IRA vs. 401(k): Know the Rules

Daryl Dagit - Savant Capital Management

Tips on rollovers, the withdrawal penalty and paying the fees…

Just like you would never play a board game without knowing the rules, you should never make a decision about IRAs and 401(k)s without knowing the rules of the game. There is no “one-size-fits-all” answer, but gathering as much information as possible can help you make an informed decision.

When Leaving Your Company…
I am often asked, “What should I do with my old 401(k) now that I have left the company?” Here’s what you may not know: Your former employer can force you out of the plan if your balance is under $1,000. If that happens, you would be responsible for taxes and a 10-percent penalty if you are under age 59½. If your plan balance is between $1,000 and $5,000, the plan administrator may deposit your money into an IRA in your name. Here are your options to reinvest your 401(k) dollars:

  1. Direct rollover. If you’re getting a distribution from your company’s retirement plan, you can ask your plan administrator to make the payment directly to another retirement plan or to an IRA. Contact your plan administrator for instructions. He or she will likely issue your distribution in the form of a check made payable to your new account. No taxes will be withheld from your transfer amount.
  2. 60-day rollover. If a distribution from the retirement plan is paid directly to you, you can deposit all, or a portion of it, in an IRA or another retirement plan within 60 days. Taxes will be withheld from the distribution (in most cases 20-percent income tax withholding), so you’ll have to use other funds to roll over the full amount of the distribution.

Paying the Penalty
Normally, if you have not reached age 59½, any withdrawals from your IRA or 401(k) will incur an additional 10-percent penalty. Here are some differences between an IRA and 401(k) when it comes to this tax:

  • The tax is usually waived for qualified higher education expenses from an IRA, but not from a 401(k).
  • The tax is usually waived for qualified first-time homebuyers, up to $10,000 from your IRA, but not from your 401(k).
  • The tax is usually waived when you use your IRA for health insurance premiums paid while unemployed, but not when you use a 401(k).
  • If you are separated from service after you reach age 55 (age 50 for public safety employees), a 401(k) will allow penalty-free withdrawals.

Some 401(k) plans may offer loans to participants. To determine if a plan offers loans, check with the plan sponsor or read the Summary Plan Description. If you take a loan against your 401(k), keep in mind that if you leave the company, you will need to pay the balance back immediately. Those under 59½ will incur a 10-percent penalty, in addition to ordinary income tax.

Limits on Moving Money
You can make only one rollover from an IRA to another IRA in any 12-month period, unless you execute a trustee-to-trustee transfer, plan-to-plan rollover, plan-to-IRA or Roth conversion, regardless of the number of IRAs you own. Beware, as this could end up costing you dearly in extra taxes and penalties.

There are Always Fees!
Contrary to popular belief, 401(k)s are not free. There are fees involved for plan administration, the custodian, bookkeeping, advisory services and fund expenses. Make sure you compare the difference in total cost to keep your 401(k) at your old company versus the fees on a new IRA. In addition, 401(k)s normally have a very limited number of investment choices in the plan. Moving to an IRA may provide greater portfolio diversification.

Knowing the rules can help you be a savvy, strategic player in the game. Consult with your financial advisor to assist in these very important financial decisions. iBi

Daryl Dagit is the Market Manager, Financial Advisor in the Peoria office of Savant Capital Management. He can be reached at (309) 693-0300.

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