special rule applies when you receive a distribution of employer stock from your plan: You pay ordinary income tax only on the cost of the stock at the time it was purchased for you by the plan.
  1. Five-year holding period — If your Roth 401(k) distribution isn’t qualified (tax-free) because you haven’t yet satisfied the five-year holding period, when you roll those dollars into your Roth IRA, they’ll now be subject to the Roth IRA’s five-year holding period.
Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2016.

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