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Avoid These 401k Rollover Mistakes

From time to time, I hear from investors who have made mistakes relating to the rollover of a 401(k) or other employer-sponsored plan. Unfortunately, many such mistakes are not reversible, so it’s best to be aware of them so you can steer clear.

Shouldn’t Have Rolled it Over

The first and most obvious mistake is to roll over money from an employer-sponsored plan when it would have been better to leave the money where it was. For example, you should consider keeping your money with your previous employer if:

  • Your employer sponsored retirement plan has lower total costs than what you would have access to elsewhere (This is the case, for instance, with federal employees who have access to the Thrift Savings Plan.),
  • You left the employer at age 55 or later and you want to take advantage of the resulting ability to get penalty-free access to the funds prior to age 59.5, or
  • Your 401(k) includes appreciated employer stock and you want to take advantage of the “net unrealized appreciation” rules.

Poor Planning with Roth Conversions

If you’re planning to execute a Roth conversion in the near future from a traditional IRA that included nondeductible contributions (or if you’ve already executed such a conversion this year), you might want to wait until the year after the conversion to roll over your 401(k).

When calculating the percentage of a Roth conversion that is not taxable, the denominator of the fraction includes your traditional IRA balance as of 12/31 of the year in which the conversion takes place. In other words, by rolling over a 401(k) in that same year, you increase the amount of the conversion that would be taxable as income.

Failed Rollovers

It’s not common, but I have heard from a few investors whose 401(k) rollovers have failed completely because they didn’t play by the rules.

You see, when executing a 401(k) rollover, you only have 60 days from the date you receive the money to get it deposited into your traditional IRA or your new employer-sponsored plan. If you fail to get the money moved before those 60 days expire, the entire amount counts as a distribution — meaning that it will be taxable and likely subject to a 10% penalty, and you will have lost your chance to get it into an IRA to take advantage of tax-deferred growth in the future.

Related note #1: When executing a direct trustee-to-trustee transfer (in which the money is moved directly from one custodian to another) as opposed to a rollover (in which the check is made out and sent to you), you do not have to worry about this 60-day limit.

Related note #2: In some circumstances, it’s possible to get a waiver of this 60-day rule. But you need a much better reason than, “I was too lazy to get around to sending a check to my brokerage firm.”

Attempting to Roll Over an Inherited IRA

This mistake is similar to the one above in that it results in a failed transfer, the loss of tax-deferred status, and (often) a whopping tax bill.

When you inherit an IRA, unless you’re the spouse of the deceased owner, you can not roll the money over into your own IRA. You can, however, have the money moved to another custodian (i.e., brokerage firm or fund company). But you have to be very careful about how you do it.

Specifically, the transfer must be a direct trustee-to-trustee transfer, and the IRA at the new custodian must be properly titled in the name of the deceased owner of the original IRA, with you named as the beneficiary. Your best bet here is to call the new custodian, tell them what you want to do, and have them walk you through the process step by step.

Rolling it Over to the Wrong Place

Finally, the most common mistake I see is simply rolling your 401(k) over to the wrong place. When switching jobs, many investors roll their old 401(k) into their new 401(k) without bothering to check the costs in the new plan. In many cases, it would have been better to roll the 401(k) into an IRA at a low-cost brokerage firm or fund company.

(Conversely, if you’re fortunate in that your new employer has a super-low-cost plan, it could be a mistake to roll your old 401(k) into an IRA rather than into the new plan.)

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  1. Can you have multiple IRA accounts? So if I quit job 1 and rolled over my 401(k) to an IRA at Schwab; can I roll over my 401(k) from job 2 to an IRA at Vanguard?

  2. John, yes, you could do that.

  3. My husband had a Roth 401k at his old company. His contributions were treated as Roth; the company match was treated as traditional.

    We rolled his 401k over to IRAs at Vanguard. There are two: a Roth and a traditional, from this.

    I don’t *think* we paid any taxes or have had any prior tax benefit from the traditional funds, since it was employer-paid.

    Should we just leave it as-is, or roll it to a Roth? I know we’d have to pay some in taxes if we did that (the traditional IRA balance is around $15k).

    How do I figure this out?

  4. Hi Kacie,

    Rolling the traditional IRA money (formerly traditional 401k money) to a Roth would be known as a Roth conversion.

    For most investors, a Roth conversion is only advantageous if:

    1. You expect to be in a higher tax bracket in retirement than you’re in now, and
    2. You have the cash on hand to pay the tax on the conversion

    The reason the second point is important is because you don’t want to use money from the traditional IRA to pay the tax on the conversion, because it would count as a pre-59.5 distribution, which would likely be subject to the 10% penalty.

    Most people I speak with don’t satisfy point #1. Some things that would increase the likelihood that you satisfy point #1 would be if one of you works in a field where you’re going to receive a traditional defined benefit pension in retirement or if your circumstances are such that your taxable income this year is unusually low for one reason or another.

  5. Thanks! I think we’ll probably be where we’re at or lower in retirement as far as tax brackets go. It’s hard to say right now. I think we’ll leave it where it’s at.

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