An IRA Dilemma: To Roll or Not To Roll
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Key Points
As you change jobs or prepare to retire, you must determine what to do with the funds in your employer-sponsored retirement plan account. A rollover IRA might be ideal for you since it can provide the following features and benefits:
■ Continued tax-deferred investing
■ A potential income stream during retirement
■ Easy access to your assets in an emergency
■ A broad range of investment choices
■ A convenient vehicle for consolidating retirement assets
You may receive a substantial sum with a distribution from your company's retirement plan, whether upon retirement or when you change employment. This windfall is commonly known as a lump-sum distribution. Along with wondering what to do with this money, you may be concerned about taxes and investment difficulties that you have never considered before, such as early withdrawal penalties and a 20% mandatory federal tax withholding.
Since this money plays a significant role in ensuring that your retirement years are comfortable, you must understand your alternatives and make selections that will fit your requirements now and in the future. The following answers a few of the most frequently asked questions concerning lump-sum distributions. Among the different scenarios is information on rollover individual retirement accounts (IRAs), which may be the best choice to consider when working toward your retirement objectives with your retirement assets, as this choice may provide flexible investing and distribution options.
Potential Drawbacks Of A Lump-Sum Distribution
A significant amount of money might encourage individuals to take actions they would later regret. For example, if you last took a vacation five years ago, you could be tempted to take a once-in-a-lifetime trip. Even if you have always been fiscally responsible, the temptation may seem too strong to resist. You might jeopardize the quality of your future retirement as more employers offer lump-sum payouts and people with modest salaries suddenly decide what to do with thousands to hundreds of thousands of dollars.
Can I use part of a distribution for important current expenses?
While utilizing a portion of a lump-sum distribution to pay off outstanding bills or mortgages makes sense, a secure retirement may be threatened if this money is not spent wisely. This lump sum may appear to be a lot of money now, but as people retire earlier and live longer, predictions of how much money a person would require for a comfortable retirement are constantly revised upward. Your nest egg may have to provide income for 20 or 30 years or more. Consequently, spending even a small portion of your lump-sum distribution early to pay off debts could result in a smaller nest egg and less income throughout retirement. Remember that any money that is distributed to you directly will be subject to income taxes.
Furthermore, unless you qualify for one of the age or other exclusions granted by the Internal Revenue Code, you may be subject to a 10% early withdrawal penalty tax.
What if I leave my job and am offered a lump-sum distribution?
One of the best initial steps might be to do nothing. In most situations, you will not be required to withdraw your money from the employer's retirement plan immediately, giving you time to make informed selections. If you have contributed, you may be allowed to keep your money in the company's 401(k) plan. Other possibilities include transferring your retirement funds to an IRA or another retirement plan provided by your new employer.
What exactly is a rollover?
A rollover transfers funds from one employer's qualified retirement plan or IRA to another. Rollovers allow retirement funds to grow tax-free until withdrawals commence.
How does a rollover IRA work?
One of the most popular rollover options is to transfer assets from a retirement plan into an IRA with a mutual fund firm, which may provide more investment options than a 401(k) (k). Nonetheless, you may be satisfied with the selections and benefit from lower prices under the workplace plan. Rollovers not made immediately from one plan to another are subject to rigorous time restrictions, and missing the deadline can result in tax liability and a potential penalty. A financial advisor or investing specialist can assist you in navigating the procedure. A rollover should be done directly between the distributing plan and the receiving plan or IRA to prevent problems. No check will be made out to you in the case of a straight rollover.
But what if I need the money before I’m 59½?
You may require money for various reasons, including early retirement, starting a business, or sustaining yourself between employment. How you accept the distribution and the account from which you withdraw may influence whether or not you are penalized. For example, if you left your previous employer's plan after January 1 of the year you turned 55, withdrawals from that plan are no longer subject to an early distribution penalty. If you are between 55 and 59 1/2, transferring that money to your new employer's retirement plan or an IRA may result in the loss of potentially beneficial tax treatment. If you require immediate income from a retirement plan distribution, consult with your financial advisor, investment professional, or tax advisor before taking action.
The IRS has authorized three distinct computation techniques, resulting in differing payment levels. Your payments will not be subject to a 10% early withdrawal penalty under Internal Revenue Code Section 72(t) if you take them out in "substantially equal amounts" based on life expectancy calculations. But, unless you meet certain conditions, a tax penalty will apply if you modify the amount or discontinue payments before the greater of five years or the period of time until you reach the age of 59 1/2. In other words, you must keep paying for longer periods.
Is an IRA cheaper than my employer’s plan?
Fees and investment-related charges may be incurred in both employment plans and IRAs. Because your company may cover part of the plan's fees, your 401(k) may be less expensive than the IRA you are contemplating. Instead, you may discover that the IRA is a less expensive alternative. The goal is to compare investment alternatives, fees, expenditures, and services side by side to identify the solution that best meets your specific needs.
How much will it cost in taxes if I take the money now?
You might be surprised. By taking even a tiny portion of your nest egg, you expose yourself to tax liabilities and, as a result, reduce the amount of money that may continue to work for you.
A rollover might be right for me. What should I do now?
When you roll over your distribution, you must choose how to invest your funds. Mutual funds are among the most popular IRA investment options because they provide expert, full-time management, diversification (to help minimize the risk), and the freedom to switch from one fund to another as your needs change. Remember that all investments, including mutual funds, entail risk, including the possibility of losing the initial investment. Mutual funds' principal value and return will fluctuate with market circumstances, and shares may be worth more or less than their initial cost when redeemed. Nevertheless, diversity does not ensure a profit or protect against loss.
There are benefits and drawbacks to transferring funds from your employer's plan to an IRA. You must examine investment alternatives, services, fees and expenditures, withdrawal options, required minimum distributions, tax treatment, and your specific financial requirements and retirement goals. Please remember that consolidating retirement assets into a single IRA account may increase costs since the underlying funds may be subject to sales loads, higher management fees, 12b-1 fees, and IRA account expenses such as custodial fees.
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Important Disclosures
This material is provided for general and educational purposes only and is not investment advice. Your investments should correspond to your financial needs, goals, and risk tolerance. Please consult an investment professional before making any investment or financial decisions or purchasing any financial, securities, or investment-related service or product, including any investment product or service described in these materials.
Portions of this article were sourced from the work of MFS Heritage Planning. Neither MFS nor any of its subsidiaries are affiliated with Optima Capital Management.
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