My Experience with a 401K Rollover

I recently changed jobs. And as part of the transition, I decided to rollover my 401k from my old employer to a rollover IRA. My 401k was with Fidelity, and my plan was to move it over to an existing IRA at Vanguard. In this article, I want to walk through the reasons I made that decision, how the process works, and things to watch out for if you decide to rollover a 401k.

Why Rollover a 401k

For me the decision was simple. I prefer the low-cost Vanguard funds over Fidelity funds. Fidelity does offer some really low-cost index funds, but Vanguard offers a wider variety of funds with rock-bottom expense ratios.

In addition, by moving funds over to Vanguard, I can qualify for even lower fees and more exclusive customer service. In addition to a standard account, Vanguard offers what it calls Voyager, Voyager Select and Flagship accounts. To qualify, however, you must have minimum account balances. By moving more money over to Vanguard, it’s easier to qualify for a higher level of service. Here are the requirements of each account type and what they offer:

Voyager Services®

Investors with $50,000 to $500,000 in Vanguard mutual funds and ETFs qualify for Voyager, which provides the following benefit

• Commission-free Vanguard ETF® trades and reduced commissions for stocks and non-Vanguard ETFs. No account service fees.*
• A detailed financial plan at a discount. A Certified Financial Planner™ professional from Vanguard will analyze your investments and saving strategy.

Voyager Select Services®

Investors with $500,000 to $1 million in Vanguard mutual funds and ETFs qualify for Voyager Select, which provides the following benefits:

• Sophisticated support from representatives who can answer your more complex investment questions.
• Commission-free Vanguard ETF trades and additional reductions on brokerage costs. No account service fees.*
• A complimentary financial plan by a CFP professional from Vanguard that analyzes your investments and saving strategy.

There are of course other considerations to make in deciding whether to rollover a 401k to an IRA. But the above two reasons were what prompted my decision.

Flagship Services™

Investors with $1 million or more in Vanguard mutual funds and ETFs qualify for a Flagship account, which offers the following benefits:

• Exceptional service from a personal representative who is your guide to all that Vanguard offers.
• “Ask a CFP® professional” program for guidance on particular financial issues as they arise. For long-range planning, a complimentary financial plan by a CFP professional that analyzes your investments and saving strategy.
• Exclusive access to select Vanguard mutual funds that are closed to other investors.
• Commission-free Vanguard ETF trades, 25 commission-free trades for stocks, options, and non-Vanguard ETFs and transaction-fee funds, and significant savings on other brokerage costs. No account service fees.*

The Process was Dead Simple

This part really surprised me. As I thought about how to start the process, I decided to call Vanguard to see what information about my Rollover IRA I would need to give Fidelity. I already had the IRA account from a rollover six years ago, but had long forgotten the actual steps needed to get the process moving.

My call was routed to a department that does nothing but handle rollovers. The rep walked me through the process and then offered to call Fidelity with me. So he dialed up Fidelity and did all the talking. I guess Vanguard really wanted my money!

We did hit one snag. According to the Fidelity representative, my old employer still had my status as an active employee. So I had to call my employer to get my status changed. That took a few days, and then the three of us got back on the phone to complete the rollover. It took all of five minutes.

You can check out an even more detailed description of the 401k rollover process here.

Watch out for the Distribution Method

One thing you need to watch is how the funds are distributed. You don’t want the check written out to you or the IRS will treat it as a distribution, not a rollover. Of course, the reps and Vanguard and Fidelity know all these rules and can make sure your withdrawal from your 401k is treated as a rollover. In my case, Fidelity will send me the check made out to Vanguard for my benefit. I’ll then need to mail the checks to Vanguard, with my Rollover IRA account number written on the check.

Once that’s complete, I’ll be able to invest the money in any Vanguard fund or ETF I want.

The Potential Tax Consequences on Retirement Plan Distributions

Apart from my own rollover, and according to the IRS, there are three permitted methods for doing a rollover of any kind:

• Direct rollover: Ask your plan administrator to make payment directly to the retirement plan or IRA you’re doing the rollover into. You’ll be given specific instructions, but most likely the administrator will issue a check for the amount of the distribution made payable to your new account. Since it is a direct rollover, no taxes will be withheld from the amount of the check. Upon receipt, you will then forward the check to the new retirement plan.
• Trustee-to-trustee transfer: This is by far the easiest transfer method because you never take custody of either the check or the funds. In this type of transfer, you ask the trustee holding your current plan to make a payment directly from your plan to the new plan, usually by electronic transfer. Once again, no taxes are required to be withheld on this type of transfer.
• 60-day rollover: Under this method, your current plan trustee issues a check to you personally. Once you receive funds, you can deposit the entire amount or just a portion of it into the new plan. Any amount of the distribution that is not deposited into a qualified plan within 60 days of issuance will become taxable. It will be subject to ordinary income tax, plus a 10% penalty if you are under 59 ½.

As already mentioned, there is no tax withholding requirement using the first two transfer methods. However, if you use the 60-day rollover, the IRS requires withholding of 10% of the planned distribution in the case of an IRA, and 20% for an employer-sponsored plan.

The Tax Withholding Complication

Unless you’re planning to actually liquidate your plan distribution, you should always go with either the direct rollover method or the trustee-to-trustee method. In my opinion, the trustee-to-trustee method is the simplest, since the funds are transferred directly and immediately from one plan to another. There’s no possibility of human error, that might cause you to miss the 60-day deadline.

But if for any reason you have taxes withheld from your transfer, there’s a major complication. The amount of tax withheld from the distribution means that less than 100% is available to be transferred to the new plan.

Let’s say you transfer $50,000 from an employer-sponsored plan to an IRA. The plan administrator is required to withhold 20%, or $10,000.

For tax purposes, the full $50,000 will be taxable. But you will only receive $40,000, due to the withholding.

If you’re going to take the distribution and keep it, there’s no problem. The taxes for the distribution will already have been withheld.

However, if you ultimately plan the roll the funds over into a new plan, you’ll only have $40,000 distributed to make the transfer. That will leave you with one of two choices:

• Rollover the net $40,000 received from the distribution, and supplement with $10,000 from your non-retirement assets. You’ll be able to claim a refund for the tax withheld if you complete the rollover within 60 days of distribution.
• Complete the rollover with just $40,000. Ironically, the $10,000 in tax withholding will become a taxable distribution. However, you should be able to receive a refund of most of the withholding since the actual amount of the taxable distribution will be much lower than the total amount.

This is why I recommend doing the trustee-to-trustee transfer. It completely eliminates the possibility of either situation happening.

WARNING: Watch Out for 401(k) Loans

No discussion of 401(k) plan rollovers would be complete without considering the implications of IRS 401(k) loan provisions.

Millions of people have loans through their 401(k) plans. You can borrow up to 50% of the value of your plan, up to a maximum of $50,000. The loan must generally be repaid within five years. However, if your employment ends and you still have a 401(k) loan outstanding, there may be tax consequences.

Under a typical 401(k) plan loan provision, the employer may allow you up to 60 days from termination to repay the loan, though some may extend that to 90 days. But if you fail to make repayment within the required timeframe, the plan administrator will declare the unpaid loan balance to be a distribution.

Once again, the distribution that will be added to your regular income, subject to ordinary income tax, plus the 10% early distribution penalty if you’re under 59 ½.

The 10% Early Distribution Penalty

I’ve mentioned this penalty a couple of times, so let’s discuss it in some detail. Under IRS rules, retirement funds are eligible for distribution beginning at age 59 ½. If you take distributions before reaching that age, which can certainly happen in the case of a distribution or an unsuccessfully completed rollover, you’ll pay a penalty equal to 10% of the amount of the distribution, over and above the ordinary income tax owed.

But there are IRS exceptions to the early distribution penalty. It can be waived under any of the following circumstances:

• Automatic enrollment – permissive withdrawals from a plan with auto-enrollment features
• Death of the plan owner
• Disability – total and permanent disability of the participant/IRA owner
• Domestic relations – an alternate payee under a Qualified Domestic Relations Order (QDRO).
• A series of substantially equal payments
• Medical – amount of unreimbursed medical expenses (>7.5% AGI; after 2012, 10% if under age 65)
• Military – certain distributions to qualified military reservists called to active duty
• Separation from service – the employee separates from service during or after the year the employee reaches age 55 (age 50 for public safety employees of a state, or political subdivision of a state, in a governmental defined benefit plan)

Unless you qualify for one of these penalty exemptions, you should avoid taking direct distribution of your 401(k) plan funds. Also remember that the exceptions apply only to the 10% penalty. You will still owe ordinary income tax on the amount distributed. Taxwise, a 401(k) rollover is by far your best strategy.

Who Should Do a 401(k) Rollover?

We should really start with why you shouldn’t do a 401(k) rollover, since the list is shorter.

Basically, if you’re happy with the old employer plan, you should consider keeping your money there. You can even get help managing the plan through a service called blooom. It’s a robo-advisor designed specifically for employer-sponsored retirement plans. It can be added to virtually any employer plan, as it does not require administrative approval. You pay a small fee to Blooom and it manages your retirement plan, including moving your money into lower-cost fund options. It’s the perfect service for anyone who isn’t entirely comfortable managing their own retirement plan.

However, if you’re not satisfied with your current plan, either because options are limited or fees are too high, a rollover has to be considered.

Many employers will allow you to roll your old 401(k) plan into their plan. Check with your new employer and see if this is possible. If upon evaluation you feel that the new plan is better than the old one, you can do the rollover into the new plan.

Otherwise, you can do a rollover from a 401(k) plan into an IRA. This type of rollover is best if you’re comfortable with self-directed investing. In my case, I feel comfortable choosing my own investments in Vanguard. But even if you don’t, you can do a rollover from a 401(k) plan into an IRA held with a robo-advisor. They’re automated online investment platforms, that will design and manage your portfolio for a very small annual fee.

Advantages and Disadvantages of Doing a 401(k) Rollover

We’ve already discussed some of the benefits of doing a 401(k) rollover from an old employer plan to a new one. In this section, let’s focus on the advantages and disadvantages of doing a 401(k) rollover into an IRA.

Final Thoughts on 401(k) Rollovers

As you can see from the advantages and disadvantages above, it will be to your benefit to do a 401(k) rollover in most situations. Just be careful to do it right. Because of the tax consequences, and the often large amounts of money involved, an incorrect rollover can create a very large tax liability.

The best advice is to rely heavily on the new plan trustee. They can handle all the details, including making contact with your current plan administrator and arranging a smooth, stress-free transfer.