Transfers vs Rollovers: What's the Best Way to Move Retirement Funds?
- By Julie Stewart
- November 16, 2016
Clients nearing retirement or changing jobs have decisions to make on employer sponsored retirement funds. One of the most important considerations is whether funds should be kept where they are or moved via Transfer or Rollover to a new plan type.
But how do we determine the best option and the correct method for moving those funds to ensure protection from taxation and penalties?
Let’s take a closer look:
**Changing Employers – moving 401k or other Plan Type**
Generally speaking, when changing employment or retiring it is often seen as a negative to keep funds in the former employer sponsored plan because they no longer have vested interest in monitoring and there are often better options outside the plan type.
Moving the funds gives your client more control and decision-making power as to how best to invest and where. If held in the former plan, they continue to pay ongoing fees and have little access to the plan administrator. In fact, in some instances, ex-employers may force a roll over without even notifying the former employee and roll them into an IRA.
At the end of the day, the ex-employer wants to avoid having to manage the fund or pay the associated fees.
So what are the options and how do they work?
If your client takes up a new job that has the same program, in this instance a 401k, they can execute a Transfer from one plan to the next. Transfers are often known as trustee-to-trustee or custodian-to-custodian. Transfers can only occur between two identical plan types: 401k to 401k, Traditional IRA to Traditional IRA, 403b to 403b; I think you get the idea.
Clients not wanting to fiddle with researching investment options or connecting with a broker may find this option the most convenient and simple, avoiding taxes and early withdrawal penalties.
IF the new employer does not have a retirement plan or offers a different plan type such as a Profit Sharing plan, Transfers would not be allowed.
This is where a Rollover comes in.
There are two types of rollovers:
### 1) Direct Rollover
Money is moved directly from one retirement account to another. No money is withheld for taxes. Funds roll from one plan type to a different plan type such as 401k to IRA.
2) Indirect Rollover
Funds are cashed out, mailed to the account holder in their name and deposited to a new plan within 60 days. In this case, 10-20% of the funds are withheld for taxes because the account holder took full possession of the funds.
If funds are not moved to a new plan within the 60 day window, they will become fully taxable.
To break this down even further, a Direct Rollover can be executed 2 ways:
1) Direct from one account type to the next
2) The check can be made payable to the new, issuing authority “For The Benefit of” your clients
This is still considered a direct rollover because the check is not made out to the client but rather to the institution or insurance carriers FBO the client and thus the check cannot be cashed or deposited by the client. It would look like “Great American Insurance Company FBO Jane Doe.”
Some plans require execution in this manner while others give options. It is always best for the client to contact the plan administrator to inquire.
Both options avoid tax withholding because the client never takes possession of the funds.
The indirect rollover presents some interesting challenges.
1) Indirect rollovers require tax to be withheld when the check is made payable to the client. Although the client has 60 days to deposit to an IRA, anything could happen, right? They could spend it or lose it through other short term investments.
2) In order for it to be considered a full rollover, the client must come up with the 20% withheld to deposit into the new IRA/Account Type. If they are unable to come up with the full amount in 60 days, they will owe income tax plus penalties on that amount.
3) As of 2015, individuals are now limited to only one indirect rollover per 12-month period. IF this limit is exceeded, the amount must be included in gross income and there may be a 10% early withdrawal tax incurred if the distribution is taken prior to age 59.5. This only affects indirect rollovers and there is no limit on direct rollovers.
As you can see, it is important to understand the difference between the ways in which retirement funds can be moved between accounts. A misstep could result in taxation or penalty to the client, thereby lessening what they worked so hard to accumulate.
There is no one-size-fits-all investment strategy. Some may like the hands off approach while others may prefer taking control of the funds themselves.
As long as the guidelines are followed, either way can accomplish the same end-goal.
If you have more questions or would like help implementing this with your own clients, contact us today.