401(k) Rollover

401(k) Rollovers Explained

A 401k rollover is simply the process of moving a 401k account from one custodian to another. While you are employed and contributing to an employer-sponsored 401(k), it is up to the employer to choose the custodian. The custodian, typically a financial services firm that specializes in managing employer-sponsored defined-contribution plans, makes sure that the money employees contribute to their retirement funds is kept separate from the employer's other accounts. (Employers cannot commingle funds such as checking and savings accounts with employee funds.) In other words, the custodian insures that the employer does not have access to the money you contribute or the money he or she provides as a matching contribution. The custodian is also responsible for handling all of the necessary paperwork and tax reporting that is required by the Internal Revenue Service.

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When you leave a job or are otherwise "separated" from your employer, you have the option of taking your 401(k) account with you. In fact, most employers will encourage this. An employer would much rather have someone else bear the cost of administering the account. By choosing a new custodian for your account, you are rolling over the 401(k) from one tax-qualified account to another. Tax-qualified simply means that the account meets the criteria established by the Internal Revenue Service to receive special tax benefits. It's important to understand that rolling over a 401(k) involves moving it into a tax-qualified account. Moving a 401(k) into an account that is not tax-qualified will result in penalties and additional taxes on the amount that wasn't rolled over.

IRS 401k Rollover Rules and Regulations

There are two types of 401(k) rollovers: direct and indirect. Neither is taxable but both must be reported on your federal tax return.

A direct rollover takes place when the account balance is transferred straight from a 401(k) to a new tax-qualified account. In other words, you don't receive the money directly. With a direct roll over, the full value of the account is transferred to a new account.

An indirect roll over takes place when you receive the distribution from a previous employer. If the distribution is received directly, the previous employer is required to withhold 20% of the account value. In addition, you have 60 calendar days from the time that funds are received until the time they must be deposited into another tax-qualified account. If the new account is not established within 60 days, the distribution will count as income for that tax year.

401(k) Rollover Custodial Options

Financial services companies such as brokerage houses and mutual fund companies, as well as banks, can act as custodians for tax-qualified accounts. Depending on age and retirement investment goals, one of these options may be better suited to your individual situation than another.

Brokerage houses typically offer a number of 401(k) rollover investment options, including individual stocks, mutual funds, exchange-traded funds, bonds, annuities, certificates of deposit and money market funds. Not all of these choices will be appropriate for all individuals and it's important to remember that the Federal Deposit Insurance Corporation (FDIC) does not insure brokerage accounts, even those that consist of tax-qualified retirement savings. Brokerage houses are required, however, to maintain membership in the Securities Investor Protection Corporation (SIPC). The SIPC is not a government agency. Rather, it is a member-funded corporation that provides insurance coverage on all brokerage accounts.

Mutual fund companies will usually only offer funds that they develop and manage. Depending on the company, fund choices can include asset allocation funds, index funds, equity funds, bond funds and money market funds. Within these groups of funds lie domestic, foreign, aggressive, conservative, and just about any option in-between. The FDIC does not insure the value of an account held at a mutual fund company. However, just like brokerage firms, mutual fund companies are also members of SIPC.

Banks typically offer the least number of options when it comes to 401(k) rollovers. Certificates of deposit and money market accounts are the most common types of tax-qualified accounts offered by banks. The FDIC currently insures each account owner up to $250,000.

Rolling a 401(k) into an IRA or Roth IRA

When a 401(k) is rolled over into an Individual Retirement Account (IRA), the money continues to grow tax-deferred. All taxes due on the earnings will be deferred until distributions are made, between the ages of 59 ½ and 70 ½. At that point, the amount that is distributed will be taxed at ordinary income tax rates. The distribution will be added to other sources of income – social security, pensions, annuity payouts, etc. – in order to establish your tax rate.

A 401(k) can also be rolled over into a Roth IRA provided it makes financial sense given your current tax rate. The amount of the 401(k) that is converted into a Roth IRA is subject to your marginal tax rate. (Marginal tax rate is the total percentage of federal, state and local taxes that is deducted from the next dollar earned). In other words, marginal tax rate increases with income.

It's imperative to understand how an increase in marginal tax rate will affect the amount of tax paid to convert a 401(k) to a Roth IRA. For example, if you are single and earn between $82,400 and $171,850 in 2010, your marginal tax rate is 28%. If, however, you earn $181,850 in 2010, $171,850 will be taxed at 28% and $10,000 will be taxed at the next highest rate, which is 33%. ($181,850 minus $171,850 equals $10,000.) Distributions from a Roth IRA are tax-free after age 59 ½.

Rolling Over Several 401(k) Accounts into One

While there is not need to roll all of your 401(k) accounts into one account, it can be helpful to at least maintain all of the accounts with one financial institution or advisor. Depending on the size of the accounts, you may be able to take advantage of personal asset management services or at least be given access to special web pages and additional management tools.

Navigating the murky waters of finance can be tricky. There is far more information than we can cover here. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.

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