Wednesday, November 7, 2012

A Little Known Irs Secret: The In-service Ira Rollover

If your employer's 401(k) investment options suck or if its just plain too expensive and eats up your retirement returns while feathering the bed of the plan's broker, move your money where you can control your investment options and fees.
Let's say you now age 60, don't plan to retire from your job until 2014, and your 401(k) plan is way too expensive and has less than stellar investment options. You can roll your million (or less - don't we all wish our 401(k)'s were worth at least million?) 401(k), into an individual retirement account (IRA), using a little-known maneuver: an "in-service" distribution.
Employers and 401(k) plan administrators don't advertise this fact (it's not in the financial best interest of brokers and some administrators), but most workers 59 and a half and older, and some younger ones, can roll over 401(k) funds while they're still working and contributing to the plan. This option isn't appropriate for everyone. But in most cases it can provide better investment choices, a better beneficiary choice options or even a chance (new in 2008) to transfer 401(k) dollars directly into a Roth IRA.
The law allows workers to empty their 401(k) accounts once they hit 59 1/2 without the Federal 10% penalty and the State penalty. They can roll all the money directly into an IRA without paying tax now. Or they can take cash out, pay any ordinary income taxes due and spend what's left (usually not a good idea). The same goes for plan participants in government and not-for-profit savings plans similar to 401(k)s.
The law permits these in-service withdrawals, but employers' plans don't have to permit it. Still, 70% of companies--and 89% of those with 5,000 or more employees--allow these in-service withdrawals, the Profit Sharing/401k Council of America found in a 2006 survey of 1,000 firms. So do some public sector employers; the federal government, for example, allows older workers to withdraw funds, but only once.
As for pre-59 and a half year old folks, the law permits them to get in-service distributions of money rolled over from previous 401(k)s; of employer (but not employee) pretax contributions; of employee after-tax contributions; and of account earnings. Here companies are less accommodating--only 16% allow this option, the 2006 survey found. Note that if a younger worker spends the cash, instead of rolling it over, he'll owe an extra 10% Federal penalty plus any State penalty (2.5% in California for example) on the taxable amount, just as he would if he got a "hardship" distribution from his 401(k) or took a loan from his 401(k) and switched jobs without repaying the loan.
One obvious reason to consider an in-service rollover is to escape a bum plan that has expensive or mediocre funds. Some small plans have annual fees on domestic equity mutual funds that top 2% a year. Outrageous. If you're stuck in one of those, you can chop your costs by rolling your 401(k) money into an IRA at a no-load fund company such as Vanguard, Fidelity or T. Rowe Price, or if you work with an Advisor, pick one who works with Dimensional Funds (DFA). They have some meaningful structural advantages to the other low cost funds.
Another strategy: roll over part of your money. If you have some good choices in your 401(k) but not enough, roll over part of your funds to an IRA so you could invest in better quality funds like those from Dimensional Fund Advisors, including small-capitalization and value funds if there are no comparable offerings in your company plan (which there probably aren't). It is a good bet that with better structured DFA funds and professional asset allocation and other advice, you'll come out ahead.
Not surprisingly, outside financial planners and Investment Advisors push rollovers, since they can frequently do a better job and, not surprisingly, it gives them more money to manage and collect fees for. In other words, it is a legitimate growth opportunity for Fee-Only Financial Planners and Investment Advisors. Fifty-year-olds, as they near retirement and their 401(k) balances grow, want and are willing to pay for professional help. You can find a Fee-Only Advisor in your area at the National Association of Personal Financial Advisors (NAPFA).
There are a few other reasons to look at an in-service IRA Rollover. One is a new provision, that allows you to roll 401(k) money directly into a Roth IRA, where future earnings will be tax free. If your plan administrator is ready to make a separate distribution with just your after-tax contributions, it appears (although the Internal Revenue Service hasn't issued final rules on this) that you can roll that money directly into a Roth IRA and pay no taxes on the conversion. For now Roth rollovers are allowed only for those with family incomes of 0,000 or less. That household income restriction is due to end in 2010.
Another reason to do an in-service rollover comes up when coordinating estate planning with retirement planning, if you're leaving retirement money to someone other than your spouse, like your kids or grandkids. A spouse who inherits either a 401(k) or an IRA can roll it into his or her own IRA with all the same flexibility that an IRA offers its original owner. Kids, grandkids or other non-spousal heirs who inherit an IRA can't roll it over into their own IRA, but they can keep the money in an "inherited" IRA, potentially stretching out withdrawals and tax deferral for decades based on their life expectancy. Under a 2006 law change, children and other "non-spousal" heirs can roll 401(k)s into inherited IRAs--but only if the employer permits it, which not all do. If your employer doesn't allow it, it might be a good topic for discussion with your HR Department. If your employer is unwilling to cooperate, get the money out now and put it into an IRA that won't have any employer getting in the way of your estate planning. (A non-spousal heir can't convert an inherited IRA to a Roth IRA.)
Before you jump to an IRA Rollover, consider some of the advantages to a 401(k). In a good plan the fees, particularly for index funds and passive asset class funds like DFA, may be extremely low. If you retire early, you can make penalty-free withdrawals from a 401(k) at age 55; with an IRA, you generally have to wait until you're 59 and a half unless you commit to a 72(t) withdrawal plan (periodic payments for 5 years or age 59 1/2 whichever comes later). If you are in a really tough spot, you can take a loan (of up to ,000) from your 401(k) but not your IRA.
Plus, if you hold your employer's stock in your 401(k), you may be eligible for a tax break at retirement (a NUA or Net Unrealized Appreciation strategy). If you transfer that stock to a taxable account, you'll pay ordinary income tax (at rates of up to 35%) only on what the stock was worth at the time it was put into your 401(k). Any further appreciation won't be taxed until you sell the stock and then only at the long-term capital gains rate--which now tops out at 15%. There are some really crazy rules here that determine whether you're eligible for this break. So if you've got your employer's stock in your 401(k), check with your plan administrator and your tax adviser. This may be a case for doing a partial in-service withdrawal leaving the company stock behind until retirement time.

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