When to do a retirement-plan rollover, and when to avoid it

Updated January 9, 2024 

When it comes to retirement planning, your client might ask if they should roll over their retirement plans. This financial strategy often involves transferring funds from one retirement account to another, usually from a 401(k) plan to an Individual Retirement Account or IRA. Account holders can also choose to roll over their 401(k) plan from their old employer to the 401(k) of their new employer.  

While a retirement plan rollover does offer certain advantages, it is not always the best option. In this article, we delve into the circumstances in which a retirement plan rollover may be beneficial for advisor’s clients or individual investors, and when it might be better to avoid it.  

By understanding the factors involved, investors and advisors alike can make informed decisions about their retirement savings without unnecessary risks or expenses. 

What is a retirement rollover? 

A retirement rollover occurs when you withdraw cash or other assets from one eligible retirement plan and contribute a portion or all of it to another eligible retirement plan. This rollover should be done within 60 days.  

The rollover transaction itself is tax-free, unless the rollover is to a Roth IRA or a designated Roth account from another type of plan or account.  

Even if the transaction is tax-free, it must still be reported on the account owner’s federal tax return. The account owner must include the taxable amount of a distribution that isn’t rolled over as income in the year of the distribution. 

When is it better to roll over a 401(k) plan? 

There are at least five cases where it may be advisable to have your clients roll over their 401(k) plans:

1. For greater portfolio diversification 

The investment options available to 401(k) account holders can be limited. If account holders don’t have as many investment options, this could lead to them losing out on potential bigger gains and/or having portfolios that are less protected against risk.  

Rolling the funds from a 401(k) plan into an IRA that offers more diversified investments can fix this problem. By doing the rollover, you or your clients can have access to a broader range of investments like REITs, managed accounts, individual stocks and bonds, mutual funds, annuities, or any combination of these.  

2. For greater control over retirement funds 

With a 401(k) plan, the qualified plan trustee assigned by the account holder’s employer owns the assets. These assets could sometimes have “blackout periods” during which account access is restricted.  

What is a 401(k) blackout period? This is a length of time when plan participants cannot make any changes, such as asset allocations, loans, or withdrawals from their accounts. The blackout period can be inconvenient, especially for the account holders who may need emergency funds.  

The reason for this is that the employer who maintains the 401(k) plan may be making updates to the plan or modifying certain aspects of the plan. Blackout periods can last from a few days to several weeks.

When you roll over to an IRA, there are no such blackout periods. Account holders have full control of the funds within them.   

3. For more flexibility in naming beneficiaries 

Compared to IRAs, 401(k) plans do not allow plan owners to name a trust as the beneficiary, nor name multiple and contingent beneficiaries. Some IRAs custodians allow flexibility to this extent, but it’s best to check beforehand.  

Other IRAs may even allow account holders to impose restrictions on beneficiaries – all these features are not usually available to 401(k)s.  

4. For avoiding the Required Minimum Distributions 

If you roll over your 401(k) into a Roth IRA, the account owner is no longer obligated to take Required Minimum Distributions (RMDs).  

Meanwhile, 401(k) plans and traditional IRAs must begin taking the RMDs by April 1st of the year when they reach a specific age.  

In this case, letting the RMDs run their course can be disadvantageous for those seeking to grow their retirement savings while they work past retirement age. Instead of leaving the funds untouched and allowing them to grow tax-free, these must be withdrawn to avoid penalties.   

5. To clean up “financial clutter” 

Because some clients can switch jobs several times over the course of their careers, they may also accumulate as many different 401(k) accounts. Rolling over several 401(k) plans into the plan of their current employer or into another account can simplify the paperwork.  
 

Doing so can also ensure that your clients do not forget or “misplace” any of their retirement accounts.  

Consolidating many separate retirement accounts can also simplify tracking and taking RMDs – your client only has to take RMDs from one account, not several.  

When should you not roll over a 401(k) plan? 

There are at least five reasons not to roll over funds from a 401(k) plan:  

1. The account holder is planning on early retirement 

In most 401(k) plans, account owners can make penalty-free withdrawals after they’ve hit age 55 for early retirees.  

If the account owner rolled over the funds of their 401(k) into an IRA, they must wait until age 59 ½ to avoid paying a 10% penalty on the withdrawal. 

2. To avoid a temporary ban on making contributions 

Some employers who sponsor their employees’ 401(k) plans may place a temporary ban on contributions. This is usually imposed on employees who made withdrawals from the fund (or a rollover) before exiting the company.  

Should you or your client intend to do this, crunch the numbers first to see if the contribution ban will make a significant dent on retirement savings.  

3. When the account owner is prevented from making IRA loans 

A 401(k) usually allows employees to take out a loan from their IRAs, but only current and active employees get this benefit.  

Meanwhile, employees who depart the company will have to pay their outstanding loans in full and are not usually allowed to make any loans from IRAs. So, if the account owner needs emergency funds, a rollover is not advisable.   

4. If the rollover results in increased fees 

In some instances, IRA investors may have to pay more than they usually would, compared to employer-sponsored plans like the 401(k).  

One possible reason is that the range of more complex investment options can be more costly than 401(k) investments. Financial planners should help investors identify what costs could result from the rollover, and if there are any benefits to justify these costs. 

5. When the investment in your 401(k) is company stock 

If you have any current or former employer’s company stock as part of your investment in your 401(k), it’s best not to roll over this part of the account. You could have Net Unrealized Appreciation (NUA). The NUA is the difference between the value of the stock when it was placed into the account and its value when you take the distribution.  

The account holder only gets taxed on the NUA when they choose to take a distribution of the stock and prefer not to defer the tax on the NUA. Should they choose to pay the tax on the NUA now, this becomes their tax basis on the company stock. So, when they sell the stock now or in the future, the taxable gain is the increase of this amount. Any increase in value in excess of the NUA is considered a capital gain.  

The account holder can choose to sell the stock and pay capital gains tax. Doing this means that the over one year holding period requirement does not apply if the tax on the NUA is not deferred when the stock is distributed.  

It’s a better strategy than rolling over the stock to a traditional IRA. Rolling over the stock means that the account owner doesn’t pay tax on the NUA now. However, all the stock’s value along with any appreciation will be considered ordinary income when the distributions are taken.  

Here’s a short video that lists the pros and cons of making a retirement plan rollover from a 401(k) plan to an IRA:   

The Rules for a 401(k) rollover 

The main rule for 401(k) rollover is known as the 60-day rollover rule. This rule requires that the account holder deposits all or part of the funds from a retirement account into another IRA account, 401(k) plan, or other qualified account within a 60-day period.  

If this rule is not fulfilled, then the funds withdrawn will be subject to income taxes and a penalty for early withdrawal if the account holder is below 59½ years old. Understanding the implications of this rule is crucial, especially if the rollover is an indirect one.  

What is an indirect rollover?  

This is a rollover where funds from one retirement account are paid directly to the account holder, then the funds are reinvested in another retirement account. The money can also be reinvested into the same account to be considered an indirect rollover.  

This is markedly different from a direct rollover wherein the funds are simply transferred from one retirement account to another.  

What is the 5-year rule on a 401(k) rollover?  

The 5-year rule means that the account holder cannot touch the earnings of a Roth IRA unless the account is at least five years old. If in 2023, an account holder rolls over another retirement account into a Roth IRA, they should not make any withdrawals at least until 2028.  

Under this rule, converting an IRA to a Roth requires waiting five years before withdrawing any contributions or earnings, regardless of age. 

If the retirement account rolled over is the first Roth IRA opened by the account owner, or if it’s the first Roth IRA opened less than five years before, withdrawn earnings will be subject to income tax.  

One advantage of this rule is that even if a Roth IRA set up more than five years ago is closed, it will still count toward the 5-year rule. The 5-year rule applies even if the account holder is older than the minimum age of 59½.  

Rollover rules for beneficiaries 

When it comes to 401(k) rollovers, there are rules for beneficiaries if assets are inherited. If a spouse or a relative other than the account owner’s spouse is named as a beneficiary, they can inherit and accept the funds tax-free.  

Special rules apply to beneficiaries of a retirement account who are not the account holder’s spouse: 

• If an account holder dies and chooses a beneficiary other than their spouse, this is called a non-spouse beneficiary rollover. In a non-spouse beneficiary rollover, the beneficiary usually receives the money as a lump sum. 
• If a beneficiary inherits a lump-sum from someone else’s retirement account, taxes will have to be paid on it. 
• Rolling over assets from one IRA to another IRA via rollover or transfer can help the beneficiary save on taxes. 

Do I have to pay taxes on a rollover?  

In most cases, no, there are no taxes to pay in a rollover. It becomes taxable if the rollover is from a non-Roth account to a Roth account. If funds are received from a distribution that is not rolled over into the new account, the taxable amount of that distribution must be declared as income for the year.  

There are cases when a retirement rollover is desirable. There are also cases when doing so can be less beneficial, or even detrimental, to the account owner. The key is to identify and list all the possible pros and cons, then compare them against the account owner’s financial objectives.  

If doing a retirement plan rollover aligns with their objectives, then the client can certainly go ahead with that. But if such a move could prove detrimental, then a better strategy would be to put off the rollover or opt for a direct transfer instead.  

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