Mistakes when rolling over your old 401(k) can be quite costly and annoying. Sadly, these mistakes are also quite common. On a happier note, these 401(k) rollover mistakes are easy to avoid.
First off, not all assets in your 401(k) can or should be rolled into an IRA. Ignoring this can cause expensive tax problems or lead you to miss some tax minimizing financial planning opportunities. A failed rollover may cause the entire balance to be distributed, which may make the withdrawal fully taxable. Depending on your age, you may also get hit with a 10% early withdrawal penalty. NO FUN!
Here are ten examples of 401(k) mistakes that everyone reading this will want to avoid.
1.Miscoding an IRA Rollover
I just helped a new client clean up a rollover that was miscoded as a withdrawal. If this mistake had not been caught, the client would have been hit will a several hundred-thousand-dollar tax bill, plus more than $100,000 in early withdrawal fees. Because the 401(k) proceeds were rolled into an IRA, there would likely have been future IRS issues if this mistake wasn’t caught early enough to have the 1099-R tax form amended and get the money withheld for taxes and penalties credited back and rolled over properly.
This new client originally called because he wanted help figuring out why he was charged a fee of more than $400,000 to rollover his 401(k). After speaking with a representative at his 401(k) provider, we discovered that the rollover had been miscoded. Simply checking the wrong, small box on a computer screen (by the 401(k) service rep, BTW) could have drastically changed this person’s retirement.
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2. Withdrawing Your 401(k) Instead of Rolling It Over
For those struggling financially during the Coronavirus Pandemic, it may be tempting to raid your retirement accounts to pay bills. Doing so could have terrible repercussions for your future retirement security. Also, you will get hit with taxes and early withdrawal penalties.
Don’t get me started on taking money from a 401(k) in order to take a trip or buy a car.
3. Losing Your Old 401(k)
You may think this one is crazy, but it is easier to do than you think. Americans lost track of more than $7.7 billion worth of retirement savings in 2015 alone by “accidentally and unknowingly” abandoning their 401(k)s.
We all are busy, and it’s easy to see how some could forget where their old 401(k)s are held. Sometimes the company is sold; maybe you moved and forgot to update your address with the 401(K) plan administrator. For this reason, I’m a fan of consolidating old retirement accounts, if for no other reason than to make your life easier and the account easier to track.
4. Rolling Over Your 401(k) to An Annuity
I hate when I see people attempting to rollover their IRAs or 401(k)s, with low fee investment options, into annuities with a crazy array of hidden fees. Not all annuities are bad, but make sure you are buying for the right reasons. Whenever possible, work with a fiduciary financial planner, so you know he or she isn’t recommending an annuity just to get a big commission or keep their employer-based health insurance. (Some salespeople are required to sell a certain amount of their company’s products to get their health insurance paid for.)
5. Required Minimum Distributions and Rollovers
Regardless of where you are in the calendar year, required minimum distributions (RMD) can never be rolled over. It is common for people to make this 401(k)-rollover mistake. In the event an RMD is rolled over, it will become an excess IRA contribution subject to the 6% penalty unless it is removed by October 15 of the year following the year of the excess contribution. Usually, you will find out you made this mistake when you receive a wonderful tax notice from the IRS, and nobody wants to receive that.
6. 401(k) Rollover of After-Tax Funds
If you have after-tax IRA funds in your 401(k), they cannot be rolled over to a new company plan. Only pre-tax IRA funds can be rolled over. This rule is actually to your advantage because it allows you to isolate the cost basis of the after-tax funds in the IRA. Typically, you can roll this portion of the 401(k) over to a Roth IRA.
7. Plan Loans — Deemed 401(k) Distributions
When you leave your employer, it is common to stop making payments towards a 401(k) loan. Eventually, this loan balance will be deemed a distribution. A deemed 401(k) distribution is taxable and may be subject to the 10% early distribution penalty (for those not yet 59.5 years of age). The deemed distribution amount, or loan balance, is not eligible to be rolled over to an IRA, even if the employee has the funds to complete the rollover.
8. 72(t) Distributions From A 401(k)
72(t) is a retirement income strategy designed to avoid the 10% early withdrawal penalty. It is useful for those retiring before 59.5 years of age. In order to qualify for the early withdrawal penalty exception, the 72(t) withdrawals must be a series of substantially equal periodic payments. Generally speaking, you can tap your IRA or 401(k) (assuming you are no longer working for the company) before 59½ without a 10% penalty if you commit to a plan of withdrawals according to the rules set out in Section 72(t)(2)(A)(iv) of the Internal Revenue Service code. Technically you can begin a 72(t) payment schedule from an IRA at any age, even if you are still working. The 72(t) retirement income payments must continue for at least five years or until age 59½, whichever period is longer, and the distributions cannot be rolled over.
There are a number of additional rules associated with 72(t) retirement income payment schedules. You must take consistent distributions, not modify the agreed-upon schedule or account, and pay the appropriate taxes on your withdrawals. If you violate this contract, then the 10% penalty will apply to all distributions taken prior to age 59 ½. This is known as the recapture penalty.
If you are on a 72(t) retirement income distribution schedule, you will want to avoid making any additions or rollovers into this account. A rollover of new funds into this IRA will modify the IRA balance and trigger the retroactive 10% penalty.
9. Trying to Rollover Different Property Types
If you make a cash withdrawal from your IRA or 401(k), then only cash can be rolled back over. If you withdraw stock from your IRA, then only that stock is eligible to be rolled back over. It must be the same property; otherwise, it cannot be rolled over. If you have highly appreciated stocks, you may be tempted to try and transfer them into an IRA to avoid capital gains taxes when eventually selling your shares.
10. Divorce And 401(k) Plan
When 401(k) or IRA funds split in a divorce and are withdrawn, those funds are taxable and cannot be rolled over to the ex-spouse’s retirement account IRA. Attempting to do so is a common and costly mistake.
To avoid adverse tax consequences, 401(k) and IRA funds should be moved from one spouse’s IRA to the other’s via a tax-free direct transfer called a QDRO. It is crucial, if going through a divorce, to consider the after-tax value of assets and how you plan to use those assets. For example, $1 million in a 401(k) will not equal the same amount of cash in a bank account because taxes will be owed on the $1 million when it is withdrawn from the 401(k). Likewise, $1 million of home equity may not be as valuable as the same amount of money in the bank if you will need to sell the home.
A trusted fiduciary financial planner can help you make the wisest choices with your retirement funds. Keep in mind, he or she may not always be able to clean up the mess after a big 401(k) rollover mistake has been made.