As you accumulate money in an employer retirement plan, somewhere along the line you are going to be faced with one question: should I leave it in the plan or roll it out? For many, that question doesn’t arise until they separate from service or reach age 59 ½. Employees that participate in plans with in-service distributions before age 59 ½ will ask that question much sooner. Like most life situations, the right answer will depend on your personal circumstances. Use the checklist below to help determine the right answer for you and your family.
- Investment Opportunities and Structure: This is arguably the most important question you should ask. The first part is obvious; you should understand what type of funds the plan offers, the investment strategy for each, their performance amongst their peer group, and how often they are reviewed and changed. This goes beyond historical performance because, as we all know, circumstances change. You also must understand how to use these investments to build a balanced portfolio. Does the plan provide assistance? Are there target date funds available? By rolling the money out into your own IRA, not only can you control the investment lineup, but you also get access to an advisor that should craft a personal strategy. In other words, you are comparing the limited offerings of the plan against the wide landscape offered under either a standard or self-directed IRA.
- Fees and Expenses: Once you understand the investment opportunities, the next step is to compare those opportunities against their cost. Some plans charge a flat fee (i.e., quarterly, semi-annually, or annually) while others charge a percent of account assets. Others impose transactional costs, such as fees for rollovers, changing investments, or taking distributions. It’s important to understand those costs and compare them not only to any potential rollover IRA, but also in terms of the investment performance being generated.
- Required Minimum Distributions (“RMDs”): If you are still working and are over age 70 ½, you can delay RMDs from an employer plan until you stop working. This is true even if you are working in a reduced capacity. However, this “still working exception” doesn’t apply to IRAs. While this exception is within the plan’s discretion, not only have the majority adopted the provision, it is actually the default rule in the Tax Code.
- Net Unrealized Appreciation (“NUA”): If your plan account has employer stock that is highly appreciated, you may want to consider requesting a distribution to take advantage of NUA treatment on the employer stock. In order to do this, the entire account must be emptied in one year after a triggering event. Under this strategy, you immediately pay ordinary income tax on the basis of the employer stock once distributed from the plan. But the gains are eligible for tax at the lower long-term capital gains rates. You pay those taxes once the stock is sold. If your account has both employer stock and other assets, the rules allow you to roll the other assets over to an IRA and defer tax on those assets.
- After-Tax Contributions: If you’ve made after-tax contributions to a plan, you should think about taking advantage of the Mega Backdoor Roth contribution strategy. This only works if your plan allows in-service distributions of those after-tax dollars. If so, you can take periodic distributions of these amounts before age 59 ½ and convert those distributions tax-free to a Roth IRA. This strategy enables you to bypass the pro-rata rule.
- Beneficiary Designation Options: Do you plan on naming a trust or a non-spouse beneficiary? Some plans do not allow trusts as beneficiaries, while others do not allow non-spouse beneficiaries to stretch distributions or name successor beneficiaries. All qualified plans allow non-spouse beneficiaries to rollover funds to an inherited IRA. However, to avoid this confusion amongst your beneficiaries, or to name a trust, you should consider an IRA rollover.
- College Aged Children (Higher Education Expenses): Do you expect to be helping children with college expenses in the near future? If so, you might to consider rolling over the funds to an IRA. IRA distributions for higher education expenses are exempt from the 10% early withdrawal penalty. Not only does this exception not apply to employer plans, it doesn’t even create a distributable event.
- Age 55 Exception: If you are age 55 or older, and terminate employment, you can take a distribution from your employer plan that is exempt from the 10% early withdrawal penalty. To apply, you must be at least age 55 when you terminate employment. This exception does not apply to IRAs and thus may be a reason to keep some funds in the employer plan.
- Federal Creditor Protection: ERISA plans have some of the strongest protection laws within the US Tax Code. In only a few limited circumstances can funds in an ERISA plan be used to satisfy some other debts or liabilities. And since we are talking federal protection, this applies across the board. IRAs, on the other hand, only enjoy federal protection in bankruptcy and only up to a limited amount. In other actions, state law will apply. Protections vary from state to state. Be advised that some states exclude Roth IRAs from protection whereas others limit the creditor protection to the amount necessary for the maintenance of the debtor.
This checklist only addresses the most prevalent questions that arise when someone becomes eligible for funds from an employer retirement. Keep in mind that there are other things to consider and that each of these topics has specific rules that must be taken into account. The point is to understand the options you have and know the right questions to ask.