The importance of understanding 401k rollovers come into play when you leave your current employer.
What is a 401K? These plans are commonly called defined contribution plans that allow you to save money tax free through your employer. You don’t pay tax on the contribution or the income made on the investments in the 401K plan until you withdraw the money when you take distributions after retirement.
The 401K is an employer sponsored retirement plan that the IRS approved in 1978. It allows the employer to make pre tax contributions to the plan. The employee can make additional contributions to the plan (in 2015 this amount is maxed out at $18,000 a year).
There are many type of 401K plans (up to 25 different options) but the benefits to employees and employers make the 401K a very attractive option. One of them is portability, or rollovers.
Here are the key ingredients of a 401k:
- A C Corporation, S Corporation, partnership, sole proprietorship or self-employed can establish a 401KPlan.
- The company can set eligibility requirements, within certain guidelines, when the plan is stared.
- Restrictions on participation are allowed; for example the employer can excempt employees with less than one year service, union members, non US citizens, part-time workers, etc.
- The contributions to the 401K plan can come from voluntary employee salary reduction as well as the employer
- In 2015 up to $18,000 or 100% of compensation can be paid in by the employee.
- Employees that participate over the age 50 and over can make additional “catch-up” contributions of $6,000 in 2015.
- Employees that participate are immediately 100% vested with their own salary reduction tax deferred contributions.
- Withdrawals from the 401K plan before age 59, 1/2 may be subject to 10% penalty.
- Employees may retire any time during the calendar year in which they turn 55, or later, and are not subject to the 10% penalty.
- Employers can establish a vesting schedule, within certain guidelines, for the contribution the company makes to the 401k plan.
- Employers are not required to make any contribution to the 401k plan, although the employer may have some obligation to contribute if plan is deemed top heavy.
- Turnkey and Internet based plans are possible.
- There is an excellent range of investment options available for the plan sponsor to offer within the plan.
- The investment choices in most plans range from 8 to 25 options. The average plan has about 19.
- 401k plans may permit “self-directed investment accounts” and company stock purchase within the plan.
- Employee contributions to the plan are not subject to federal income taxes until a distribution from the plan is made. Any investment gains and earnings also enjoy tax deferral until distribution.
- This type of plan can permit loans and hardship withdrawals, but is not required to do so.
- Participants can start and stop contribution during course of year, as determined by the company.
- The employer can receive certain tax benefits for contributions.
- Plans are subject to top heavy and discrimination testing.
- Typically the amount the owners and highly compensated individuals can contribute to a 401k is a function of the contributions of the other employers.
- 401k plans can be subject to IRS Form 5500 filings.
- Generally, the vendor selected by the plan sponsor does all accounting, participant reporting, testing, and files 5500 reports with the IRS.
Understanding 401k Rollovers
The question arises when you leave an employer or are terminated. Lets assume you left the account with your former employer – what do you do now? You have four options:
1 – Do nothing and leave it there
The second option, leaving it in the account with your former employer, will depend on the type of plan you have. Check with your former employer, there are minimum amount requirement that he may have set with the plan. What I don’t like about this is that you are more or less out of the loop and less likely to pay attention to the plan. Leaving it there is certainly an option if you like how things are being run and the plan has done well.
2 – Cash out and take the money
Unless you have reached the required age of 50 ½ you will have to pay a penalty PLUS taxes on the distribution as ordinary income. Not only that, but the employer is required to withhold 20 percent for the IRS. Not a Good option
3 – Rollover the 401k into an individual retirement account
Rolling over your 401K into an individual retirement account. This method will give you control over your money, allow you to place the money in financial instruments though your brokerage house. In a rollover the funds go directly from the 401K plan to your new qualified plan. You can also have the check sent to you and you have 60 days to place it in the new qualified plan. Many brokerage houses will gladly help you facilitate the roll over.
4 – Borrow Against it
The fourth option, if you really need the money, is a combination of option 2 and 3. If your former employer’s plan lets you borrow against his 401K plan (most do) and you like how the plan is being run – keep the money there and borrow against it. Remember that borrowed money is always tax free (as long as you pay it back).
Please always consult a professional to help you with your investments!