Help a Reader: 401k Rollover

Here's an email I recently received from a reader:

I was laid off from my job a couple of months ago.  I found a new job and everything seems to be ok now but I have a 401(k) from the old job just sitting there.  I know the best thing to do is an IRA rollover but I just don't know much beyond that.  Can I do a Roth or must it be traditional?  I don't like the thought of shelling out a lot for taxes if I do the Roth though...  but the balance is only around $20,000.  What's the best company to go with?  Vanguard?  What funds should be considered for investment?  I usually stick with an even blend of small-cap, mid-cap, large-cap, and international funds (25% of portfolio in each).  I'm only 27 so I have plenty of risk tolerance and no desire for bonds, etc.  Currently the 401(k) is with Schwab.  They would probably create an IRA for me if I wanted I'm sure.

Any advice?

I responded to him but also said I'd post here for you all to offer thoughts. What are your suggestions?

Comments

[JerryB]

The easiest way would be to roll it over into a Schwab IRA. Personally, I like Vanguard (I stick with Index Funds). My brother on the other hand has his at Schwab because of the wider variety of choices available.

[Travis]

@ Andy

Really? Sounds too good to be true...and I'd stay far far away from this. From my past experience at looking into these they work in the ideal conditions but nothing is every ideal and kept in a bubble. In fact I wouldn't be surprised if gains are capped and if gains go above the cap you get nothing. Either way I would be very wary about a free lunch.

That being said a 401K rollover is very easy and best done so you can keep control of the funds. Vanguard is nice because of their extremely low fees and fees are really the only thing you can control so why not shoot for a low cost leader. Index funds are great, as the great investor Warren Buffet said "The best way to own common stocks is through an index fund."

I understand the desire to not pay taxes on the rollover but think is it better now or later. In my opinion tax rates have no place to go but up and up a lot so you might be best served to bite the bullet now and get into a ROTH.

[Strick]

For the Roth tax issue, just roll it into a Traditional IRA and then convert a little at a time to the Roth. And even if you can "afford" the conversion taxes (have the money available outside of the 401K) for the $20K all at once, still don't let it push you into the next tax bracket when splitting it over a couple of years would prevent this and save money.

[Charelotte]

You can spread out Your tax liability over 4 years and only pay taxes on 4000 Dollars every year!Now is the best time to convert to a Roth IRA!

[FMF]

Travis --

I deleted Andy's comment because it looked like a sales pitch.

[jeffinwesternwa]

professional help! My 15+ yearss in the business saw folks who knew just(not) enough about investing, asset allocation, risk, taxes and realizing the IRA is PART of your overall investment portfolio....go get a planner you like and trust.

[Mike B CPA]

Just to complicate the matter a little more. Since you were out of work you should try to estimate your tax rate for this year. If it very low and will be lower than follow-on years then this is the year to convert to a Roth.

[Jim]

When you do the rollover make sure they roll it over straight into the new IRA. Tell them specifically that you want them to do a direct rollover to the new account. Otherwise they'll probably just send you a check which is easier for them but a pain for you. If they send you a check and you do something wrong with the new account setup then you owe taxes and potentially a 10% early withdrawal fees. So just have them do it direct so you don't have to worry about that.

I'd roll it over straight into a traditional IRA. There's no big rush to be paying taxes today to avoid taxes 40 years from now. If you are end up in a 0% tax rate due to unemployment or something then converting some amount over to a Roth could be a smart move.

Vanguard is a good choice. But Schwab is fine too. If you want low fees then Vanguard is good. They can set you up with index funds with very little expenses.

[mark]

Vanguard. Takes < 30 minutes of work. You convert to Traditional and then to a Roth. You do not need a professional to help.

Look at the Index Funds FMF recommended in the 3 fund portfolio (Vanguard Total Stock Market (VTSMX); Vanguard Total International Stock Market (VGTSX); Vanguard Total Bond Market (VBMFX)) Allocate the percentages among the 3 based on your risk tolerance.

Unless you are in an ultra high tax bracket, I would convert to Roth (I have converted everything I can right now). understand where you are at in the tax bracket and realistically evaluate if you will ever be in a lower one. Also, I expect taxes to be higher than today (we are at all time lows now) given current considerations in the government (healthcare, Social Security, etc.). This way all your earnings from there on out are TAX FREE. That sounds better than TAX DEFERRED to me. This especially helps since you are young and can benefit from the 30+ years at tax-free and the market is still close to lowest levels in years.

And don't forget if the market goes down more (I hope not), you can characterize back to a Traditional. This too would take <30 minutes of work. Maybe more if you already filed taxes and must amend a return.

[Mr. Bee]

I would second the Vanguard recommendation. If you have money to afford the tax next year, I would really look into Roth IRA conversion too. I converted all of mine to Roth IRA last year. In term of allocation, I personally prefer further breakdown instead of just VTSMX, VGTSX and VBMFX. But that is just my preference, since I prefer to have higher allocation toward Small Cap and Value (for domestic) and slightly higher allocation toward emerging market. I balanced the increase risks with bond allocation in short term treasury, inter-term treasury and TIPS.

Personally, I tried to follow closer toward FundAdvice.com allocation. If you want to stay with Schwab, you can use ETF and sort of follow their recommendation too.

You may want to look at other model portfolios from Lazy Portfolio articles (http://www.marketwatch.com/LazyPortfolio). Either way, I think moving out from 401k to IRA will give me more options and flexibility in term of your investment options.

Good luck.

[D]

I'm confused. Why not either leave it where it is or rollover into your current company's 401k plan? Why would an IRA bet a better solution? (Not talking about the Roth IRA here as that's a different issue).

[Mr. Bee]

@D,

There are several advantage:
- If you roll it over to Rollover IRA (which is really a traditional IRA), you usually have the option to roll it over to your new company 401k later if you view that they offer better investment options.
- But in term of investment options, in most cases, the investment options from 401k are limited. You can only buy funds offered by your company 401k. If they offer the funds that you like, then it is probably make your life easier by rolling it over to your new company 401k, thus having to deal with only one account.

My primary reason for rollover is the range of investment options. And better yet, if you really like ETF, you can do it easily with IRA.

Some people may be able to offer better thoughts and ideas too.

[Jim]

@ mark,

You say taxes are at "all time lows".

From 1947 to 2006 the effective federal income tax rate for median income earners has varied from 6% to 13%. In 2006 we were at 9% and today should be similar. So if you look at effective tax rates as a % of median income (typical for most of us) then we're about in the middle of what taxes have been in the past 60 years.

Top marginal tax rates for the most wealthy have trended down over the decades. But those only impact the top few % of wage earners so they don't apply to the vast majority of us.

[Bad_Brad]

Your options (and the pros and cons of each):

1. Leave the money in the old company's 401(k)
PRO: requires no action, incurs no cost and no tax liability
CON: you are limited by the investments offered by that 401(k)

2. Roll it over into your new employer's 401(k)
PRO: incurs no cost and no tax liability (assuming you don't roll it over to a Roth 401k)
CON: you are limited by the investments offered by your new company's 401(k)

3. Roll it over into a traditional IRA
PRO: you can choose your brokerage and you can choose what you want to invest it in, incurs no tax liability
CON: your new broker will charge you a commission

4. Roll it into a Roth IRA
PRO: you can choose your brokerage and you can choose what you want to invest it in, and while it does incur tax liabiliy, if your income is going to be lower this year because you were out of work a couple months, it might be a good year to take that tax hit since your marginal income tax rate may be lower
CON: your new broker will charge you a commission and there will be a tax liability incurred

[David]

"3. Roll it over into a traditional IRA
PRO: you can choose your brokerage and you can choose what you want to invest it in, incurs no tax liability
CON: your new broker will charge you a commission"

Also:
PRO: You can roll the IRA back into your new employer's 401k at a later date,
if desired, as long as you don't "corrupt" it with contributions (I think),
ask your brokerage about proper steps for 401k->IRA and IRA->401k.
CON: Your IRA is considered a cash account, which means it is limited when
compared to a margin account. A margin account is usually required
to do more exotic stock trades, like shorts. A cash account is
plenty fine, but if you're sophisticated or become more so later,
you may bump into some of these differences of cash vs margin.

I don't recall Schwab charging me a commission to create a Rollover IRA.

I've never contributed money to my Schwab Rollover IRA, but I don't
have any intention of rolling it back to my employer's 401k either,
so I don't know how/if new contributions to the Rollover IRA would
get treated differently if rolled back to 401k.

I do most of my stock trades from my Schwab Rollover IRA, since gains
(in particular, short term gains) are not taxed in that account.

I use other accounts for longer term investments; meaning I try to
discipline myself to avoid selling stocks too soon and creating
short-term capital gains in my taxable account.

I highly recommend you do a direct transfer into a Rollover IRA,
call Schwab or TD-Ameritrade or whomever and they will gladly
hold your hand and take care of it, all for free, I bet. You
don't have to talk to the old 401k plan, the new brokerage
literally does all that (ie, they'll tell the 401k folks to
do the direct transfer to them, you don't want to receive
your 401k monies in any capacity else you'll get dinged by
the taxman). I remember thinking that a 401k->IRA transfer
using Schwab was ridiculously easy, all I had to do was make
a phone call ... give them all my data, and voila, done.

Once you get the 401k->IRA completed, you can do simple
investments or actively trade a few stocks, whatever you
want. You can buy one or more mutual funds, too, and/or
ETFs, or any combination of those.

The advantage is your only 27 and you may not want to do
much trading, so fine, buy an index fund in your IRA and be
done with it. But later, perhaps in your 30s you may want to
trade a stock or two. The beauty is the IRA will grow with you
if/when you expand your investing knowledge and interests. An
IRA is hugely flexible, while a 401k is more of a straitjacket.

My IRA has almost tripled since March 2008, but not my 401k.
Why? Because I can trade stocks in my IRA, whereas my 401k
is limited to about a dozen mutual funds chosen by my employer.

[David]

"I remember thinking that a 401k->IRA transfer
using Schwab was ridiculously easy, all I had to do was make
a phone call ... give them all my data, and voila, done."

Well, that was about 12 years ago, I suspect maybe they'll
mail you some paperwork, too. I forget exactly, but there
was no pain. I honestly don't remember, it was so dang
quick & easy.

"An IRA is hugely flexible, while a 401k is more of a
straitjacket."

Another thing to realize is that if you 401k->IRA and
then decide (perhaps, say, to simplify your retirement
account mgmt) to IRA->401k of your employer, you are
putting on the straitjacket and you can't take your
money out of that 401k until you quit or retire. That
is, you can't just undo that roll into the new 401k.
Once your new 401k gets your IRA money you have effectively
prevented yourself from ever self-investing that money
except for what your employer says you can invest in.

Managing both one IRA *and* one 401k is dead simple, so
you shouldn't think that kind of dual setup is a problem.

[mrm]

If you do a 401(k) rollover into a Roth IRA and have to pay taxes on the full amount, wouldn't they just take the taxes out of the sum in the 401(k)? Doesn't seem like you would actually be out of pocket on anything... Or do I have that wrong?

[David]

@mrm

From what I've been reading, I get the impression that the
the total sum of monies in a Traditional IRA when rolled over
to a Roth IRA (are you talking about the upcoming opportunity
for high income earners to convert their IRAs to a Roth?) will
remain intact during the conversion. The taxes owed because
of this conversion can be spread over 2 (maybe more?) years
or so. That's what makes *that* exciting ... the fact that
you can take your time paying the taxes ...

When converting a 401k to an IRA, I believe the target IRA
must be qualifying IRA ... and I don't think Roth IRAs can
be the target of a 401k rollover. Think about it, taxes
have to be paid somewhere, either going in or coming out, so
401k to a Roth IRA makes no sense to the govt because you
would have avoided paying *all* taxes on that money.

Thus when we speak of transferring 401k monies to an IRA,
by definition and govt decree, we are automatically speaking
about traditional IRAs. (My Schwab IRA account knows it is
from a 401k rollover, so it's called a Rollover IRA, but
that is a subcategory of Traditional IRAs.)

Finally, the preferred process to convert your 401k to an
IRA (or to an existing qualifying IRA) is called a "direct
trustee to trustee transfer" ... if you do it this way, *you*
never physically take possession of money, you never see a
check, you are simply not involved in the transfer *at all*.

I say "preferred" because it is only by the the trustee-to
trustee direct transfer method that you avoid paying taxes
on your 401k transfer to a qualifying IRA.

In other words, you want to avoid this transaction becoming
known as a "distribution" which means you will be taxed on the
money. But if you perform a "transfer" correctly via a
trustee to trustee direct transfer, you don't pay taxes.

So, back to my 1st paragraph, can the taxes for a conversion
of traditional IRA to Roth IRA be subtracted from the monies
during the transfer? Is that your question? I'm not sure
the answer ...

[David]

@mrm

If converting a 401k to a Roth IRA is indeed possible, then I'd be surprised. I'm not an expert by any means, so I don't claim to know what I'm talking about. ;)

[David]

"If converting a 401k to a Roth IRA is indeed possible, then I'd be surprised."

Well, I've been surprised.

I found this website,

http://www.fairmark.com/rothira/eligible.htm

which says,

"For years before 2008, the only thing you could convert to a Roth IRA was a traditional IRA (including a SEP IRA). You couldn't convert directly from a 401k or other employer plan to a Roth IRA. If you were eligible to roll a distribution from an employer plan to a traditional IRA, and also eligible for a conversion from a traditional IRA to a Roth IRA, you could accomplish your goal in two steps: first roll to a traditional IRA, then convert to the Roth IRA. But a direct rollover from an employer plan to a Roth IRA wasn't permitted.

A direct conversion from an employer plan to a Roth IRA is permitted beginning in 2008, but only in circumstances where you would be eligible for both steps in the two-step conversion just described (a rollover to a traditional IRA followed by a conversion of that IRA to a Roth)."

About mrm taxes question, I don't know. Maybe I should
have just stayed in bed this morning. Sigh ... I need
coffee ...

[Steve Keller]

Probably can't add much to the above, except to amplify, but will do so in case it is helpful.

- Don't access the funds unless you need it for food & shelter, or, need it for a can't miss professional education program that is a true investment in your career

- Moving to an IRA is a good move, unless there are investment options in the 401k you won't have access to outside of it (a good stable value fund is worth thinking twice about before moving)

- Roth IRA's are excellent if you can afford the tax hit. Go for it if you can, it is a great long-term investment.

- Handle the rollover yourself if you can, otherwise, just ask the provider for help (such as Schwab, etc.)

- Agree with other posters that index funds are probably best unless you have time and a knack at picking stocks. Maybe 3% of the population have both of these qualities.

Good luck.

[mikeD]

Can you move a rolloverIRA->401K plan of an old employer in which you still have a plan?

I have a separate traditional IRA with non-deductible monies that I would like to convert to a ROTH in 2010 (high earner problem).

Problem is that my rollover IRA is great and would be considered when calculating taxes. I figure I can move the rollover IRA back into an old employer's 401K which isn't considered for conversion taxes and then in years later - roll it back out into a self directed IRA account.

Is this a way around it or not?